The Baldwin & Lyons Insurance-Linked Securities (ILS) Fund dropped 4.37% in March in the aftermath of the Japanese earthquake and tsunami according to their latest market report, published yesterday. The fund is a good indicator of the price adjustment and market nerves which have dominated since the disaster in Japan on the 11th March. The fund is down 2.85% year to date, however since it was launched it has risen 25.52% demonstrating the high yields achievable with ILS.
Baldwin & Lyons say that the market appears to be absorbing losses from the Japanese disaster in an orderly manner and reacting in a way which was to be expected, as this is just the kind of event ILS and catastrophe bonds were designed to address. They make a great point regarding the value an issuer gets from a cat bond, something much of the mainstream press have neglected to mention since the disaster. They say:
It is important to note, however, that from an issuer’s perspective, the value of a catastrophe bond is not limited to its potential for default. The recent Bloomberg article, “‘Hole-in-One’ cat bonds are top asset eluding quake’s grasp,” largely missed this point.
ILS serves as a substitute for equity in an insurer’s capital structure. For those companies with established programs, this capital is now much more valuable as a result of the earthquake. It is providing assurance to customers, regulators and rating agencies that the insurer has the necessary capacity to fund its contingent obligations, even in extreme scenarios.
Baldwin & Lyons say that it appears that only a single cat bond will default due to the disaster, we assume they must be thinking of Muteki Ltd. which appears most at risk of default right now. However they note that:
Investors are taking mark-to-market losses on numerous positions. To the extent that this reflects an increase in the price of risk, it should prove beneficial to ILS investors over the long term.
The report discusses the differences between indemnity and parametric transactions and the relative benefits (or drawbacks) of each. In Japan, the majority of earthquake bonds were parametric based, meaning they could be safe from default as the earthquake was a significant distance from Tokyo where most of the deals are focused. Baldwin & Lyons say that if no parametric deals trigger, but an indemnity cat bond does:
Insurers will become much more basis-risk averse, augmenting the demand for indemnity protection. We believe this is a positive development for the ILS market as long as the consideration offered to assume indemnity exposure adequately compensates investors for the additional risk.
They say that the secondary market has begun to provide clear signals as to the expected loss on catastrophe bonds which have been exposed to the Tohoku earthquake:
Bid-ask spreads, which widened considerably in the immediate aftermath of the event, have stabilized as information becomes more available. In the one case where default appears to be imminent, the bond’s price has dropped to $1, even though the loss has yet to be officially reported. The valuations on a few second event bonds have also dropped since these appear to have been “activated” by the quake and may now respond on a first event basis. Market values are also factoring in the possibility of triggering extension provisions. In an extension event, a bond’s maturity is extended, without exposure to prospective losses and at a lower spread, in order to provide time for losses to develop.
Even bonds not directly impacted by the earthquake have experienced a shift in valuation due to a heightened awareness of risk. The Tohoku quake occurred on a fault that had previously been considered relatively benign. Experts must now recalibrate their models to account for this newly revealed exposure. In addition, according to AIR, the quake has loaded stress onto well-known fault lines near Tokyo, possibly exacerbating the potential for another major quake.
On the recent reinsurance renewals and the prospects for a harder reinsurance market and how it could impact cat bonds, they say:
Price hardening causes the value of outstanding bonds to drop. This is analogous to how corporate bonds behave in a rising interest rate environment. It remains to be seen whether this rise is sustainable, since the reinsurance industry remains abundantly capitalized, but we expect it to create opportunities in the short term.
So Baldwin & Lyons seem to maintain a positive outlook for the catastrophe bond and insurance-linked securities market, despite the potential for losses from events in Japan. This pragmatic position is being adopted by many others within the market and most sources we speak with say once the loss is understood and investors have time to adjust positions we should see the market spring back into life and issuance return to the market again.