Cat bonds are set to buck the trend elsewhere in the ILS market, with a strong issuance pipeline for Q4 2020 and Q1 2021. This is according to Des Potter, managing director ILS origination and structuring at GC Securities, part of Guy Carpenter, in an interview with Artemis.
Encouraged by the firming of reinsurance and retrocession rates, he thought cat bonds would help fill the capacity gap in the retrocession market, where the availability of collateralised aggregate protection has dropped off significantly since 2019.
“We’re seeing a shift away from collateralised reinsurance into the bond market to try to reduce some of the pressure that may exist because investors in the collateralised reinsurance space are pulling back. We’re expecting to see quite an active Q4 in terms of cat bond issuance.”
Over the past two to three years, the collateralised market has gone from c.60% of the retro markets to around 50%, with the reduction in ILS capacity a continuing trend, explained Potter.
The capacity crunch in the retro market has been exacerbated by the collapse and run-off of Markel CatCo and trapped collateral following major events over the past three years, with loss creep also an issue.
More questions than answers
Looking ahead to January 1 2021, the uncertainty surrounding COVID-related losses is adding a further layer of frustration for institutional investors. But it is not the only issue, said Potter.
“Pre COVID the collateralised reinsurance component of ILS as an asset class was on the watch list for certain investors,” he explained. “That’s mainly due to historic performance and the surprise contribution of some of the recent losses, as well as general concerns about the impact of climate change.”
“Most investors are in this asset class because of the low correlation features of property cat and they certainly didn’t expect to incur losses from a global pandemic,” he continued.
“I do generally believe that most ILS funds want to honour valid loss claims and they do understand the difficulties of ceding reinsurers in setting the loss reserves over COVID 19.”
While the uncertainty of the COVID-related losses and sidepocket reserving is a challenge, investor appetite for the ILS asset class will largely rest upon whether or not principal is impaired come 2021. “If it is impaired, it will have a material impact on the availability of capacity to support aggregate excess of loss and quota share contracts, despite the attraction of underwriting conditions as forecast for 2021.”
At this stage there are more questions than answers. “It’s difficult for the reinsurers because there is so much uncertainty and legislation,” said Potter. “There have not actually been that many loss notifications to reinsurers. So it’s very difficult for them to set the loss reserves because they are worried about where the loss could develop ultimately.”
“The fundamental advantages of property cat as an asset class will remain in terms of its low correlation to financial markets and we will see most pension consultants advocating for the asset class,” he added. “But lessons do need to be learned from recent experience on the clarity of coverage and ensuring investors are getting an adequate risk-adjusted return for the risks they’re taking on.”
Hardening continues, but for how long?
There will continue to be upward momentum of rates in 2021, with particular volatility in the retro space, he predicted, although how long these conditions last is uncertain. It is for this reason that he is less bullish about the prospects for a Class of 2020 start-up reinsurers.
“I’m not sure we will see a Class of 2020 in the same way we saw a Class of 2001 and 2005,” said Potter. “There have been a lot of management teams encouraged by ambitious investment bankers that have pursued start-up ventures. But as private equity investors undertake their due diligence of these business plans, the start-up offering has proved to be less compelling than investing in an established platform or perhaps supporting a management buy-in.”
“There is a question about the longevity of the current market conditions and the ability to access good business and deploy capital efficiently,” he continued.
“There have been a couple of ILS funds seeking to gain traction, and they have got some very reputable management teams. But they are facing the same headwinds and need to convince the investor base now is a good time to come into the asset class and to demonstrate that the lessons of the prior years have been learned and the propensity of a surprise loss has been mitigated.”
Potter noted that ILS funds are having some success attracting capital into their cat bond strategies, offering further indications the supply-demand dynamics are currently more favourable in this space.
“It’s going to be an active Q4 and there’s a decent amount of maturity happening in Q1 as well, so there will be more capital flowing back into funds,” he said. “A lot of institutional investors do deploy their capital after January 1 so the cat bonds strategy will remain liquid. Some issuers who don’t have to have capacity placed at January 1 will take advantage of some quite attractive issuance conditions in the first quarter.”
Peak perils will continue to dominate the next wave of cat bond issuances, which is “where the cat bond product adds most value”, he thought. Cedants seeking to transfer secondary perils, such as wildfires and severe thunderstorms, will need to turn to the traditional market.
Meanwhile, collateralised capacity for longer-tail liabilities will become more difficult as the global economic downturn sets in with the prospect of an even longer period of low or negative interest rates. “Securitising long-tail classes is pretty challenging without any form of leverage,” noted Potter.