13 December 2019

Cat bonds: repricing risk

A series of costly natural catastrophes in recent years continues to take its toll on sentiment in the catastrophe (cat) bond market.

In the wake of events including wildfires in California, hurricanes in the US and typhoons in Japan, a number of cat bonds were impaired, leaving investors nursing losses and concerned about collateral being 'trapped'.

For example, Californian utility PG&E issued its first ever cat bond in Q3 2018, raising $200 million. It was the first cat bond to solely cover wildfire. Just 98 days after its issuance came the Camp wildfire – the most destructive wildfire in Californian history, causing some $9.2 billion in total losses. PG&E was deemed liable due to faulty electrical equipment and the bonds are expected to make a full pay-out to the sponsor.

"Over the past two years, investor confidence has been challenged," says Des Potter, a managing director at GC Securities, part of Guy Carpenter, which was voted Best Broker for the second year in a row.

Potter says wildfire risk in California has not been "well modelled or well understood".

He argues the insurance-linked securities market as a whole – which includes collateralised reinsurance, sidecars and industry loss warranties as well as cat bonds – has been "unsettled".

However, it is collateralised reinsurance "where some of the surprises have come through in terms of the bigger losses", he says, while the cat bond market, which "benefits from better risk disclosure and pricing transparency", remains "robust and vibrant".

Des Potter

"Cat bonds are the most stable part of the market," he adds.

Potter predicts that new issuance will roughly match maturities this year – he says there will be about $5.5 billion of issuance by the end of the year, leaving $28 billion to $29 billion outstanding.

2019 has been a quieter year in terms of natural catastrophes, but sentiment in the market is still shifting. Across the cat bond market, investors have started to demand more yield to compensate them for the risks.
"We have seen a 10% to 15% increase in risk-adjusted pricing – it reflects the loss experience and investors' concern about the impact of climate change," adds Potter.

Laura Taylor, President of Nephila's Bermuda office and head of the portfolio management group, has also seen changes in pricing dynamics.

Laura Taylor

"While interest remains strong, we are seeing shifts in expectations," she explains. "Following the events of 2017 and 2018, the view of risk has changed, and investors expect to be compensated accordingly.

"Earlier in the year, we saw many of the new issuances price at the wide end, and in some cases struggle to get done," she says. "On more recent new issuances, we see yields out about 25% from 2018, along with improvements in terms and conditions."

Nephila won Best Dealer (structurer/arranger) for cat risk for the second time in a row.

In 2020, Taylor expects "continued repricing, as investors reassess their view of the risk, and possibly more vanilla structures as issuers try to keep pricing in check. Either way, risk-adjusted returns will need to continue to improve as the bond market competes for investor capital."

However, she sees further diversification in the market. She points out that a fund managed by Bayview Asset Management recently came to market with a California Earthquake bond to cover its mortgage-related securities business.

"This could result in a new pool of issuers for the market, allowing it to expand beyond traditional players," she believes.

"The cat bond market remains an attractive market to both managers in the property cat space and investors who allocate for a diversified return stream, though, to some extent, it feels like the minimum yield/floor is being reset higher and appetite for 2% yielding paper is limited.

"Some investment managers, both independent or part of a re/insurance platform are leaving or are out, new managers are emerging, pricing is adjusting."

GC Securities' Potter adds: "Some investors have pulled back but the fundamentals remain pretty strong and investors are moving their money around by strategy and manager.

"We are feeling pretty confident about the future – there's a very healthy pipeline of potential issuance in the next 12 months. The growth of the market will resume, assuming no more surprises." EF