As pricing decouples, the catastrophe bond market grows up: Guy Carpenter

Reinsurance broker Guy Carpenter’s capital markets and insurance-linked securities specialist arm GC Securities has published an update on the catastrophe bond market at the end of Q1 2013. The report discusses the growing acceptance of catastrophe bonds and catastrophe risk in general as an investment among capital markets and institutional investors and says that the market in catastrophe risk is showing evidence of growing up.

The first-quarter of 2013 was not a banner year for issuance of new catastrophe bonds, with GC Securities only logging two non-life ILS deals totalling just $520m of issuance. Our Deal Directory also contains Aetna’s health insurance ILS and a private cat bond meaning that our recorded issuance figure for Q1 is higher at $731m.

GC Securities says in the report that this low-level of issuance does not tell the whole story and is deceiving. Contrary to the story told by Q1, GC Securities believes that activity in the capital markets area of reinsurance and the influence of non-traditional capacity has never been higher. GC Securities makes a very good point that the term ‘non-traditional’ is itself becoming obsolete as third-party backed reinsurance capacity is now growing to a very meaningful portion of the overall market.

The report says that more conservative institutional managers of assets are starting to access the catastrophe risk investment market. These large investors are in charge of trillions of dollars and have now largely accepted catastrophe risk as a component of a mainstream investment strategy.

The motivations are changing too, according to GC Securities, the chase for yield in a low-interest rate environment is not the only driver anymore and it expects this capital to be more stable and, after spending time evaluating the asset class, is likely to stick around looking for stable returns.

“Spreads in the catastrophe market tightened significantly during the first quarter of the year, driven by strong demand from investors seeking additional deployment opportunities,” commented Cory Anger, Global Head of Insurance-Linked Securities (ILS) Structuring at GC Securities. “Although the low interest rate environment has made the catastrophe market more attractive to institutional capital, it is not the primary driver of inflows. Rather, we are seeing significant demands in part because of the ‘decoupling’ of pricing between the traditional reinsurance and capital markets. While traditional reinsurance has capital constraints for peak risk zones, such as Florida, the cat bond market may be able to offer capacity at a lower price point because it does not have the same capital costs.”

The report says that this institutional capital has been waiting to see how the market reacts during a live catastrophe event and whether secondary trading is orderly under these circumstances. According to GC Securities, the examples set by hurricanes Irene in 2011 and Sandy in 2012 have provided evidence that this is the case and given investment managers more confidence.

GC Securities says that the catastrophe risk, and catastrophe bond, market has grown up and is now ready to transition from adolescence to young adulthood. It’s still early days for this market, which has only existed since the mid to late 1990’s, but Guy Carpenter is bullish on the markets prospects to continue growing up in years to come.

The impact that this maturation, or growing up, of the catastrophe risk investment market and cat bonds as an asset class has been dramatic, the broker says. Pricing on recent transactions has decreased by as much as 50% year on year, quite astonishing and testament to the appetite to invest in cat risk.

GC Securities says that the largest price decreases have been seen on peak U.S. risks, such as Florida hurricane, which are perils that usually carry a significant profit margin for traditional reinsurers.

The report says that it is unfair to call the spread tightening we’ve seen in the first quarter as a ‘bubble’ or to assume that institutional investors are willing to invest in catastrophe risk at rates that are too low. Rather, GC Securities says, the reason for this is that traditional reinsurers have a different (higher) cost of capital for these peak risks, meaning that third-party capital can afford to deploy into these peak peril regions more cheaply.

GC Securities says that institutional money can, on a sound basis, deploy capital into perils such as U.S. hurricane at significantly lower prices than traditional reinsurance and on a sustained basis. That statement certainly won’t be music to many traditional reinsurers’ ears but is aligned with the feedback we’ve had from a number of large asset managers who are now deploying capital into cat bonds and ILS.

This dynamic, where a class of investors have now entered the market who are willing and able to deploy capital at lower cost than traditional sources of reinsurance, is the decoupling of pricing that had been predicted for some time, says GC Securities. Investors are no longer uncomfortable breaking from the price levels that the traditional market set, provided the rationale for doing so is sound.

The investor base continues to broaden, with GC Securities noticing two emerging trends from the end of 2012 and into 2013. Firstly, small to mid-sized ILS investment managers are beginning to generate new investment mandates from institutional money, largely pension funds and this is increasing smaller ILS specialists capabilities with respect to the line sizes they can participate on.

Secondly, and perhaps more importantly, there are a growing number of large institutional sources of capital which are beginning to access the 144A catastrophe bond market directly now they are becoming comfortable with the asset class and catastrophe risk investments. These include life insurers, endowments, asset managers, multi-strategy hedge funds and other institutions who want access to liquid catastrophe risk on a stable and longer term basis, not as opportunistic as many of these investors used to be.

GC Securities says that some of these large institutional investors are so big that they are able to participate on deals in a meaningful way, sometimes deploying more capital into a transaction than the largest dedicated ILS managers do. That’s a very interesting insight as it suggests that the dominance of a number of large ILS specialist investment funds on new cat bonds may become a thing of the past if these large institutional buyers continue to deploy significant capital into the space.

The report says that the increase in capital and investor breadth is a good thing for the cat bond and cat risk investment markets as it increases capacity without leaving the market susceptible to reckless deployments of capital into deals with poor terms. Capacity is expanding because the markets sophistication and attention to transaction mechanics is increasing, not decreasing, says GC Securities.

On the recent and upcoming reinsurance renewals, GC Securities says that institutional capital has had a dramatic dampening effect on rates, both in April and is influencing the upcoming June and July renewals already.

GC Securities is bullish on the prospects for the market through the rest of 2013, saying that it is possible that catastrophe bond issuance could reach an all time high, exceeding the $7 billion of issuance it recorded in 2007, if these market dynamics continue through the remainder of the year.

“The catastrophe risk market is demonstrating its readiness to transition from ‘adolescence’ to ‘young adulthood,” said Chi Hum, Global Head of Distribution for ILS at GC Securities. “We are seeing that conservative institutional asset managers have largely accepted catastrophe risk as a component of a mainstream investment strategy. The broadening investor base is certainly a positive trend for the long term, as it increases the level of available capacity without leaving the market susceptible to reckless capital. Looking forward to the balance of 2013, capacity from the alternative markets has never been more competitive.”

This is testament to a market that is growing up rapidly and it appears that the decoupling of pricing is stimulating further growth and maturation of the market. As with any market which is still in its relative youth though the future is not yet certain and predicting exactly how impactful the influx of institutional money is going to be on traditional reinsurance is very hard. The future for the catastrophe risk investment market does look bright, as evidenced by continuing strong cat bond issuance in recent months, it’s going to be fascinating to watch how the reinsurance market reacts to this at the upcoming mid-year renewals.

You can access the full report via the Guy Carpenter GCCapitalIdeas blog here.