Monday, January 19, 2009

Cat Bonds Persevere in Tumultuous Market

From GC Capital

A slow issuance year in 2008 masks a story of resilience and risk management flexibility. After a record-setting year in 2007, catastrophe bond issuances fell 62 percent by new principal and 52 percent by volume. Turmoil in global capital markets and the second costliest catastrophe year since at least 1970 exacerbated what was already expected to be a quieter year. But, while spreads on corporate debt grew wider, catastrophe bonds withstood the impact of onerous market forces and survived a substantial financial market test of their utility as risk and capital management instruments.

2008 by the Numbers

Issuers brought USD2.7 billion in new capacity to market last year via 13 issuances. All but two came in the first half of the year. After the beginning of August, the market fell silent, as carriers waited to see the implications of the financial catastrophe and Hurricanes Gustav and Ike on traditional treaty reinsurance pricing. Yet, if 2007 is treated as an outlier, the first half of 2008 generally kept pace with the same period in 2006, in which USD2.7 billion in new principal was issued through 18 catastrophe bonds.

As a whole, 2008 was the third busiest year since catastrophe bonds were introduced in 1997, accounting for 11 percent of all issuances. Risk capital was above the 11-year average of USD2.1 billion, and the USD2.7 billion issued last year came to market at a time when reinsurers had excess capital on their balance sheets. Even with continued buybacks and dividends - not to mention the Guy Carpenter World Rate on Line (ROL) Index’s drop of nine percent at the January 1, 2008 renewal, carriers perceived a benefit to transferring risk to capital markets. Rates continued to drop steadily through the July 1, 2008 renewal … which is when the catastrophe bond market effectively dried up.

The quiet third quarter that followed, in which new issuances were down 75 percent year-over-year, signaled a drastic and sudden change. Of course, the fourth quarter is usually the year’s most active, and it was silent in 2008-compared to that of 2007, when seven bonds resulted in USD1.9 billion of new capacity.

Ambiguity in the (re)insurance market as a whole - and more broadly in global financial markets - is the primary reason for the sharp drop in catastrophe bond issuances year-over-year. As the (re)insurance industry approached the January 1, 2009 renewal, few could gauge where rates were headed for specific regions and lines of business. Loss history ultimately mattered more than the other factors that influence pricing, but at the time, carriers decided to confirm the market’s direction before making specific risk management decisions.

Questions about Capital Availability

The availability of capital remained a major concern through December 2008, as markets cited increased costs in efforts to increase rates for traditional reinsurance. While this condition did not define the January 1, 2009 renewal, it certainly shaped cedent and market thinking. Capital management factored into many reinsurance buys, as carriers moved to protect themselves from unfavorable market forces.

These same issues were at play in the broader capital markets space, as alternative investment vehicles coped with the same investment asset impairment and capital access challenges that (re)insurers faced. Alternative investment vehicles - such as hedge funds and private equity funds - lost access to leverage and experienced an increase in redemptions. Multi-strategy hedge funds began to exit the catastrophe bond market. As conditions deteriorated around the world, a situation accelerated by the interconnectedness of the global financial system, issuers opted to watch and wait. The loss of several international financial institutions - which coincided with Hurricane Ike’s contact with Galveston, TX - virtually guaranteed that issuance activity for the year would come to an end.

Prior to the events of mid-September, several firms were planning catastrophe bond issuances for the fourth quarter. The volume and value would have been below that of the same period in 2007, but cautious insurers decided to defer the deals to the first quarter of 2008, in order to gauge the effects of an uncertain January 1, 2009 renewal.

Because of the decision to defer planned issuances to 2009, the total amount of risk capital outstanding fell 14.5 percent, from USD13.8 billion to USD11.8 billion. Risk capital of USD2 billion disappeared as 21catastrophe bonds reached maturity.

Financial Catastrophe and Beyond

Almost since the inception of the catastrophe bond market, these instruments have been touted as not correlated with broader credit markets. A downturn among corporate bonds, many believed, would not cause catastrophe bonds to follow suit, as they are linked to physical events - such as earthquakes and hurricanes - not an issuer’s likelihood of default. While spreads did increase during the tumultuous days of September, they did not do so at the same rate as corporate bonds.

Both investors and issuers did pause when four catastrophe bonds seemed to have been infected by the global credit crisis, due to the loss of their total return swap (TRS) counterparty. The subsequent mark-down of these bonds initially unsettled some participants in the market, as they perceived it to be an indication that significant credit risk and (more alarmingly) moral hazard issues were embedded in the cat bond market. But, as details emerged, it became evident that there was not a fundamental flaw in the catastrophe bond mechanism. Improved transparency and tightened collateral requirements, however, are likely to follow this year.

In contrast to other credit risk-related asset classes - such as auction rate securities and residential mortgage securities, which have effectively been extinguished by the ongoing credit crisis - catastrophe bond issuance activity will continue, and the asset class should actually emerge with improved utility for both sponsors and investors.

Global financial markets are still dealing with the effects of the financial catastrophe, and the future remains unclear. Traditional reinsurance capacity is expected to contract this year. Further, we have yet to see full-year financial results for publicly traded (re)insurers. The revelations that will begin in the middle of March will define the severity of the crisis for the (re)insurance industry. Forecasts of an above-average catastrophe year could complicate the situation, as well.

To a certain extent, the industry’s agenda in 2009 will reflect that of the fourth quarter of 2008. Disciplined risk and capital management will be crucial. Financial market constraints are likely to continue, resulting in an important role for alternative sources of capital. The catastrophe bond has persevered through a property catastrophe and a financial catastrophe - which occurred simultaneously. This resilience is likely to come to mind as carriers manage their portfolios over the coming year.

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