2008 was a year of ups and downs for the insurance linked security and catastrophe bond markets, while the weather risk management market did not fare so badly (although it has been quiet on the news front). At the start of 2009, we thought we’d ask some of our friends within these markets to contribute their thoughts on the outlook for the year ahead.
William J. Dubinsky, Director – Insurance Linked Securities
Swiss Re Capital Markets
Even at current levels, a good number of cat bond deals would make economic sense especially given the challenging retrocessional reinsurance markets. Improving on 2008 cat bond issuance levels will depend on relative movement of reinsurance rates and cat bond spreads, which both remain challenging to predict.
The cat bond collateral structure will not present obstacles to new deals for investors or for sponsors as improvements have been made to alleviate issues that surfaced in 2008. Another point: Simpler structures will prevail over more complicated structures and this will favor non-indemnity triggers for more complex business lines.
For non-indemnity triggers, we believe that hybrid triggers such as the MITT trigger used in the Calabash Re transaction will continue to gain favor as an effective way to minimize basis risk. Activity in the broader ILS market beyond cat bonds will return in tandem with the broader structured finance market; however, it is too early to tell if this will occur in 2009 or in subsequent years.
David Friedburg, CEO
WeatherBill continues to work with companies that are new to hedging weather risk. These companies need help mitigating their risk with products that are easy-to-use, customizable, and, financially secure. Our innovative technology platform allows these companies to do so, with features and flexibility not available before. Thus, we are seeing them using weather hedging products in unique ways to create programs not previously available – refunds for rained-out vacations, refunds for rained-out sporting events, fixed fee programs for enterprise customers buying seasonal weather-sensitive services, and more. We hope for, and look forward to, more innovative programs that are possible because of unique technology-enabled weather hedging. We expect to see programs in agriculture, outdoor entertainment, travel, and more. The future for weather risk management remains exciting and unbounded.
Barney Schauble, Principal
We think that the two trends we have seen evolve slowly over the past years will accelerate in 2009. The first is demand for secure (collateralized and/or highly rated) risk capital in order to hedge exposure to natural catastrophe and weather risks. The concern about volatility in earnings volatility / balance sheet exposure is even greater now that there is effectively no access to capital in the equity and debt markets. Re/insurance carriers, utilities, agricultural companies and others are already seeking larger limits of protection and are facing a smaller pool of traditional risk capital.
The second trend is interest by institutional investors in allocating capital to these (non-correlated) sectors. The track record of insurance-linked securities strategies over the past 3 years shows robust outperformance relative to almost all other asset classes. While many multi-strategy hedge funds have pulled back from the cat bond / sidecar and weather sectors because of their broader investment performance, we expect the flow of capital from their underlying investors (pension funds, endowments, family offices, etc) will expand even more in 2009 than in past years.
First Enercast Financial
The recent economic downturn has shown to have quite a significant impact on trading as a whole and weather futures and options were not immune. Deleveraging and curtailed trading operations have negativly impacted volumes of most markets, including weather, as many finacial groups have been forced to reduce the amount of risk held. However, I do not expect to see the large decline in weather trading volume that has recently plagued other markets since weather risk is so different and moves completely autonomously to most markets. Recently I’ve watched weather contracts gain nearly 20% while the Dow has lost nearly 10% in the same month. This bodes well for the weather futures in 2009, as it is an excellent vehicle for diversification and hedging portfolio risks. Many institutions are seeking this type of non-coorelated haven given the current economic environment.
The other reason I see 2009 being a good year for weather markets is the imense volotility in the energy prices. Since temperature coorelates so well with energy demand, companies rely on weather contracts as a volumetric hedge. The dramatic 2008 price swings we experienced in the energy markets has made it more critical than ever to have a sound and comprehensive risk management program. This has caused many companies to move beyond typical base load energy price contract hedes to now include volumetric protective weather contracts. Market volotility has made it much more critical for companies to expand their risk management program to reduce weather risk. If there is anything we’ve learned from 2008, it’s that we can’t afford to not manage risk.
Diego Wauters, CEO
Coriolis Capital Limited
2008 was a difficult year in the Cat Bond market, owing to three factors. The first was a reduction in reinsurance rates in the first half leading to new Cat Bond issues with lower spreads over LIBOR. The second was the financial crisis, which curtailed almost all new issues after September. Finally the same financial crisis has forced some investors in Cat Bonds to liquidate their portfolio in order to get cash. After all, Cat Bonds were among the very few fixed income instruments to hold their prices well.
2009 looks like a very different scenario. We at Coriolis expect that increases in reinsurance rates will lead to new issues with much higher coupons over LIBOR, more like those we saw after September 11th or Hurricane Katrina. There is already a significant pipeline of deals lined up for 2009, with the main uncertainty whether there will be enough investor appetite for all of them.
As well as better returns in the primary and secondary market, investors will also benefit from much tighter terms and conditions within deal structures. For example, the old trend developing in the first half of 2008 towards deals where the modelling wasn’t independent, or which contained unmodelled perils, is likely to be reversed towards more robust structures. Additionally, the collateral structure protecting investors in Cat Bonds will be strengthened to minimize the credit risk on new issues.
In general, investors should be interested in this asset class which has shown great resilience through the recent financial crisis. The expected return to investors on Cat Bonds in 2009 will be greatly improved compared with a year ago, while risks, particularly credit and modelling risks, should be reduced on new issues.
John Webster, Director
We see a basis for continuing demand for Insurance Linked Securities. The argument of limited correlation with other investment markets still largely holds true, although recent events have highlighted some limitations as elements embedded in certain structures have thrown up some unanticipated exposures. However, there is a growing standard of expertise in the investor base which should be able to accommodate increased analytical requirements, and a selectively hardening reinsurance market will make the investment decision more attractive. In the short term, an undeveloped secondary market and current liquidity hoarding will act as a brake. Once market conditions improve, we can start to work on the areas which are holding back volumes such as treatment of basis risk, standardisation, data quality, all of which will encourage greater issuance diversity, secondary market depth and investor understanding.
Martin Malinow, CEO and Co-founder
Galileo Weather Risk Management Advisors LLC
As we at Galileo look at the weather market for 2009, we see a big change coming in market structure. For years, the market has been bifurcated into two very distinct segments – the end-user segment and the trading segment – with very little overlap. There were companies who
focused on getting their risk from structured end-user deals and those who got it from other traders.
There were several reasons for this split but it was largely one of access in that most weather traders didn’t have the rated balance sheet to face customers so were confined to the CME which did not offer any other products beyond generic temperature. The result of this was that the majority of non-temperature risk originated from end-user transactions did not find its way to the trading segment of the market and simply stayed on the balance sheet of the primary protection writer. Primaries retained and traders traded and there was very little common ground where these two groups met.
This bifurcated structure has to change for several reasons in 2009 and beyond:
(1) Protection writers have less balance sheet capital than they did in the past due to the current credit contraction and will have to manage the capital they have more efficiently through hedging and not just simple retention
(2) Traders will be looking for alternative sources of margin as the number of players and risk capital in this segment has contracted due to redemptions in the hedge fund industry.
The foundation for the union of these two segments has now been built by the CME in the form of flexible clearing for products other than degree-days. This means that two counterparties can agree on a trade based on precipitation or wind speed or what have you and post it to the CME who will dictate the margining model for that transaction…the same as with temperature deals.
This will act as a bridge between the two segments in that they will be able to transact in non-degree-day products on the exchange for the first time ever and truly share in each other’s risk. Once this takes hold, end-users will be the customers of primaries and primaries will be the customers of traders, and traders will trade risks other than degree-days with other traders. We believe this will lead to the market hitting on all cylinders for the first time in its ten year existence and realizing the potential participants and observers always knew was possible.
So our commentators see a largely positive 2009 ahead. The economic climate will be testing but ensuring diligence in structuring of deals and efforts to minimise basis and counterparty risk where possible will help to attract both cedents and investors into the ILS markets. While the weather risk management sector needs to keep innovating new ways for corporates to hedge against inclement weather and also continue to extend those hedging opportunities to consumers through refund deals and the like.
A big thank you to all who contributed to this article! If you have any comments or want to send us your own predictions for 2009 please add them here by using the comments fields and leaving a reply below.