Catastrophe bond market issuance is typically slow during the peak months of the U.S. hurricane season and 2012 has been no different. August saw no cat bonds complete during the month and just the one, Eurus III Ltd., which began marketing but completes this week. When primary issuance of cat bonds is low, sometimes the secondary market picks up the slack and becomes a little busier as investors seek to put capital to work, as has been witnessed in August.
Swiss insurance-linked securities investment manager Plenum Investments has noticed this trend and discussed it recently. They said that the lack of supply in the primary cat bond market led to robust demand for outstanding cat bond notes in the secondary market. This demand was reflected in rising prices Plenum said, which again allowed their fund to post a good increase in value over the course of the month.
It seems that there have been two factors at work on pricing in the secondary market this year. Scarcity of new cat bond deals at a time when there is a lot of capital both in and on the edge of the sector means that demand is high enough to have some pricing impact. Combine that with seasonal price increases of hurricane exposed cat bonds, which Plenum expect to continue as we pass the peak of the hurricane season, and you have conditions which are conducive to fund managers achieving high returns.
Plenum themselves have achieved a return of 4.71% in 2012 up to the end of August, with 0.73% return in that month alone, in their USD denominated fund class. This has now enabled them to recoup everything their fund had lost in value since the impact of the major catastrophes in early 2011. We expect that other ILS fund managers will be reporting similarly strong returns for August.
Plenum noted some livecat trading during the approach of hurricane Isaac, which spiked secondary market cat bond trading volumes at the end of August. Cat bonds such as Pelican Re Ltd., which was potentially exposed, attracted the bulk of this interest. Plenum notes that this is a feature of the cat bond market which allows investors to reposition their portfolios during a ‘live’ insured event and is testament to the liquidity and advanced stage of development of the cat bond market.
Plenum explained how they monitor their portfolio as a hurricane such as Isaac approaches landfall. As the forecasts and available data improves, as the storms intensity and path become clearer, they run scenario analyses on the storm to predict whether there would be any impact to their portfolio of cat bonds. They also analyse the potential impact to cat bonds which are not held in their portfolio, which allows them to better understand how the secondary market will function. Their initial analysis showed no loss to their portfolio and only minor damage probabilities for cat bonds.
24 hours before Isaac made landfall Plenum ran additional simulations with improved forecast data which again showed no loss to their portfolio. They again analysed the storm as landfall was made and as soon as the results came back showing no loss to their portfolio Plenum notify their investors of that fact.
This type of active analysis and modelling of a cat bond or ILS portfolio is essential for ILS fund managers to be prepared to attempt to sell positions in the secondary market. This is one of the big advantages of the cat bond sector over an investment via a collateralized underwriter as it is possible to trade your way out of trouble, although any trades of this type will certainly mean selling positions at a discount.
As we wrote last week, secondary market cat bond indices did not tell a tale of nervous investors dumping their positions as Isaac approached, and the indices rose strongly to the end of August. It will be interesting to see whether strong secondary market increases continue into this month as well.