ILS market shows its new maturity
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2017 was a record breaking year for cat bond issuance. Gary Harris and Brad Adderley from legal firm Appleby take a look back at what was a year to remember.
Catastrophe bond and insurance linked security (collectively, cat bond) issuances passed $1.9 billion during the fourth-quarter of 2017, according to the latest industry statistics.
This meant that cat bond issuances outperformed the ten-year average for the fourth-quarter at a time when some had forecast a capitulation of this alternative market owing to the significant amount of funds backing fully collateralized reinsurance and retrocession contracts that had been lost or trapped. However, as Swiss Re rightly pointed out in its latest quarterly report on the cat bond market, investors “endured the onslaught” of the major catastrophe losses of 2017, “displaying immense fortitude and demonstrating the discipline and importance of alternative capital to the re/insurance market.” The investors’ understanding and appetite for cat bonds all led to a record breaking 2017 with about $12.6 billion of new risk capital brought to market.
With over $3 billion of cat bond issuances already in Q1 2018, there is no sign of slowing down. According to publicly available information, this is the fifth consecutive year that first-quarter issuances have reached a new high, surpassing the $2 billion mark for the fourth year in a row. This is because cat bond investors have for the most part displayed a readiness to reinvest in upcoming transactions. These investors have a strong appetite for an asset class that is viewed as being more attractive (i) since their terms will have improved because of the 2017 catastrophes and (ii) since their returns are largely uncorrelated to the financial markets.
Traditional Reinsurers and ILS
The 1/1 renewals do shed some light on the growth of the ILS market and the increased influence it has generally over the market cycle. After HIM and the Mexico earthquake, the debate on rates carried on for many months, but during the 1/1 renewals we only saw small to moderate rate increases. While some reinsurers chose not to increase their book, others did so significantly. Interestingly, the latter chose to use this opportunity to try to regain some of their lost market share by offering to keep their rates close to the 2017 rates in return for larger signings.
Some feel that in addition to the small rate increases achieved at the 1/1 renewals, there is a good chance of further increases at the April and June renewals. We believe that this is unlikely as any boost to margins will be short-lived due to the establishment and rate of growth of cat bond capital which will serve as a balance due to its competitive pricing.
Many traditional reinsurers already realize that the era of massive rate increases has passed and are now leveraging the capital markets and cat bonds to provide a platform that efficiently matches risks with the most appropriate capital. In order to stymie shrinking returns-on-equity, we expect to see more and more reinsurers use third-party capital to (i) increase their returns by providing underwriting or management services and (ii) reduce their exposure while optimizing their book of business.
Companies like XL and Renaissance Re took advantage of investor appetite in the fourth-quarter of 2017 and in early 2018 by increasing their catastrophe protection using alternative capital. We expect other traditional reinsurers to similarly seek to extract as much profit from their intellectual capital (i.e. from internal teams responsible for underwriting, structuring, pricing etc.) as they can.
2018 Trends - Innovation and Growth
In recent years the cat bond market has been very innovative and we expect this to continue in 2018 through a focus on new lines of business, new territories and new structures. Innovative transactions such as Operational Re, where we assisted Credit Suisse in securing insurance for its operational risks through a cat bond, as well as transaction structures such as Alpha Terra Validus, a cat bond lite transaction which was the first cat bond to feature Latin American perils, are just the beginning. Already in 2018 we have seen the World Bank’s parametric earthquake catastrophe bonds issued for the benefit of the Pacific Alliance member countries (i.e. Chile, Colombia, Mexico and Peru). This desire to innovate is primarily fueled by investor demand - as was illustrated in the World Banks cat bond where the $1.4 billion issuance received almost $2.5 billion worth of investor orders.
The 2017 catastrophes have provided answers to major uncertainties such as how the market would deal with, and respond to, the issue of trapped collateralWe expect further growth and expansion owing to a renewed confidence in cat bond structures from both the cedants and the investors. The 2017 catastrophes have provided answers to major uncertainties such as how the market would deal with, and respond to, the issue of trapped collateral. Despite all the worry, what we indeed saw was responsive fundraising.
The Swiss Re ILS report rightly highlights that we may see a dip in market size at the mid-point of 2018, with $4.6 billion scheduled to mature, as well as uncertainty regarding the size of impairments to additional bonds from 2017’s events. We expect such a dip to be short-lived as new funds will be committed to replace the matured collateral as the cat bond market continues to exhibit high levels of activity.
2018 - Structuring trends
Although parametric triggers have dominated cat bond issuances during the first-quarter of 2018 (mainly because of the World Bank’s cat bond), we expect indemnity triggers to continue to dominate issuances during the course of 2018 and we have been seeing proof of this on many of our February and March transactions. If history is anything to go by, it is likely that indemnity triggers will be followed by industry loss triggers and then closely by parametric triggers.
The average deal size in the first-quarter of 2017 was approximately $197 million across 14 deals, which is above the ten-year average size of $178 million, and six deals above the average number of transactions completed. By comparison, in 2018 the average first-quarter deal size seems to be in the region of $240 million across 16 deals. We expect this record breaking trend to continue throughout the year.
In 2017, a diverse spread of new cedants such as Terra Brasis Re and ICAT Syndicate 4242 came to the cat bond market in 2017. Likewise, in 2018 we have Terra Brasis Re returning to the market to participate in the Alpha Tera Validus II transaction as well as the Pacific Alliance (Mexico, Peru, Columbia and Chile) participating in the World Bank’s cat bond. We expect this to be a continuing trend in 2018, especially now that the market has been tried and tested. Our expectation is that the new entrants will most likely be primary insurers, public sector sponsors and reinsurers.
Generally, no one peril dominates over the others with a significant amount of the capital raised going to reinsure International Multi-peril, US Multi-peril, US Named Storm, Japan Typhoon and US Earthquake. We expect this trend to continue in 2018.
After comfortably withstanding its first major test, the cat bond market has exhibited its permanency in the reinsurance marketplace. The fact that the cat bond market now has more capital from a wider investor base than it had prior to the 2017 catastrophes is a clear indication of this. It is natural therefore to expect further growth and expansion even if another string of natural disasters were to strike again this year as such a string of disasters would only serve to push rates higher which in turn should attract many new investors. Additionally, the relationships that industry players (such as arrangers, service providers, attorneys, brokers, insurance managers, etc.) have established with various investors and cedants greatly solidify the cat bond industry and ensure that its foundation remains secure in spite of global catastrophes.
Brad Adderley is a partner at Appleby.
Gary Harris is a senior associate at Appleby.
ILS, market, 2017, Appleby, record, year, issuance