In its latest report, Aon said it expects momentum in the cat bond market to continue through the second half of this year to reach record issuance levels of 2021.
In the broker’s 2022 ILS Annual Report, Aon Securities Chairman and CEO Paul Schultz called this momentum “an impressive achievement given the headwinds experienced at times in the industry during the first half of 2022.”
From July 1 last year to June 30 this year, cat bond issuance reached a near record level of USD 12 billion. The record level of $13 billion was reached last year.
“We expect an orderly market to continue and momentum to continue into 2023,” Schultz added.
Geopolitical factors such as the Russia-Ukraine conflict, rising global inflation, rising interest rates and currency volatility were headwinds in the first half of 2022 as cat bond spreads widened.
However, cedant demand for the product “remained resilient,” Aon noted.
“While the market for cat bonds has seen interest rate hardening, it continues to diversify, attracting both new and returning sponsors, with relatively larger price increases for traditional (re)insurance turning the ILS market into a more competitive one year on year position,” the report noted.
For the year ended June 30, 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 worldwide.
The “search” for more capacity
Investors have turned to cat bonds as a type of ILS product that diversifies their portfolio. This asset class offers relatively attractive terms given the modest frequency and severity of disasters.
And “the general theme remains that diversification is performing well compared to previous ‘bull years’ in broader financial markets,” said Richard Pennay, CEO of ILS at Aon Securities.
“As the space continues to demonstrate its ability to provide a source of diversification from the volatility seen in the broader capital markets so far this year, it is reasonable to assume that more capital will seek to capitalize on this characteristic “, he added.
Pennay also noted that “the search for more capacity from the ILS markets is well underway” for products such as proportional sidecars or non-proportional reinsurance via cat bonds or collateralised reinsurance.
In the first half of this year, the capacity of the ILS capital markets was estimated at US$95 billion, down about 2 percent compared to the same period last year.
However, Aon noted that as a resilient and resilient 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 is outstripping the supply of ILS capital and while this is leading to higher prices and tougher terms and conditions, regular sponsors of ILS products are increasingly appreciative of this alternative source of capital and are building strong relationships with the capital markets in the process,” added Pennay.
Separately, Moody’s said reinsurers have become increasingly dependent on cat bonds and sidecars for retro protection as total secured capacity shrank over the past year as trapped capital resurfaced. According to the rating agency, reinsurers have sponsored 15 cat bonds since June 2021 to access retro capacity and provide a limit of $2.85 billion.
Enlarged cat bonds
In its latest update on the ILS market, AM Best reported that total P&C cat bond issuance for the first half of this year totaled $8.1 billion from 35 deals, compared to $8.5 billion. USD from 29 transactions in the first half of 2021.
$5.0 billion placed in Q2 2022 was down from $5.9 billion in Q2 2021.
However, according to the report, 23 — or 66 percent — of the 35 144A cat bond deals in the first half increased from their original forecasts, totaling $1.6 billion and an average increase of 36 percent is equivalent to.
Overall, the amount issued in the first half of 2022 was 23 percent higher than the original forecast.
The report also found that 23 cat bonds were above the median of the original price prediction and 13 were above the upper limit of the original price prediction.
“Pricing in the first half of 2022 contrasted with pricing results in the first half of 2021, when none of the 29 cat bonds issued during this period were above the upper bound of the original price forecast, while 20 of the 29 were below the lower bound lay,” the report said.
It added: “Compared to previous years, more cat bond tranches could not be placed in the first half of 2022 – in some cases entire deals could not be placed. Fifteen tranches in eight transactions were marketed to investors but were drawn in the first half. The target amounts for these tranches totaled more than $500 million.”
AM Best commented that reasons for buying a cat bond vary, but the inability to place some cat bonds “appears to be related to the broader issue of market hardening”. The rating agency suggested that more sponsors had never made it far enough to market a cat bond because they felt the pricing and terms were not favorable.
Cat bond CAGR maintained in H1
Meanwhile, Swiss Re Capital Markets (SRCM) found that the ILS market offers 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 altogether, leading to increased opportunities in the ILS market,” the report reads. “In view of the need for more reinsurance capacity overall, we expect the trend towards increasing new issues and thus further growth to continue.”
SRCM said the cat bond market is on track to maintain its 8.96 percent compound annual growth rate since 2012. As of mid-2022, just over $36.2 billion was outstanding.
Net cash flow (new issues minus maturities) into the market was nearly $4.9 billion from early 2021 through the first half of 2022, SRCM said, helping to explain spread widening this year.
Net cash flow was also impacted by loss payments to sponsors. Payouts in the first half of 2022 from claims events in previous years reached almost US$230 million, while claims payments in the last four and a half years reached US$2.0 billion.
The cat bond market in 2022 has paid rallies for events from the previous year including Hurricane Ida, Hurricane Florence and Hurricane Michael.
Despite the decline in cat bond issuance during the first half of the year, a handful of new sponsors emerged, issuing $805 million in cat bonds for the first time during the period. The new sponsors were Inigo Insurance, Kin, SureChoice Underwriters Reciprocal Exchange, Core Specialty, Peak Re and The Hanover.
The different strategies of ILS managers
AM Best said in its report that investors are evaluating their options as the financial landscape changes.
“Real estate catastrophe ILS are often touted for their diversification benefits, but investors may be willing to forego the benefits if the expected rate of return from another asset is high enough to offset the lack of diversification,” the report states. “For this reason, there appears to be a 6 percent to 7 percent floor for cat bond spreads, regardless of the expected loss size, the quality of the sponsor, the type of coverage, or other aspects of the transaction.”
AM Best commented that ILS managers use different strategies to improve results – “some emphasize price increases, while others focus on optimizing business structures and business conditions”.
ILS managers believe they can improve outcomes by moving to severity-based instead of frequency-based agreements. This results in them writing contracts, focusing only on named hazards, and writing more contracts per occurrence than aggregate contracts.
“For the aggregate deals, ILS managers are more inclined to set per-event caps that limit the amount a single loss contributes to the erosion of the aggregate retention. In some cases, per-event caps are set such that the aggregated annex is not violated until three to four events have occurred,” the report said.
AM Best believes investors’ skepticism about catastrophe risk models could discourage them from committing additional capital, even if prices rise to attractive levels.
The rating agency noted that the first half saw Cat losses from flooding in Australia, storms in Europe, earthquakes in Japan and convective storms in the US. However, ILS managers believe that the measures taken to tighten underwriting over the past 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 cost the industry an estimated $15 billion in losses.
Over 130 insurers are collectively suing the Electric Reliability Council of Texas and dozens of power generation companies over grid outages, with growing confidence that a successful litigation or settlement can significantly reduce insurers’ losses.
“Some market participants are of the opinion that if significant recourse claims result from this litigation, the overall contracts may not be linked to the layers of cover,” AM Best said.
ILS yields slightly negative in H1
SRCM’s report highlighted that broader financial markets had navigated the first half of the year through volatility stemming from rising inflation, the Russia-Ukraine war and interest rate fluctuations.
“Despite these factors, ILS markets have performed relatively well in 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 reported year-to-date investor returns of -0.35%, with the negative return reflecting spread widening as a result of the hardening reinsurance market.
SRCM said this points to an improved outlook for returns in the coming years. “Barring any major natural catastrophes that could cause capital losses, we expect performance to rebound strongly in the second half of the year,” the report reads.
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