Last year was a watershed for many industries, and the insurance-linked securities market was no exception. ILS is a sector that has gained considerable momentum in the last decade, and was included in the same category as other, more volatile financial products.

Unlike other financial products, however, catastrophe bonds–a major component of the ILS market–held their values quite well during the downturn.

Despite the influence of market rumors and pushback by naysayers, cat bond supporters have not wavered in their claims that the returns on these types of securities are relatively uncorrelated with those of the broader financial markets. They continue to offer significant diversification benefits (especially with respect to default risk). Last year provided further proof of this concept.

During the height of the turmoil, from January 2007 to June 2009, the S&P 500 Index declined by some 35 percent and the Barclays Capital High Yield Corporate Index increased by 1 percent, according to Barclays Capital.

In contrast, others have remained strong–even increasing. While some financial asset markets have been thrown into considerable turmoil by the global financial crisis, the fundamentals of the cat bond market remained strong.

While retaining relative value during economic crisis is great news for cat bond investors, what do cat bond returns mean for the property-catastrophe reinsurance market? Like the financial markets, the reinsurance sector has had its share of challenges in the last year. In 2008, insurance capital was destroyed in an unprecedented fashion.

Select non-life insurers had capital surplus reductions of alarming double-digit decreases between 2007 and 2008, some of which were as high as 20-to-25 percent.

With less capital to support their risks, insurers need additional sources of capacity, either through traditional reinsurance markets or through securitization. During the same period, reinsurers have seen their capital bases depleted by the financial crisis. Both reinsurers and insurers find that replenishing the shortfall with equity has also become dramatically more expensive.

They also need to increase capacity and are likely to turn to the capital markets to do so. Capacity was long assumed to be obtained through various capital market solutions, but turmoil in the broader financial markets led many to question whether the cat bond market was in a position to meet the changing needs of the reinsurance and primary markets.

The fourth quarter of 2008 brought a barrage of rumors of the “death of the cat bond market,” because 2008 issuance did not mirror the success of 2007.

The cat bond market did not escape the economic turbulence unscathed–the volume of cat bonds issued fell from $7.7 billion in 2007 to $2.7 billion during 2008, Swiss Re determined. However, new-issue volume in the first half of 2009 is $1.4 billion, with a robust new-issue pipeline for the remaining half of the year.

Myriad reasons account for the drop in issuance. For one, cautious issuers and investors were focused on shoring up their capital structures and dealing with the impact of the crisis on their balance sheets. Multiyear cat bond deals had not yet matured, so those already entrenched in the market had no need to facilitate additional issuance.

In addition, many cat bond investors were engaged in forced selling to increase liquidity. Since cat bonds had retained their value relative to other securities, these were among the first to be sold in the market.

This caused secondary market overhang, temporarily suppressing demand through creation of substantial supply. As a similar situation had not yet developed in late 2008 in the broader property-cat reinsurance markets, cat bond spreads increased more than reinsurance rates.

The bankruptcy of Lehman Brothers in fall 2008 also drew concern from insurers and investors. Though a mere four deals (out of a total of 166 in the market at that time) were impaired by Lehman Brothers collapse, the news had a strong aftershock. Many expressed concern that other bonds in the sector would suffer a similar fate or had the same collateral backing issues.

It turns out, not surprisingly, that some bonds had more robust structures than others.

On the more positive side, Lehman Brothers' situation highlighted crucial credit-risk issues, which the market has since made a concerted attempt to address and alleviate on a more consistent basis. Swiss Re and some other arrangers have made changes to the structures of several recent deals that will aid in further reducing credit risk and increasing transparency.

Early 2009 also demonstrated a considerable turnaround for the cat bond sector, as investors have become comfortable with the improved structures and the property-cat reinsurance market has begun to adjust to a harder market (as predicted in part by the late 2008 widening of the cat bond spread).

Significant transactions came to the market, including:

o Chubb's East Lane III transaction, which provided the company with $150 million of cover for Florida hurricane.

o Mystic Re II, a transaction that provided sponsor Liberty Mutual with $225 million of cover against U.S. windstorm and earthquake risks.

o Calabash Re III, a $100 million transaction on behalf of ACE.

Most transactions were renewals or expansions of existing cat bond programs.

As these transactions expire, investment capital will be released for new issuance, and sponsors will seek to replace the expiring coverage with new issues.

The market will build on this solid foundation of transactions as new sponsors are attracted to the benefits offered by cat bonds and other ILS. In addition, ILS structures designed to cover a broader variety of perils are being developed.

Over the next few years, we expect to see the emergence of cat bonds designed to cover perils such as casualty risks. Aggregate data from new market entrants, such as Perils AG in Europe, will also act as a catalyst for greater transparency, which in turn will facilitate the cat bond market as new sponsors and investors gain more in-depth understanding of risks involved through availability of exposure and loss data.

In essence, the turbulence of the past 12 months has strengthened the foundation of the cat bond market and led to greater innovation and transparency. Insurers and reinsurers–as well as corporate and government entities–still need to source affordable capacity for peak perils.

Qualified investors are still able to access attractive returns that are uncorrelated with the wider market as a whole and provide real diversification benefits.

Hedge funds and others investing specifically in cat bonds are still raising investment capital. The cat bond structure remains a robust and credible way for the reinsurance industry to expand its capital base and tap the broader capital markets.

Markus Schmutz and William Dubinsky are both managing directors with Swiss Re.

Special Reports /

Economic Turmoil Does Not Alter Value For Catastrophe Bonds Over Long Term

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