Further issuance growth tipped for cat bond market despite price hardening

Cat bond pricing hardened in the first half of 2022 as investors required higher compensation for the capital they provided to sponsors, but observers say demand should remain strong given the reduced traditional reinsurance capacity.

In its latest report Aon said it expects cat bond market momentum to continue through H2 this year to match the record issuance levels of 2021.

In the broker’s ILS Annual Report 2022, Aon Securities chairman and CEO Paul Schultz referred to this momentum as an “an impressive feat given the headwinds experienced in the space at times throughout the first half of 2022”.

Cat bond issuance reached near-record issuance levels of $12bn from 1 July last year to 30 June this year. The record level of $13bn was reached in the prior year.

“We expect an orderly market to continue and momentum to carry into 2023,” Schultz added.

Geopolitical factors such as the Russia-Ukraine conflict, a spike in global inflation, rising interest rates and currency volatility were all headwinds in the first half of 2022, as spreads increased for cat bonds.

Cedant demand for the product “remained robust”, however, Aon noted.

“Whilst the cat bond market has observed rate hardening, it continues to diversify and attract both new and repeat sponsors, with relatively larger increases in traditional (re)insurance pricing placing the ILS market in a more competitive position year on year,” the report noted.

In the year ended 30 June 2022, Bermuda was the largest issuer domicile with 41 transactions, followed by five from Singapore and three from Cayman, out of a total of 54 transactions globally.

The “quest” for more capacity

Investors have turned to cat bonds as a type of ILS product that offers diversification to their portfolio. This asset class has been offering relatively attractive conditions, given the modest catastrophe frequency and severity.

And “the overall theme remains that diversification is playing out well compared to prior ‘bull years’ of the broader financial markets”, said Richard Pennay, CEO ILS at Aon Securities.

“With the space continuing to display its ability to offer a source of diversification from the volatility so far observed in the broader capital markets this year – one can reasonably expect further capital to seek to benefit from this trait,” he added.

Pennay also noted that “the quest for more capacity from ILS markets is well under way” for products like proportional-based sidecars or non-proportional reinsurance via cat bonds or collateralised reinsurance.

In the first half of this year, ILS capital markets capacity was estimated at $95bn, a decrease of around 2 percent compared with the same period last year.

But Aon noted that, as a resilient and robust market, ILS capacity is in a strong position for the remainder of the year.

“We are now in a market where the demand for ILS capacity exceeds supply of ILS capital, and whilst this results in higher prices and tighter terms and conditions, regular sponsors of ILS products are increasingly grateful for this alternative source of capital, forging strong relationships with the capital markets in the process,” Pennay added.

Separately, Moody’s said reinsurers are increasingly dependent on cat bonds and sidecars for retro protection as collateralised aggregate capacity contracted last year with the re-emergence of trapped capital. According to the rating agency, reinsurers have sponsored 15 cat bonds since June 2021 to access retro capacity, providing $2.85bn of limit.

Upsized cat bonds

In its latest update on the ILS market, AM Best reported that overall property casualty cat bond issuance in the first half of this year totalled $8.1bn from 35 transactions, compared with $8.5bn from 29 transactions in the first half of 2021.

The $5.0bn placed in the second quarter of 2022 was down from $5.9bn in Q2 2021.

However, the report said that 23 – or 66 percent – of the 35 144A cat bond transactions in the first half were upsized from their initial guidance levels, for a total $1.6bn upsized amount and an average increase of 36 percent.

Overall, the amount issued in the first half of 2022 was 23 percent higher than initial guidance.

The report also noted that 23 cat bonds were priced above the midpoint of initial pricing guidance, while 13 were priced above the upper bound of initial guidance.

“Pricing in the first half of 2022 contrasted with pricing outcomes in the first half of 2021, when none of the 29 cat bonds issued during that period priced above the upper bound of initial pricing guidance, while 20 of the 29 priced below the lower bound,” the report said.

It added: “There were more cat bond tranches that could not be placed in the first half of 2022 compared to prior years – in some cases, entire deals could not be placed. Fifteen tranches in eight transactions were marketed to investors but pulled in the first half. The target amounts for these tranches came to more than $500mn.”

AM Best commented that the reasons for pulling a cat bond vary but the inability to place some cat bonds “seems to connect with the broader theme of market hardening”. The rating agency suggested that more sponsors never made it far enough to market a cat bond because they perceived that pricing and conditions would not be favourable.

Cat bond CAGR sustained in H1

Meanwhile, Swiss Re Capital Markets (SRCM) noted that the ILS market gave sponsors an alternative source of risk transfer capacity in a hardening reinsurance market.

“Some reinsurers have reduced capacity in peak zones or closed their natural catastrophe portfolios entirely, which has led to increased opportunities in the ILS market,” the report said. “Given the need for more overall reinsurance capacity, we expect the trend of increased new issuance volume to continue and result in further growth.”

SRCM said the cat bond market is on track to sustain its compound annual growth rate, which is 8.96 percent since 2012. At the midpoint of 2022 there was just over $36.2bn notional outstanding.

Net cash flow (new issuance minus maturities) into the market from the beginning of 2021 through the first half of 2022 was nearly $4.9bn, SRCM said, which it noted helps explain the spread widening seen in this year.

Net cash flow has also been impacted by loss payments to sponsors. Payouts in H1 2022 from loss events in prior years reached nearly $230mn, while in the past four and a half years loss payments have reached $2.0bn.

The cat bond market in 2022 has paid recoveries for prior-year events including Hurricane Ida, Hurricane Florence and Hurricane Michael.

Despite the drop in cat bond issuance in the first half, a handful of new sponsors emerged, with $805mn in debut cat bonds issued in the period. The new sponsors were Inigo Insurance, Kin, SureChoice Underwriters Reciprocal Exchange, Core Specialty, Peak Re and The Hanover.

ILS managers’ different strategies

AM Best in its report said that investors are evaluating their options, with the financial landscape in flux.

“Property catastrophe ILS often is touted for its diversification benefits, but investors may be willing to forgo the benefits if the expected return on another asset is high enough to make up for the lack of diversification,” the report said. “For this reason, there appears to be a floor of 6 percent to 7 percent for cat bond spreads, regardless of expected loss level, sponsor quality, type of coverage, or other aspects of the transaction.”

AM Best commented that ILS managers are employing different strategies to improve results – “some are emphasising pricing increases, while others are focused on optimising deal structures as well as terms and conditions”.

ILS managers believe they can improve results by moving toward severity-based, rather than frequency-based, agreements. This is leading them to word contracts to focus on named perils only, and write more per-occurrence contracts rather than aggregate contracts.

“For the aggregate deals, ILS managers are more inclined to include per-event caps that limit the amount that any single loss contributes to the erosion of the aggregate deductible. In some cases, the per-event caps are set so that the aggregate attachment will not be breached until three to four events have occurred,” the report said.

AM Best believes that investors’ scepticism of catastrophe risk modelling may keep them from deploying additional capital even as prices rise to attractive levels.

The rating agency noted that the first half saw cat losses from floods in Australia, windstorms in Europe, earthquakes in Japan and convective storms in the US. But ILS managers believe that the underwriting tightening measures taken over the last year should mitigate the impact of these events on ILS investments.

ILS investors are also increasingly optimistic about avoiding losses from Winter Storm Uri in 2021, which caused industry losses estimated at $15bn.

Over 130 insurers are jointly suing the Electric Reliability Council of Texas and dozens of power-generating entities for grid failure, with increasing confidence that successful litigation or settlement may reduce insurers’ losses considerably.

“Some market participants believe that, if significant subrogation recoveries result from this litigation, the aggregate contracts might ultimately not attach to the coverage layers,” AM Best said.

ILS returns slightly negative in H1

SRCM’s report highlighted that the broader financial markets in the first half navigated volatility resulting from rising inflation, the Russia-Ukraine war and interest rate fluctuations.

“Despite these factors, ILS markets have performed relatively well throughout the first half of 2022 with year-to-date returns only slightly negative for the year and the third most active H1 for new issuance on record,” it said.

The Swiss Re Global Cat Bond Total Return Index showed year-to-date investor returns of -0.35 percent, with the negative return driven by spread widening as a result of the hardening reinsurance market.

SRCM said this suggested an improved outlook for returns in years to come. “Barring any major natural catastrophes which might cause principal losses, we expect performance should recover strongly in the second half of the year,” the report said.