After a record start to 2014 issuance of catastrophe bonds and insurance-linked securities (ILS) ratings agency Standard & Poor’s expects more growth, at a more moderate rate, to come, but warns that any future growth of ILS must not be at the expense of discipline.
Through the first six months of 2014 Standard & Poor’s rated $3.4 billion of catastrophe bond transactions, the highest amount it has ever rated for a first-half of a year. In fact the first half of 2014 saw more S&P rated cat bond volume than the whole of 2009 saw and already around two-thirds of 2013’s S&P rated issuance.
S&P expects to see continued growth from the ILS and catastrophe bond market, noting that it is a small piece of the growing alternative reinsurance capital which is seeking returns from insurance and catastrophe risks. This alternative capital puts pressure on the traditional reinsurance market in many forms, from the rated 144A catastrophe bond, through collateralized reinsurance structures such as ILW’s, sidecars and private cat bond transactions and also now through equity investment in startups.
This future growth may not be at expected rates, warns S&P, adding that the traditional reinsurance model still adds value and has benefits which ILS finds it hard to compete with, such as the reinstatement. For the ILS market to reach its true potential the whole market and reinsurance market needs to grow, to enable capital to be put to work so ILS managers no longer have to return or turn down allocations.
S&P says that it strongly believes that ILS market growth should not come at the expense of looser underwriting discipline or diligence. S&P notes the trend for other risks to be included in reinsurance and warns that ILS should not follow this path. It also highlights that creating new products which do not meet investors investment horizons or liquidity needs, just to put capital to work, would be a dangerous path.
S&P, like many others, sees opportunities for growth for ILS in emerging, frontier type markets, where reinsurance penetration as a whole needs to grow in order to sustain local markets. This will lead to greater demand for catastrophe protection in new peak peril zones, providing opportunity for the ILS market to grow into.
Another potential opportunity that S&P sees is for strong underwriters to partner with capital providers, such as hedge funds, to create new platforms which could have new appetites for risk. This is where the reinsurers are seeking to enter the market, by partnering with investors to leverage lower-cost capital alongside their balance sheets for underwriting.
On the topic of how sticky ILS capital is and how prepared to shoulder losses, S&P says that longer term investors, such as pension funds, are likely capable of absorbing a full-limit loss within their investment tolerance as they only allocate a small amount of capital to the sector. Also, if such an event occurs S&P said while prices could harden a bit it does not expect anything as dramatic as in the past, while even more capital could flow into the sector.
The ILS market has seen a drive to reduce costs and to make issuance more efficient and affordable in recent years, notes S&P, with the volume of transactions which are not rated growing each year. Interestingly, S&P notes that it would likely rate a transaction where an investor performed its own risk modelling using one of the accepted, main risk model platforms. That could lead to private cat bonds seeking a rating, if the sponsor or investors required one.
S&P notes that it already has some concern about underwriting discipline in the alternative reinsurance capital markets, particularly for cat bonds. S&P raises the question of whether investors really understand indemnity catastrophe bond deals and the exposure they have to the underwriting and claims risk inherent in every cedent.
The broadening of terms and conditions is the other worry, with some recent cat bonds including unusual or non-modelled perils. “The question is whether looser underwriting standards will hurt ILS investors searching for diversification and yield,” says S&P.
Both the growth and the competition in the ILS and catastrophe bond space are set to continue, S&P said, with recent growth providing; “An additional avenue for capital to flow and provides more sources of reinsurance to primary companies at lower rates.”
“In our view, growth should come from various avenues such as increased take-up rates in disaster-prone areas, disaster protection purchased by governments, and product innovations through underwriting joint ventures,” commented Standard & Poor’s credit analyst Maren Josefs.
But the ILS market should not be complacent in terms of discipline, S&P says; “The current competition among market players has been leading to a welcome reduction in prices and a loosening of terms for cedants. However, we caution that for the alternative market to maintain the credibility it has gained after all this time, growth should not come at the expense of looser underwriting discipline and less due diligence.”