Inflows of capital into the reinsurance space through insurance-linked securities (ILS) and catastrophe bond funds may experience a downturn if ILS rates remain at current low levels, warns the world’s largest reinsurance company Munich Re.
In a report published by Munich Re today titled ‘Insurance-Linked Securities (ILS) Market Update Q1 2014’ the reinsurer warns that with a significant volume of outstanding ILS and catastrophe bonds set to mature in early 2015, the returns achievable by ILS funds not be as easy for the ILS managers to maintain. This could result in a slowdown in the alternative capital inflows which have been coming into the ILS and cat bonds space.
ILS managers and funds have benefited from stronger pricing on catastrophe bond and ILS transactions issued prior to the end of 2012 when rates began to decline. With many of these outstanding ILS and cat bonds scheduled to mature in 2015, being largely three-year duration bonds, a chunk of the higher returning bonds in the market are set to disappear.
ILS and cat bond rates have steadily declined through 2013 and continue to in 2014, reflecting the lower-cost of ILS and alternative reinsurance capital and investors willingness to take on risk at ever lower returns. Munich Re warns that once the higher rate cat bonds and ILS are gone from the market through maturities there will be an impact to ILS fund returns and they may find attracting new capital more difficult.
Munich Re’s quarterly ILS report looks back at the first-quarter of 2014 transactions and finds that the outstanding size of the ILS and catastrophe bond market shrunk a little due to high levels of maturing bonds during Q1. Munich Re counts $1.535 billion of new issuance, while $2.072 billion of ILS and cat bonds matured, which by its reckoning shrunk the market by approximately $500m to end the quarter at $18.61 billion.
That’s a little lower than Artemis’ Q1 issuance figure of $1.585 billion with the outstanding ILS market finishing the first-quarter at a size of $20.05 billion. The reason for the difference is Artemis’ inclusion of more of the private transactions and cat bond lite deals in the Artemis Deal Directory.
U.S. insurers dominated Q1 2014 catastrophe bond issuance, bringing a significant volume of U.S. perils to market. Munich Re notes that all of the U.S. focused catastrophe bonds apart from Merna Re V included coverage for severe thunderstorm risks, so hail, tornado and other convective storm losses, which perhaps shows an increasing use of cat bonds for reinsuring this peril.
The market environment for issuing ILS and catastrophe bonds reflected the buyers conditions in the reinsurance market, with the majority of transactions upsizing and pricing below initial guidance through the first-quarter issues. Munich Re said that significant maurities in Q1 meant that ILS funds had a strong need to reinvest capital returned from maturing deals, which helped to increase demand and led to deal over-subscription.
Munich Re agrees with Artemis that Q1 2014 was a record quarter (see our report: Q1 2014 Catastrophe Bond & ILS Market Report – A Record Quarter) with the volume of issuance seen slightly outpacing the previous high first-quarter seen in 2012.
While the market may have shrunk slightly in Q1 Munich Re believes that it will catch up through the second quarter. In fact, with the help of the record $1.25 billion Everglades Re 2014-1, the largest catastrophe bond ever, it perhaps already has.
Munich Re expects that some of the cat bond sponsors which did not renew transactions in the first-quarter will come back to the market in Q2 to renew those deals. Munich Re said that overall Q2 issuance should exceed $2 billion (as we reported earlier it already has).
Looking further ahead towards the end of 2014 Munich Re expects a number of primary insurers will seek to renew cat bond transactions which mature in Q1 2015 early. Munich Re said; “We expect several issuances from mainly US insurers, as the bulk of maturities in the first quarter of 2015 are scheduled for the beginning of January and many sponsors will attempt to lock in their protection prior to the corresponding maturity.”
The secondary trading environment indicates that favourable market conditions continue to persist for both U.S. and non-U.S. perils, with cat funds and ILS specialists continuing to need diversification helping non-U.S. perils to increasingly become more attractively priced. Munich Re notes that Japanese quake risk is at record low levels of yield, saying; “Secondary trading currently implies a 275 basis point return requirement from investors for a Japan Earthquake bond with a 100-year return period.”
Catastrophe and ILS funds have successfully attracted new capital based on the rates available from 2010 to 2012 catastrophe bonds, says Munich Re, but with many of those deals maturing and more recent issues having a significantly lower yield it may become difficult for managers to maintain these returns.
Munich Re said in the report; “The majority of these bonds are set to expire during the first half of 2015, which will lead to a deterioration in forward performance for cat funds and likely induce a reduction in new capital inflows to the market and a corresponding adjustment of rates.”
Whether a reduction in capital inflows will cause a rate adjustment is not at all certain in the current market environment, but the reduction in market yield, once higher yielding bonds start to mature, will inevitably have an impact on ILS managers ability to maintain return targets.
How the ILS market deals with this upcoming challenge will be interesting. Will ILS managers move even more capital into colllateralized reinsurance and private transactions to try to access higher yielding business? What might be more productive for a market which clearly has many investors that appreciate the securitized 144A cat bond and ILS deal, would be for some more deals at higher yields to come to market, bringing some lower layers of reinsurance programs to cat bonds and ILS.
The overall return of the outstanding ILS and catastrophe bond market has already dropped, as the high level of issuance in 2013 at increasingly lower pricing was absorbed into portfolios. That overall market return has further to drop as Munich Re’s report highlights.
How this impacts the market we will have to wait and see and the market reaction will be markedly different if we have a few major catastrophe losses between now and year-end. If the reinsurance market remains largely catastrophe loss free then we could well see a slowdown in inflows, more ILS managers shutting funds to new capital and perhaps even some managers looking to return some capital to investors if their portfolios cannot maintain targets set when issuance yields were much higher.
Q1 2014 Catastrophe Bond & ILS Market Report – A Record Quarter
This report reviews the catastrophe bond and insurance-linked securities (ILS) market at the end of the first-quarter of 2014, looking at the new risk capital issued and the composition of the transactions completed during Q1 2014. Download your copy here.