Has the catastrophe (CAT) bond market become passé? Lost its luster? If you were talking about insurance-linked securities (ILS) around the water cooler as recently as 2017, that’s the impression you may have walked away with. CAT bonds were so ‘90s; collateralized reinsurance was where ILS was. And since the credit crisis of 2008-09 the numbers have borne that out. But since the fourth quarter of 2018, CAT bonds have come back into the fore and are proving that they have some inherent advantages over collateralized reinsurance when included in ILS portfolios.
I break the ILS sector into three segments: CAT bonds, collateralized reinsurance and reinsurance sidecars and similarly styled vehicles. Collateralized reinsurance includes both primary (to insurers) and retrocessional (to reinsurers) reinsurance contracts, as well as indexed contracts like industry loss warranties (ILWs), because ILWs are typically just an excess of loss reinsurance contract with an additional payment trigger. This article focuses on CAT bonds, and more specifically Rule 144A CAT bonds that typically trade on the secondary broker/dealer market.
While CAT bonds are the oldest form of ILS currently being used, their growth following the credit crisis has been outpaced by that of the collateralized reinsurance market. According to Aon Securities, in 2007 CAT bonds constituted approximately $15 billion (68%) of the $22 billion in ILS market capacity, with collateralized reinsurance making up about $3 billion (14%) of that total. By July 2018, CAT bonds were approximately $30 billion (31%) of the $98 billion of total ILS market capacity, while collateralized reinsurance made up about $55 billion (56%) of that total. Why such a change? There are many reasons, but two main ones are: 1) the heightened awareness by cedants of their reinsurer credit risk post-crisis (especially since Hurricane Ike made landfall in Texas the same weekend that Lehman Brothers filed for bankruptcy!), and 2) a desire on the part of investors to access a wider range of independent insurance event risks across the yield spectrum than what was available in the CAT bond market.
See also: The Challenges With Catastrophe Bonds
Fast forward to 2019. After two consecutive years of multiple catastrophe losses of moderate size (and in 2017 the most total insured catastrophe losses ever, surpassing 2005), a rarely observed phenomenon hit collateralized reinsurers: a liquidity crunch. While deal specifics vary, in its simplest form a collateralized reinsurer posts 100% of the policy limit (less premium in many cases) as collateral for a given transaction. If a loss occurs, it takes time for the reinsured to adjust the loss, and that amount of time may extend past the next renewal of the reinsurance contract. If the size of the loss is unknown at renewal, the collateralized reinsurer may have to post additional collateral to renew the contract. If it does not have sufficient cash or liquid securities, or cannot quickly raise additional capital, it will not be able to participate in the renewal. Multiply this situation across the many reinsurance contracts in a collateralized reinsurer’s portfolio, and the result can be reduced portfolio returns because the reinsurer has to maintain collateral balances that will only earn money market yields.
The need to have sufficient liquid securities available to facilitate reinsurance contract collateral requirements after one or more insured catastrophes was missed by some collateralized reinsurers. Prior to the credit crisis, most investment managers in the ILS sector had significant traditional reinsurance experience and were familiar with the loss adjustment process of significant catastrophes. After the crisis, a number of ILS funds were formed by managers who did not possess this experience and appreciation for the nuances of catastrophe claims adjustment (particularly the time associated with the claims adjustment process). Following the recent back-to-back years of notable natural catastrophe losses, the discussion of “loss creep” began in the trade press, which is not really a new phenomenon and is to be expected within the first year or so of adjusting complex catastrophe claims.
Given the need for liquid collateral after a catastrophe, what’s an ILS manager to do? Unless the manager is a multi-strategy or multi-asset fund, the investment mandate is typically limited to ILS and cash. Maintaining too large a cash position creates a drag on portfolio returns and makes the manager less competitive. That leaves the manager with one choice for liquid securities: CAT bonds.
While CAT bonds are not highly liquid exchange-traded securities, there is an active over-the-counter broker/dealer secondary market for CAT bond trading, and they are often recognized as Level II assets under Fair Value Measurements standards. CAT bonds have traded continuously at non-distressed prices through major financial market dislocations, including the dot-com bust and the credit crisis. Prior to the credit crisis, however, there was limited visibility into CAT bond secondary market trading volume and pricing. Then, in 2012, the U.S. regulatory agency FINRA launched the Trade Reporting and Compliance Engine (TRACE), which tracked CAT bond (and other fixed income securities) secondary market trades by FINRA-registered broker-dealers and provided a window into this opaque world.
CAT bonds proved themselves again as a liquid asset in 2018, particularly in the fourth quarter, despite the catastrophic activity occurring in real-time from events like Hurricanes Florence, Michael and the California wildfire outbreak. ILS managers who were savvy enough to include CAT bonds in their portfolios sold them as needed to raise additional capital for their collateralized reinsurance businesses. According to Swiss Re Capital Markets, TRACE secondary trading volume in 2018 totaled over $2.1 billion, with the second half of 2018 exceeding $1.1 billion and $700 million of that occurring during the fourth quarter. Second half 2018 trading volume exceeded that of the same period in 2017 by 35%. With $30 billion of CAT bonds in circulation at year-end, the 2018 secondary trading volume was approximately 7% of the outstanding market.
See also: Dying… or in a Golden Age?
Leaving aside the fact that CAT bond portfolio returns often outperformed those of ILS portfolios weighted toward collateralized reinsurance and sidecars in 2017 and 2018, the data suggests that CAT bonds can also perform a valuable liquidity function in ILS portfolios of all types. CAT bonds clearly give managers of ILS funds a multi-dimensional portfolio management tool that benefits both portfolio return and liquidity.
Whither the CAT bond market? I suggest that thou speakest too soon!