Cat Bonds: Weathering the Storm

The catastrophe bond market resisted the pull of the broad financial market turmoil in 2008, but it did not emerge completely unscathed. Issuance activity dropped precipitously, and spreads in the secondary market widened. Investors and issuers both expressed concern about counterparty credit risk. Yet despite a few moments of anxiety, we’re now looking back on a market that has persevered and is currently regaining its footing. There may have been a few scratches, but catastrophe bonds continued to demonstrate their viability as risk transfer tools.

For the catastrophe bond market, 2008 was a quiet issuance year. Following records set in 2007, the risk capital issued fell 62%, and the number of issuances dropped by 52%. Most activity occurred in the first half of the year, when issuances kept pace with 2006. But the market fell silent by September.

Reinsurance market conditions, rather than financial market turmoil, contributed to the decline in catastrophe bond issuances in the first half of 2008.Traditional reinsurance capacity was more than sufficient to address cedent risk transfer needs, reducing the appetite for alternative forms of coverage. Further, reinsurance rates were already low and were expected to continue falling throughout the year. At the Jan. 1, 2008 renewal, the Guy Carpenter World Rate on Line (ROL) Index fell 9% year-over-year, and it continued to gain downward momentum through the July 1, 2008 renewal.

The pace of business was nonetheless brisk. Issuers ultimately brought US$2.7 billion in new capacity to market through 13 transactions (11 of them in the first half of the year), making 2008 the third busiest year in history — and still well above the 12-year annual issuance average of US$2.1 billion.

The dynamic changed, however, during the second half of the year. Consistent with previous years, the third quarter was light; the difference came in the fourth quarter. Potential sponsors became cautious after the financial market events of mid-September. As the Jan. 1, 2009 renewal approached, the uncertainty of where traditional reinsurance rates were headed led many issuers to defer their plans to the first quarter of the new year. Thus the last quarter of 2008 was silent, unlike the same period in 2007, in which seven catastrophe bonds brought US$1.9 billion in new capacity to market.

Although only part of the drop in issuance activity can be attributed to the meltdown in global financial markets, the issue of counterparty credit risk arose directly as a result of the loss of a major financial institution. Four catastrophe bonds lost their total return swap (TRS) counterparty, causing both investors and issuers to pause and wait for the implications of this development to become clear.

Initially, some investors and issuers were unsettled by the markdown of these four bonds. They were concerned about a potentially significant credit risk and (perhaps worse) moral hazard in the catastrophe bond market. As the dust settled, though, investors and issuers saw the market did not suffer from an underlying flaw. Instead, the value of improved transparency and tightened collateral requirements were realized; these measures are being addressed in future solutions.

The secondary market for catastrophe bonds, on the other hand, had record amounts traded during 2008 Q3. Turmoil in the financial markets caused multi-strategy hedge funds to divest their catastrophe bond holdings in order to meet the liquidity calls created by market losses and investor redemptions. Essentially, the catastrophe bond asset class was among the few asset classes to maintain its value through the general capital markets dislocation of 2008. Secondary trades were done at significant discounts; they represented a profitable opportunity for investors in the catastrophe bond market with cash to invest.

Substantial non-correlation is the principal reason for catastrophe bond performance in the midst of the global financial catastrophe. Since these vehicles were first issued in the mid-1990s, many have touted them as being generally uncorrelated with broader capital market risks. After all, catastrophe bonds are linked to physical events such as hurricanes and earthquakes rather than an issuer’s default risk, interest rate risk or currency risk. Consequently, one would assume that catastrophe bonds would not follow broader credit markets into a downturn. However, since this is still a securities structure, some elements remain — such as the collateral and funding mechanisms — that carry some degree of capital market risk. As a result, unlike other credit risk-related asset classes, it is likely the catastrophe bond asset class will actually emerge with improved utility for both sponsors and investors.

As the catastrophe bond continues to mature, issuers are likely to advance their thinking from the basic features and benefits of this risk transfer tool (i. e. non-correlation and targeted risk transfer) by integrating them into broader risk and capital management plans. The decision to issue a catastrophe bond rather than buy traditional reinsurance will be influenced by more than just the availability of capital and the difficulty of placing a particular program.

Of course the ongoing financial catastrophe will play a role in the evolution of the catastrophe bond market, and the future remains unclear. Traditional reinsurance capacity is expected to contract; we continue to wait for full-year financial results for publicly traded (re)insurers to be reported.The revelations to begin in the middle of March will indicate the potential severity of the crisis for the issuers for the coming year. But the catastrophe bond market has remained resilient — a fact that is likely to shape portfolio management practices in 2009 and further into 2010.

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Traditional reinsurance capacity was more than sufficient to address cedent risk transfer needs, reducing the appetite for alternative forms of coverage.

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Essentially, the catastrophe bond asset class was among the few asset classes to maintain its value through the general capital markets dislocation of 2008.