Reinsurance shortage a decisive factor in higher cat bond yields: Plenum

A general shortage of reinsurance capacity for some peak zone perils, particularly US wind, has been a particularly decisive factor in driving the recent spread widening in the catastrophe bond market, resulting in much higher cat bond yields, specialist investment manager Plenum has explained.

Specialist catastrophe bond, insurance and reinsurance investment manager Plenum Investments commented on the fact catastrophe bond investment yields are now at a roughly 10-year high recently.

A number of factors have contributed to this rise in cat bond investment yield, but they are not all equal, Plenum believes.

Rising interest rates are one factor that boost cat bond fund yields, as the collateral yield itself is raised on the back of the increase in short-term US interest rates.

But, for now, this is a relatively minor floating rate effect, albeit one that could become more pronounced as interest rate expectations continue to rise.

A far more decisive factor in lifting up cat bond fund investment yields is the general shortage of reinsurance capacity for some perils where the insurance-linked securities (ILS) market has a significant market share.

This general shortage of reinsurance capacity was well-documented around the recent renewal season and Plenum notes that it is reflected in a marked increase in cat bond yields.

In coastal and hurricane exposed US states, for example, some insurers have been unable to find sufficient reinsurance capacity despite the significant price increases, which has enabled the cat bond and ILS market to increase its pricing as well.

“Not only are traditional reinsurers reluctant to do business in these two U.S. states, but ILS investors are also providing less capacity,” Plenum said.

Exacerbating this has been a lack of liquidity in the catastrophe bond market as well, Plenum notes, as maturities were not as pronounced as perhaps required to allow all the reinvestment needed during the current quarter and some negative currency effects also squeezed cat bond fund liquidity even further.

Investor caution remains high at this time, given the state of broader financial markets, which means new inflows are also relatively limited.

Put all of this together and you have an almost perfect storm for the availability of capital in the catastrophe bond market, driving higher prices and ultimately yields for cat bond investors.

Plenum expects this to continue for a time, although how much longer is very hard to say with the market likely to slow, in terms of new issuance.

Despite this capacity crunch in the cat bond market, it is testament to the way managers invest and manage their capital that the vast majority of catastrophe bonds have still been placed successfully in recent weeks, even though at much higher pricing.

We are now beginning to see signs of the capacity crunch lessening, as the primary issuance pipeline slows a little, releasing a bit of the upward pressure on spreads and resulting in some recent issues pricing within initial guidance ranges, it appears.

But, it is still a little early to be calling an end to the market widening, as it may just be the market finding a little more equilibrium, in terms of supply and demand. So we’ll need a little more evidence to emerge before an end to the cat bond spread widening can be called.