Cat bonds compete outright for top layers, no longer just an add-on
Cat bonds may have what it takes to dominate an ever-larger portion of the upper layers of property-cat reinsurance programmes heading into the next renewals cycle—possibly even replacing some capacity available from traditional reinsurers and the insurance-linked securities (ILS) vehicles they offer.
That is the view of Dirk Schmelzer, senior fund manager at ILS and cat bond asset management house Plenum Investments.
“The capital markets are most efficient in the most risk-remote parts of the market,” Schmelzer told Intelligent insurer, explaining the cat bond bonanza playing out in 2023. “That is where cat bonds can replace a lot of reinsurance protection,” he said.
At a certain height in reinsurance towers, cat bonds may offer unbeatable capital efficiency, despite their otherwise high structuring costs.
Go lower in the towers, where traditional reinsurers offer sidecars and collateralised ILS vehicles alongside admittedly higher rate on line, and investors may demand extra spread to cover not just structuring costs, but the volatility risks, the liquidity risks, the risk of trapped capital and even operational risks that come from being closer to frequency perils.
Stay high in the towers and the spread only has to cover cat bond structuring costs over expected return.
That can look very attractive compared with the nearly pure equity solvency costs cedants would have to bear if forgoing reinsurance altogether. “From the cedant’s point of view, why pay an investor more to take liquidity and volatility risk?
“My suspicion is that investors have realised that if they do non-cat bond ILS, these valuation and operational risks are higher than the structuring cost for cat bonds,” Schmelzer said. It might beat equity investments in traditional reinsurers by the same measure.
More cat bond issuance
At what layers cat bonds lose that comparative advantage is a tough guess: pricing in other ILS segments and even in traditional reinsurance is not sufficiently transparent to draw clear lines. It certainly doesn’t match the transparency built into cat bonds, Schmelzer suggests.
For now, market participants can marvel at the comparative capital flow figures for cat bonds versus collateralised reinsurance and at the rising number of cases on the market where penthouse layers of reinsurance towers turned cat bond only.
That surge in cat bond issuance to $9.7 billion in the first half of 2023 outpaced maturing volumes for a net gain of nearly $4 billion. H1 issuance beat the FY2022 tally outright and proved 14 percent ahead of the pace set in the first half of 2021’s record year. Sponsor counts, debut sponsor counts, average deal size and pricing versus guidance all speak to a banner year.
That’s primarily a reflection of investor demand, Schmelzer says, although primary insurers worn down by a difficult set of reinsurance renewals have been all too happy to oblige.
“The growth is not necessarily driven by protection buyers, but predominantly driven by investor interest,” he said.
While the market usually goes quiet around peak hurricane time right now, Schmelzer has picked up “a lot of meetings” starting end-September and through October, including new capital possibly seeking expansion into ILS.
Meanwhile, the proof seems visible in the secondary market pricing where spreads, still quite high historically, have compressed by roughly 25 percent in the year to date, Schmelzer noted.
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