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Credit FAQ: In A Correlated Market, Catastrophe Bonds Stand Out

Financial markets have recently proved to be highly correlated, as the COVID-19 pandemic cut a swath through various different industries. However, catastrophe bonds (cat bonds) usually protect against specific perils across different regions and cover predominantly residential risks, with limited exposure to commercial business. Hence, S&P Global Ratings does not expect investors in cat bonds to suffer significant losses as a result of COVID-19 and hence future new issuance to continue.

Here, S&P Global Ratings answers questions from market participants about how the insurance-linked securities (ILS) market has been faring and what could happen as the pandemic continues.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Frequently Asked Questions

Did investing in the ILS market offer the diversification benefits that investors hoped for?

In the current pandemic, financial markets have demonstrated a high level of correlation. However, even under this extreme level of stress, the ILS market and in particular, the cat bond market, has once again demonstrated its value as a source of diversification. The ILS market predominantly provides protection against natural catastrophes and other named perils across different regions, most of which should be unaffected by recent events. A limited number of cat bonds, which represent less than 5% of the outstanding principal amount, are exposed to pandemics; these include extreme mortality, medical benefit ratio, or specific pandemic bonds like the ones issued by the World Bank.

The cat bond market, which is the most liquid part of the ILS market, enabled investors to trade out of their positions where needed during the first weeks of the crisis. The increase in trading was fueled by draw-downs from funds which rebalanced their portfolio; realizing the value of cat bonds to pursue short-term opportunities in other asset classes; or converting cat bond investments into cash to meet liquidity needs for margin calls on foreign exchange hedges.

However, if the demand for pandemic risk transfer increases in future, we could see the ILS market assume a portion of the exposure. In turn, this could increase correlation with other asset classes. For the ILS market to remain attractive, investors need to ensure that they hold a diversified portfolio across different regions and perils.

What rating actions have you taken on outstanding cat bonds in relation to COVID-19 developments?

As of the date of this publication, we have taken only one rating action related to COVID-19 in the ILS space. We placed our rating on the outstanding $100 million 2015-I class A notes issued by Vita Capital VI Ltd. on CreditWatch with negative implications (see "Rating On Vita Capital VI Ltd.'s 2015-I Class A Notes Placed On CreditWatch Negative Due To COVID-19 Pandemic," published on March 31, 2020). These notes enabled Swiss Re to obtain protection from the capital markets against extreme mortality events, such as a pandemic. We see an increased risk that investors could lose principal if the COVID-19 pandemic leads to a significant increase in deaths in the U.K., Canada, or Australia.

We also published a bulletin in relation to the four outstanding Vitality Re transactions (see "The Coronavirus Pandemic May Pose A Risk To Four Vitality Re Transactions," published March 19, 2020). The notes could be triggered if the pandemic leads to a significant increase in medical claims payments by Aetna Life. Our ratings on these issues remain unchanged for now, but we continue to monitor the transactions and will incorporate developments as they occur. Based on the stress tests we have performed, we consider that it would take a severe morbidity stress to trigger the notes (see "Morbidity Stress Test: How A Hypothetical Pandemic Could Affect U.S. Health Insurers," published March 12, 2020).

As the midyear reinsurance renewals approach, how will the pandemic affect ILS rates?

ILS and reinsurance prices are much more aligned nowadays, so that our overall expectations for the Florida renewals can give some guidance here. We consider that the Florida market is facing a dislocation, which could support rate increases of over 10% (see our recent pricing article "U.S. Casualty Reinsurance Pricing Revives During The January 2020 Renewals," published Jan. 15, 2020). Florida is a peak zone exposure for many reinsurers and a large market for alternative capital. After consecutive years of catastrophe losses and a shift in views on risks, we expect both traditional and alternative capital to increase their return targets.

Bearing in mind that COVID-19 will erode overall investment returns and could lead to further claims, we expect underwriters (including ILS asset managers) to come under greater pressure to achieve higher returns during the upcoming renewals.

Will the pandemic eat into ILS capacity at the next renewals?

We still expect the ILS market to play a significant role in the upcoming midyear renewals. However, third-party capital inflows were already slowing in 2019, because of investors' concerns regarding issues such as model credibility, risk selection/underwriting, loss reporting, reserve setting, and the potential impact of climate change on the frequency and severity of natural catastrophes. The resulting flight to quality made investors more selective, and this trend is likely to continue post-pandemic. Investors already preferred well-established sponsors or managers with better track records and modeling capabilities, clearer underwriting strategies, and stronger reserving practices and governance. If losses from the pandemic creep into contracts where the pandemic risk was not modeled, we expect investors to scrutinize individual fund performance and diversification even more closely.

Some investors may leave the market for other opportunities, or to free up cash following the COVID-19 pandemic, and we could see an increase in trapped collateral in the short term. That said, investors will be seeking to achieve their higher target returns. If successful, this could be an incentive for investors that have been waiting on the sidelines to come in and increase ILS capacity at future renewals.

Could demand for cat bonds increase in the long term, as investors seek investments with low correlation to the market?

We anticipate that investors are likely to show as much interest in cat bonds as before, or even more. Initially, investors may make a trade-off between the lower correlated returns of ILS investments and the potential short-term opportunities in other asset classes. But at the beginning of the outbreak, when financial markets were in turmoil, cat bonds provided a liquidity benefit to investors that wanted to sell their positions. Bid and ask spreads remained reasonable and investors were able to sell their positions close the par. By contrast, sidecars and collateralized reinsurance positions proved much more illiquid. Investors in these vehicles usually have to wait until the next renewal to release their capital. In addition, volatility in the cat bond market was much lower than in the rest of the capital markets.

Furthermore, the uncertainty regarding whether unmodeled pandemic-related business interruption claims could creep into reinsurance contracts, will play out in favor of cat bonds. Collateralized reinsurance and sidecar positions are more likely to become subject to legal disputes around wording. As a consequence, collateral could be trapped for some time. Cat bonds, by contrast, usually work on a named perils basis and cover predominantly residential risks. They have limited exposure to commercial business. Hence, investors in cat bonds covering natural catastrophes do not expect to suffer significant losses as a result of COVID-19. Cat bonds that have parametric or modeled loss triggers (that is, they are not dependent on cedants' ultimate losses) provide investors with even more certainty.

As a result, we could see investors' interest turn from the less public part of the ILS market, such as collateralized reinsurance or sidecars, to the more liquid and transparent cat bond market, while demanding pandemic exclusion at contract renewals

Even before the pandemic outbreak, issuance was at record levels. Nat cat bond issuance reached over $4 billion in the first quarter of 2020 (source: Artemis.bm), making 2020 the most active first quarter recorded and beating the $2.8 billion issued in 2019. In addition to replacing maturing transaction, we saw an increase in deals seeking retro protection, possibly because of the anticipated capacity constraint in the retrocession market. For example, Swiss Re sponsored two issuances of $605 million in the first quarter of 2020, and is currently back in the market with a third issuance of around $250 million. Another interesting development was an investment fund issuing a parametric U.S. earthquake cat bond to obtain risk transfer protection for its mortgage-related investments.

After a very short halt at the beginning of the global outbreak, new issuance has now continued at slightly higher spreads, and spreads also increased in the secondary market (see chart 1). According to Willis Re, about $4.6 billion of bonds will mature in the second quarter of 2020 and another $2.2 billion during the rest of the year, which should create a reinvestment need for investors. For this reason, we do not expect new cat bond issuance to drop, as it did back in 2008. On the contrary, we expect 2020 to remain on track, becoming another active new issuance year.

Chart 1

image
Could the pandemic cause the ILS market expand, as it did after the 2008 global financial crisis?

Any boom should be considered in relation to the event's effect on demand for insurance protection and the supply of capital to invest in insurance risk, rather than to the event itself. Most of the expansion in the ILS market following the 2008 financial crisis occurred in the collateral reinsurance space. Investors, and specialized ILS funds in particular, started to provide capacity alongside the traditional reinsurance market, for different risk-return strategies. By contrast, the cat bond market, where new issuance had reached an annual record of just over $8 billion in 2007, didn't return to that level again until 2013. Total annual new issuance dropped to roughly $3 billion per year in 2008 and 2009. Only from 2013 onward did new annual new issuance go back up to pre-crisis levels, with significant more growth occurring in 2017 and 2018 (see chart 2). To date, new issuance in 2020 is already double the level back in 2008, and we expect further new issuance to continue as outstanding deals mature.

Chart 2

image

We expect ILS investors to seek higher returns at future renewals, following years of record losses from natural catastrophes, exacerbated by the COVID-19 pandemic. If long-term investors expect to be sufficiently compensated, they are likely to supply alternative capital and remain committed to insurance risk.

However, this time around, we anticipate the cat bond and industry loss warranty markets will benefit from any ILS market expansion. Investments in collateral reinsurance or sidecars are unlikely to expand as they did after the 2008 financial crisis, because they have been affected by liquidity constraints and uncertainty regarding potential losses during the COVID-19 pandemic.

The ILS market has also recently expanded into other lines of business, such as mortgage and in-force life and annuity blocks. We expect these trends to continue unless investors incur substantial losses through their mortgage insurance-related investments as a result of COVID-19. At the same time, investors' interest could also evolve because of calls for the insurance industry to play a bigger role in absorbing the economic impact of the COVID-19 pandemic. As we have just witnessed, there is substantial correlation between business lines, regions, and markets in the case of a pandemic. For investors to be willing to meet any increase in demand for pandemic protection, modeling needs to be credible and pricing adequate.

This report does not constitute a rating action.

Primary Credit Analyst:Maren Josefs, London (44) 20-7176-7050;
maren.josefs@spglobal.com
Secondary Contacts:Ali Karakuyu, London (44) 20-7176-7301;
ali.karakuyu@spglobal.com
Johannes Bender, Frankfurt (49) 69-33-999-196;
johannes.bender@spglobal.com
Additional Contact:Insurance Ratings Europe;
insurance_interactive_europe@spglobal.com

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