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Cat bonds find favor amid investor frustration with insurance-linked securities

The catastrophe bond market continues to thrive despite investors' apprehension about insurance-linked securities more generally after three years of nasty surprises. This is prompting a shift toward catastrophe bonds from other strategies, according to market participants.

The insurance-linked securities, or ILS, market allows investors to participate directly in insurance and reinsurance risks. The market has four main elements: collateralized reinsurance, which is the largest component; catastrophe bonds; special-purpose reinsurers known as sidecars; and industry loss warranties. Much of the market's focus is on covering extreme events such as natural catastrophes.

The ILS market is often talked about as a whole, but investors' fortunes have diverged depending on the type of structure they backed. Investors in collateralized reinsurance in particular have suffered three bad years in a row, and the coronavirus pandemic could make 2020 the fourth. Not only were 2017 and 2018 heavy catastrophe years, but the losses from some of these catastrophes — notably 2017's Hurricane Irma and 2018's Typhoon Jebi — also continued to worsen over time, meaning investors paid more than expected.

When the ultimate claims bill is unclear, the ceding companies in collateralized reinsurance transactions retain the collateral investors put up to pay claims until they can determine the outcome more accurately. This so-called trapped collateral is then unavailable for the investors to redeploy in new deals.

In addition, investors have had to pay more than they thought for other losses such as wildfires in California, and may end up paying claims that they never considered. Coronavirus-related business interruption claims could be covered by collateralized reinsurance or sidecar structures, for example, and the uncertainty around coronavirus-related losses could lead to more trapped collateral.

"You start to pile up the number of negative scenarios suggesting that the ILS market didn't behave the way it was supposed to behave," Quentin Perrot, international head of ILS at Willis Towers Watson PLC unit Willis Re Securities, said in an interview.

The resulting investor exits and trapped collateral have shrunk the ILS market. Broking group Aon PLC's reinsurance market outlook, published in July, said the amount of reinsurance capital provided by the alternative market had shrunk by 4% to $91 billion at the end of the first quarter of 2020. It said at least $15 billion of collateral is thought to be trapped because of recent major losses, "now including COVID-19."

A 'bright spot'

It is a different story for the catastrophe bond portion of the ILS market, which Aon's report described as a "bright spot." Perrot said that, other than the typical ebb and flow, "the investors have not withdrawn capital" from catastrophe bonds.

Florian Steiger, executive director of cat bonds strategy at investment manager Twelve Capital, said that although cat bonds had a "difficult year" in 2017, when hurricanes Harvey, Irma and Maria hit the U.S., "thereafter they pretty much performed well" and "investors see that." He added: "In fact there is quite a bit of money ... coming into our cat bond strategies."

Paul Schultz, CEO of Aon Securities, said there was "strong appetite" for catastrophe bonds from both investors and sponsors. He said via email that as a result: "We are expecting that 2020 will be very robust in terms of issuance."

Cory Anger, managing director of Marsh & McLennan Cos. Inc.-owned reinsurance broker Guy Carpenter's GC Securities division, said via email that in 2020 to date, $6.65 billion of catastrophe bonds issued under Rule 144A of the U.S. Securities Act have come to market, from 31 deals and 27 sponsors. This compares with $5.3 billion from 22 deals and 20 sponsors in 2019.

Anger said about $3.3 billion of deals had come to market since the coronavirus pandemic escalated in mid-March, "demonstrating availability of ILS capital albeit at higher pricing."

Given the challenges in collateralized reinsurance around valuation, trapped collateral and the uncertainty over business interruption losses, Steiger said that "within the ILS market, the cat bond market right now seems to be a bit more in favor" than private collateralized reinsurance.

Part of the reason for catastrophe bonds' appeal is their structure. Unlike collateralized reinsurance and sidecars, cat bond coverage is typically restricted to specific, named risks, such as Florida windstorm or California earthquake. Even if the coronavirus pandemic were deemed a natural catastrophe, for example, it would not affect these tightly defined structures.

As they can be publicly traded, they are also more liquid. Schultz said investors are showing "a preference for liquidity," meaning "catastrophe bonds may see relatively more growth than, say, collateralized reinsurance."

For ceding companies, catastrophe bonds are also providing an alternative to collateralized reinsurance for aggregate, or sideways, retrocession, which covers reinsurers when they suffer losses from a series of events. Dirk Lohmann, head of Schroder Secquaero, the ILS investment management division of asset manager Schroders PLC, said in an interview: "If you want sideways-type coverage, one of the few places you can get it is in the cat bond market, and one of the only ways you can get it is on a [property claim service] index basis not on an indemnity basis."

Taking another look

Although some investors have exited the ILS market, and challenges persist, market participants say it remains a tempting prospect, thanks to increasing reinsurance prices and ILS instruments' lack of correlation with the broader financial markets.

"I would argue the case for ILS, either on the private or the cat bond side, has never been stronger in the history of ILS," Steiger said. "If you look at ILS stand-alone, the risk-return profile has hardly ever been more attractive."

Anger at GC Securities said a number of previous ILS investors have been waiting for the insurance pricing cycle to change and "we expect this is an opportunity for them to come into the market either for the first time and/loop or revisit participation in the market."

Lohmann said Schroder Secquaero has been "having quite a few discussions with institutional investors who have put ILS back on the agenda, and did not allocate in the past but see that the overall pricing environment is quite opportune." But he added that although he was expecting inflows from these investors, "they don't move at lightning speed, and so I don't see that money coming until later in the year."