The Intelligent Quarterly from the publishers of The Insurance Insider

Spring 2012

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The first half of 2010 was a healthy one for the cat bond market, with $2.4bn of new bonds issued - up 40 percent on the $1.7bn raised in the same period the year before and not far off the $3.5bn total funds raised in 2009.

Most of these deals were done in a frantic burst of activity in April and May, with seven cat bond transactions raising $1.7bn in as many weeks. This made the quarter the second most active on record, according to broker Guy Carpenter's Cat Bond Market Update report.

Fundraising conditions were broadly favourable, with continued strong investor demand and attractive conditions for sponsors to offload risk, the report noted.

However, some of the issuers who came to market in late April/May had to offer investors concessions on interest rates and fundraising targets, after a swathe of US wind issues led to greater reluctance to invest in these perils, said GC Securities' global head of distribution Chi Hum.

This reversed the pattern that had endured since late 2009 of sponsors generally reaching or upsizing their issue targets and achieving spread pricing that was at or below mid-points of indicated ranges.

Click to enlarge Moreover, total capital invested in cat bonds shrank during the first six months of 2010 to $11.8bn, after fundraising failed to keep pace with maturing bonds, according to Guy Carpenter figures.

An extra $1.9bn of risk capital is scheduled to mature during the second half of 2010, releasing more cash onto investors' books for reinvestment.

Predictions from industry experts for second half sales range from $1.5bn to $3.7bn, depending on market conditions and whether the wind blows this season.

But all bets are off if the storm season lives up to forecasters' turbulent predictions and a hard traditional market ensues.

A wind season producing $50bn or more losses could bump up issuance, said Michael Millette, Goldman Sachs' head of structured finance, investment banking. He predicted that a heavy storm season could stimulate an extra $1bn of cat bond issues in the fourth quarter of 2010 and drive issuance above $6bn in 2011.

And a hard rating environment would also aid the emergence of new sidecars - quota share vehicles funded by non-specialist investors, which thrive on the high returns of capacity-crunch pockets in the traditional markets. Another $1bn of sidecar capital could enter the market later this year if there is a market-changing hurricane season, Millette predicted.

"The higher price level would be likely to attract significant non-specialist investor interest, particularly if credit markets continue to tighten," he said.

"Once we get through this wind season and this [forecasting] issue goes away, I definitely see [non-specialist investors] jumping back into the game"
Judy Klugman, managing director, Swiss Re Capital Markets

Side effect
But Bill Dubinsky, managing director at Willis Capital Markets and Advisory, said that if sidecar activity did take off it might come at the expense of bond issues, although both would increase. "For reinsurers, access to sidecar capacity could in some cases limit their need for new cat bond capacity," he noted.

Assuming a more benign hurricane season, experts are divided on which perils will feature more strongly in the second half of 2010.

Traditionally, Q3 sees a predominance of European wind exposures transferred to the capital markets, with the spotlight returning to US wind in the final quarter.

However, the glut of US wind cat bonds that choked the market in Q2 led some commentators to predict a lack of investor appetite for US perils for the remainder of the year.

The experts in this camp include Munich Re's head of risk trading, Rupert Flatscher, who emphasises the attractive conditions for non-peak issuances such as European wind bonds.

Investors are currently willing to accept lower spreads over benchmark returns for sought-after diversifying bonds.

But others, such as Millette, say peak US hurricane bonds will have a strong presence.

Either way, most experts agree that investors will be ready to digest more peak peril in the second half.

Heavy storm forecasts for the approaching hurricane season were one of the reasons investors may have held back on US wind in the face of a softening market. "Once we get through this wind season and this [forecasting] issue goes away, I definitely see [non-specialist investors] jumping back into the game," said Judy Klugman, Swiss Re Capital Markets' managing director.

Investors will also renew their appetite for US wind as they raise new capital and look to reinvest retained earnings and income, said Aon Benfield Securities president Paul Schultz. "Most, if not all, third-party managers are raising additional funds," he added.

Meanwhile, although investment tactics are always subjective - "if you talk to six different investors you'll get nearly six different opinions on what the right approach is," Dubinsky notes - experts say cat bond investors are increasingly willing to take on a higher concentration of exposure to US wind risk.

After all, for most non-specialist investors catastrophe bonds are a diversity play in themselves and they require less dilution of US wind perils within their allocation.

Other buyers, for whom diversification may still be a focus, will be able to partake in peak bond offers once they have topped up their non-peak assets in coming months, Klugman said.

End users are becoming more sophisticated in their approach to the sector, she added. "People are also realising that just because you are concentrated in US wind events, not all US wind events affect all bonds equally."

Guy Carpenter's Q2 survey sounded a more cautious note, saying that investor appetite for US wind remains subdued.

Bipolar market
These dynamics have also translated to what Swiss Re labelled a "bipolar market dislocation", meaning investors are keen to pick up diversifying perils while secondary trading prices on peak US wind perils languish.

By the end of July, spreads for US wind and multi-peril cat bonds rose near to peaks last seen in 2009. Meanwhile, spreads on non-peak perils declined to 2007 levels.

Spreads are a measure of the risk premium an investor earns on a cat bond, which will rise or widen as secondary trading prices decline.

By the end of July, spreads on 2010 US wind risk cat bonds had already risen by 10-20 percent from their issue date, Swiss Re's first ILS market update noted.

However, spreads for 2009-issue US wind bonds are still about 40 percent lower than their initial issue peak, although they have risen slightly from an April 2010 trough of 40-50 percent below initial issue.

This came as some cat bond investors moved against the trend to snap up cheap US wind bonds. Swiss Re predicted this trend would accelerate, with a flurry of trading early August lifting prices 5 percent from mid-year lows.

Cat bonds returned 3.3 percent to investors in the first half of 2010, according to the Swiss Re Global Cat Bond Index. Negative returns in the second quarter were offset by a strong first quarter.

The global index tracks total returns, which are calculated taking secondary price and accumulated coupon interest into account.