Cat bond spreads won’t widen significantly, but issuance to rise: Fermat

Catastrophe bond spreads are not expected to widen significantly following the impacts of recent losses, according to cat bond and ILS fund manager Fermat Capital Management LLC, who only expect spreads will widen less than 10%. However the manager does expect an uptick in issuance anyway.

Early evidence from recently closed transactions, the first cat bonds since hurricanes Harvey, Irma and Maria struck the United States and Caribbean, supports this.

Pricing, on a risk adjusted basis, seems little more than 5% higher than previous similar transactions for the higher layers of risk, for which catastrophe bonds are perhaps best known. For the lower down, working layers of risk, pricing may not have moved at all so far.

The catastrophe bond market has not faced the significant losses that it could, had hurricane Irma barreled up the east coast of Florida through Miami as the forecasts had at one stage implied. Irma shifted west and the other catastrophe bonds have been more of an aggregate deductible attrition, rather than large enough to create significant losses across the market.

As a result, the expectation is that the overall loss to the $30 billion cat bond market will only be in the hundreds of millions, perhaps only the low hundreds as our listing of cat bonds considered to have defaulted or that are likely to.

So the capital draw-down for the catastrophe bond investment specialists and their end investors is set to be much lower than will be seen at traditional reinsurers and collateralized reinsurance funds or vehicles. Hence there is an expectation that cat bonds could become very keenly priced at the upcoming renewals and into 2018.

Fermat Capital Management said that investor interest in catastrophe bonds has shown a “net increase” following hurricanes Harvey, Irma and Maria.

The ILS investment manager went on to say that as the hurricanes, “Will likely only cause principal losses to
a small portion of the catastrophe bond market, we are only expecting moderate (< 10%) spread widening for the market.”

Fermat said that rate increases are expected to be higher elsewhere, as “Loss-affected reinsurance programs
in the traditional and collateralised re markets should see steeper increases.”

Of course this provides an opportunity for the catastrophe bond market to cement itself as an efficient source of reinsurance capital, for the right layers of risk, accepting lower rate increases as it has not faced the size of losses other channels for insurance risk transfer have.

But the need for rate increases in some areas was already clear anyway, Fermat says, noting that in the traditional and collateralized reinsurance market, “Many of these were priced too low heading into this year’s storm season.”

For some investors in cat bonds, price rises of below 10% will be disappointing. A number of ILS investment managers who used to allocate a significant portion of their assets to the cat bond market had been pulling back as rates declined more than 40% over recent years.

For these ILS and reinsurance investors the prospects of rates only creeping slightly up will not be appealing.

But for other investors, who have entered the cat bond market in recent years and are happy with the broadly diversified mid-single digit returns they can achieve, any rate rise will be appealing and we could see a significant push into cat bonds over the coming year, if the pipeline of activity builds strongly.

Fermat believes that some of the new cat bond issuance that had been planned for the fourth-quarter of 2017 could now be pushed into Q1 of 2018, raising the prospects of a busy start to the New Year for the market and its investors.

The manager also expects that insurers and reinsurers will be assessing their protection in the wake of the recent hurricanes, which could result in more chances for ILS and cat bonds to demonstrate their worth and efficiency as reinsurance alternatives.

Join us in New York in February 2018 for our next ILS conference