Over time investors in the insurance-linked securities and catastrophe bond market have become more comfortable with investing in deals with a greater risk profile, says Willis Capital Markets & Advisory in their latest quarterly ILS market report. The latest report, which you can read about and download via the Willis website here, contains an analysis of the non-life catastrophe bond market from 2005 to 2011 and shows that investors have become comfortable with increased modelled loss profiles and have sought access to higher yielding risks.
The analysis shows the overall expected loss and risk spread for each year. Willis notes that the chart hides individual deal specifics on pricing factors such as perils and trigger type but it does show that the overall risk profile, expressed as average expected loss, has been steadily rising in recent years. They say that 2006 is an exception as the expected loss figure of 2.3% was biased due to the large Successor cat bond program which included some very high yield tranches.
The greatest margin between average risk spread and average expected loss occurred in 2009 as the first half of that year saw very wide spreads being demanded as a knock on effect of the financial market crisis which began in 2008.
As the ILS and cat bond market matures and investors become better educated in the structure of these assets as well as the risks they cover it is likely that the comfort levels will increase further. Should the market ever become more liquid, perhaps through a trading platform, allowing investors to more easily get into and out of ILS deals the comfort in these higher risks could grow even further.
The chart below shows a steady upwards trend in both average expected loss and average risk spread.
Of particular note in the WCMA report is their discussion of the jump in average risk spread from 2010 to 2011. They note that the increased capital inflows into the market which have been experienced over the last year or so as investors have become increasingly interested in ILS and cat bonds as an asset class, combined with slightly lower issuance, has not resulted in reduced risk spreads. Accepted wisdom would suggest that more available capital competing for fewer investment opportunities could have resulted in a reduction in risk spreads.
Willis Capital Markets & Advisory says that several factors have influenced this including the availability of other forms of alternative capital, continued impact of risk model changes and the inability of investors to take on more U.S. hurricane exposure when the market is already top-heavy with this type of peril (as we discussed earlier).
In their view this has been a missed opportunity by the cat bond and ILS market, who could have increased the relative attractiveness of their pricing at a time when traditional reinsurance became more expensive. They conclude this analysis by noting that it will be interesting to see if recent pricing trends for cat bonds exposed to U.S. hurricane risks will continue or if it is a temporary trend caused by the high issuance volume in late 2011.