Catastrophe bonds have transformed from an esoteric asset class to a mainstream alternative to catastrophe reinsurance. More than $20 billion of limit is now transferred into the capital markets displacing traditional reinsurance programs. The success of these structures is one cause of the current soft market in the global reinsurance market. Cat bond yields are at long term lows. This seems to be for at least three reasons – the broadening acceptance of the asset class, excess capacity in the reinsurance market and the price of risk in comparable asset classes (in particular junk bonds). This analysis examines how the relationship between ‘expected loss’ (a catastrophe model’s estimate of the average annual loss) and the ‘coupon spread’ (similar to the ‘rate on line’ in reinsurance pricing) has changed over time. This first chart shows the risk/return relationship for 12 months of US wind exposed cat bond issues up to June 1 2014. A simple linear regression implies that the spread for 10% expected loss should be 15.5%, the spread for 5% expected loss should be 9.5%, the spread for 1% expected loss should be 4.6% and the (hypothetical) spread for zero expected loss should be 3.4%. Note, a number of bonds have priced below this, including East Lane VI at 2.75%. The second chart plots the implied coupon spread for these four expected losses (10%, 5%, 1% and 0%) at the first of every month back to January 1 2002 using the prior twelve months of cat bond issues. Note that using the trailing twelve months of bonds leads to a six month lag in the timings of the plot. The minimum (expected loss = 0%) spread has remained relatively steady over time. In fact, it was the same in June as it was in January 2002 (3.4%). What has changed dramatically is the spread that the market offers for higher risk levels. The market pays just 15.6% for 10% expected loss – less than half the spread at the beginning of 2002 for exactly the same level of risk. The yield for any individual deal will be significantly affected by a large number of factors peculiar to that placement. Overall pricing level can be explained by a combination of three factors. 1. The perception of Insurance Linked Securities (ILS) has changed from an exotic asset class to mainstream and this explains much of the secular decline in pricing. This change in perception has meant a significant change in the types of investors that invest in cat bonds (or pay ILS funds to invest for them). In 2002, cat bonds were largely owned by reinsurance companies and hedge funds. Today, institutional asset managers – including pension funds – are driving the market. These investors have much lower return thresholds. 2. A second factor in the price of cat bonds is the close relationship between the cat bond and reinsurance markets. The price increase in 2006 is likely to be related to hurricanes Katrina, Rita and Wilma in 2005 which had a dramatic effect on reinsurance pricing due to the sudden reduction in global reinsurance capital. Conversely, it seems likely that today’s cat bond prices are affected by the surplus of capital in the reinsurance industry. The growth of the cat bond market has itself been part of the cause of the excess capital. 3. The two jumps in returns – at the beginning of 2009 and 2012 – are hard to associate with events in the reinsurance market. A plot of high junk bond yields shows similar movements which suggest a third factor. The financial crisis and Eurozone crisis offer good explanations for these price movements. The high cat bond spreads in 2002 also corresponded to a peak in junk bond returns following the collapse of the dotcom bubble. Does this final observation undermine the non-correlation argument that is used to sell cat bonds in the first place? Not really – almost all of the volatility of cat bond returns is related to defaults rather than yields. The recent, rapid drop in cat bond returns seems to be due to these three effects pulling in the same direction. The same three factors are likely to influence the price of risk in the coming years. The chart below illustrates the effect of these three forces compared with the spread of cat bonds at 2% expected loss. A note about InsuranceLinked data – data has been gathered from private and public sources and so has limited verifiability. InsuranceLinked aspire to use data that is as accurate at possible – if you spot an error or omission, please write to the Editor and it will be corrected quickly. The InsuranceLinked library page contains a number of high quality data sources. In this article, exhibits have been filtered to include only public cat bonds with exposure to natural catastrophes. We use the conservative ‘short-term view’ for expected loss estimates. Junk bond spread is BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread © US$50bn (all perils) ILW is from Guy Carpenter data.

Both indices have been offset by six months so that the timings are consistent with the 12 month trailing average for cat bonds.

In January 2002 the expected return (coupon spread less expected loss) for 2% risk was 7.4%, by the beginning of June it was 3.8%. Material slippage in terms and conditions mean that these numbers underestimate the fall in risk adjusted return.

These numbers refer to a 12 month average. By looking at only 2014 issues (or yields in the secondary market) it is clear that there is now less than 3% of expected profit in the cat bond market. There are few reasons to believe that that yield compression is slowing.

It is common for ‘traditional’ reinsurers to blame the capital markets for the current market conditions (and vice versa). However cedants now use these two types of protection interchangeably and the two markets are going to have to get used to each other’s company.

Almost all of the volatility of cat bond returns is related to defaults rather than yields.

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