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Cat bond spread stabilisation positive for reinsurance prices: Morgan Stanley


The recent stabilisation of pricing in the catastrophe bond issuance market is a positive signal for the broader catastrophe reinsurance market, suggesting that technical levels have been reached and capital providers will go no lower, according to analysts at Morgan Stanley.

The reduction in returns from catastrophe bonds was particularly striking over the last two years, as insurance-linked investors found their return appetites and began to capitalise on lower cost structures.

This resulted in steep declines in pricing over two years, during which time the available spreads between expected loss and coupon returns more than halved. Now, however, there has been a slight uptick in spreads as investors and ILS managers began to establish a pricing floor, which analysts believe is a positive sign for reinsurance.

The analysts at investment bank Morgan Stanley see the stabilisation of cat bond spreads as a “silver lining” for the reinsurance market which has been facing the never-ending downward spiral of pricing.

The analysts note, based on Artemis data, that spreads between expected loss and coupon had been as high as 800bps as recently as 2009, but then plummeted down to just under 300bps in 2014, which was the lowest spread level since the cat bond market began.

In 2015 however, the average spreads have ticked up slightly, to 307bps (up from the average of 292bps for 2014). This has been caused by the uptick in coupons outstripping a slight uptick in the average expected loss, so enabling the cat bond market to provide a slightly improved return above the risk in 2015 issuance so far.

The analysts explained; ” In 2015 YTD, cat bond spreads have shown signs of stabilization and even a smaller widening, indicating investors might not be willing take further smaller spread.”

The analysts also note that 2015 has seen a catastrophe bond pulled due to too aggressive pricing, as well as a number pricing above guidance as investors demanded a higher coupon for the risk.

The uptick in spreads is now clearly evident, thanks to a few more deals pricing at levels above the middle of launch guidance. The chart below shows the way the spread of cat bond issuance has developed over the years, from the 380+ cat bonds recorded in the Artemis Deal Directory.

Catastrophe bond spreads by year

Catastrophe bond spreads stabilise - Coupon, expected loss and spread by year of issuance (click for interactive chart)

It’s worth noting here that while the average coupon has increased in 2015 at a slightly higher rate than average expected loss, resulting in a higher average spread, the multiple has not. In fact, the average multiple at market of newly issued catastrophe bonds in 2015 is lower than that seen in 2014, which suggests despite the higher spreads there is more risk being assumed at a lower return multiple.

The analysts go on to explain that there are hopes that traditional reinsurance pricing may follow suit and stabilise as well, although the latest renewals saw further price declines. However declines have moderated and are expected to continue to do so.

With ILS fund managers playing an increasing role at reinsurance renewals on a collateralised basis, there is a chance that they will begin to force a floor in that market as well. The big traditional reinsurers will likely welcome and support this to a degree, although competition may keep small price declines as the norm for the coming few months.

The analysts explained that there are a number of factors that will support price stabilisation more broadly in reinsurance, despite the ongoing competitive renewal conditions.

“We recognize that market hope for pricing stabilization in each of recent renewals has been dashed by the imbalance between supply and demand. However, large cumulative pricing decline and early indicators from alternative market could lead to pricing moderation which will be welcomed by investors. The heightened interest in industry consolidation also supports reinsurance valuations,” the analysts wrote.

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