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Paradigm shift in the catastrophe insurance market - What does it mean for Cat Bonds?

The already difficult situation in the (re)insurance market was further exacerbated when Hurricane Ian made landfall in Florida, causing extensive devastation and human misery. It is one of the most expensive storms in history.

November 16, 2022

Inflation and its impact on construction and replacement costs, increasing catastrophe losses over the past five years, and the resulting expected imbalance between supply and demand of reinsurance capacity had already been the main topics of discussion before Hurricane Ian. The storm has now brought additional challenges to the industry, and significant rate increases for natural catastrophe risks seem inevitable. 

The Cat Bond market, already plays a major role in this market segment (i.e. property natural catastrophe risks), could play an increasingly important role in the coming months and years. However, this will only be possible on the terms of investors, who are likely going to push for higher premiums and clearer structures, in part to quickly recover from the losses caused by Hurricane Ian. 

The uncertainty around the ultimate losses of Hurricane Ian remains high and will be one of the key factors as to how premiums will develop. In any case, the market dynamics are very high and could lead to opportunities in the Cat Bond market from an investor’s point of view.

What are Cat Bonds?

Cat Bonds are a sub-segment of the ILS market (short for Insurance Linked Strategies). They are securitized, standardized instruments that transfer insurance risks from the sponsor (usually insurers, reinsurers or larger institutions) to the capital market. Cat Bonds typically cover property natural catastrophe risks (e.g. hurricanes/storms, earthquakes, floods) in countries and regions with high insurance values. Man-made risks, such as aviation, marine or other specialty lines as well as life risks typically only constitute a small part of the overall market exposure.

The Cat Bond investor receives a coupon for assuming the risk but may suffer losses on his capital if the predefined insurance event occurs. The nominal of the Cat Bond is typically placed in a special purpose vehicle and invested in money market investments. The total return thus comprises the return on the nominal plus the risk premium (coupon), which depends on the underlying risk and the probability of default. Consequently, Cat Bonds have a floating return structure. 

Unlike traditional reinsurance transactions, Cat Bonds can be traded on the secondary market and thus offer some liquidity. However, it is important to note that certain factors, such as an acute catastrophic event, can severely impact liquidity or significantly widen the bid-ask spread in the secondary market.

The risk of loss due to a severe catastrophe can be reduced by investing in a diversified portfolio of Cat Bonds with different risk classes, risk regions or trigger structures, with U.S. wind risk (hurricanes) being the dominant risk class in the Cat Bond market and thus representing the greatest risk.

How have premiums in the Cat Bond market evolved (prior to Hurricane Ian)?

Cat Bond coupons are driven by the supply and demand of risk capital (reinsurance protection). This means that in times when risk capital is scarce, an increase can usually be observed. On the other hand, when demand from the capital market (i.e. Cat Bond investors) is high, premiums usually decrease. 

As can be seen on the chart to the right, yield spreads have tended to decline since 2013, due to relatively low catastrophe losses and a significant influx of capital into the Cat Bond market. This picture has changed since 2017, with record insurance losses (driven in part by Hurricanes Harvey, Irma, and Maria, as well as wildfires in the U.S.). Although the initial response was hesitant, additional years of losses for the insurance industry have continued to raise expected returns ("yields"). In the wake of Hurricane Ian, we expect this trend to become much more pronounced (as explained in the next section). The recent spike in yield spreads in the chart to the right can be explained by the strong negative price reaction for many Cat Bonds caused by Hurricane Ian. 

Line chart showing the development of the yield spread and expected loss of the cat bond market from Sept 2003 to Sept 2022.

Historical average yield spread and expected loss

Source: Lane Financial for data from 2001 until 2021; Credit Suisse and Broker for data as of 2022; excluding impaired cat bonds. 
Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. 
Data as of 30 September 2022.

Comparison of the expected loss, yield spread and coupon of Cat Bonds at issuance in Q2 2017 vs. Q2 2021 and 2022

Cat Bond primary market pricing 2017 vs 2021/2022

(asset-weighted comparison at issuance)

The above illustrations provide an exposure view based on the risk start date of cat bonds. It excludes life, mortgage and private cat bonds. 
Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. 
Source: Credit Suisse and Broker. Data as of June 2022.

The chart to the left shows the asset-weighted comparison of new issuances in the Cat Bond market in the second quarter of 2017 versus the second quarters of 2021 and 2022. It again highlights the trend we have seen since 2017 and which further solidified in 2022. For 2023, we expect a further strong continuation of this trend, as described in more detail in the outlook section.

In addition to rising coupons, we have also seen several risk mitigating factors in the market (such as higher deductibles, stricter contract terms, or the exclusion of specific risk classes), which further increases the risk-adjusted attractiveness of Cat Bonds. These movements clearly show that investor behavior has changed. They are no longer willing to accept low coupons or structurally weak Cat Bonds in today's environment, which has significantly improved the quality of Cat Bonds issued in the marketplace.

Market Outlook

Already at the RVS reinsurance conference in Monte Carlo in early September, when the Atlantic was still calm, all signals pointed to a further strong increase in (re)insurance premiums for 2023. With Hurricane Ian approaching later that month and causing significant insured losses in the state of Florida, the pressure on the natural catastrophe (re)insurance market has increased even further, posing major challenges for the entire industry. The reasons for this are manifold. 

  • Volatile developments in the financial markets and the resulting impact on the investment returns of major (re)insurers are forcing many companies to either reduce their insurance portfolio or purchase more protection in order to meet their solvency obligations.  Rising demand for reinsurance protection
  • Inflation and the associated increase in total insured values is driving insurers' demand for additional reinsurance protection even higher.  Rising demand for reinsurance protection
  • On the other hand, the above-average event activity of the past few years and the associated high insured losses have put the share prices of major reinsurers under pressure, forcing many companies to massively reduce or even completely discontinue this particular line of business (natural catastrophe reinsurance).  Decreasing supply of reinsurance protection
  • As a result of Hurricane Ian, a large part of the retrocession market is expected to suffer a total loss. Consequently, retrocession capacity will be severely constrained at the January renewal due to the large losses and locked capital. Retrocession is one of the most important hedging instruments for the reinsurance industry. Developments in the retrocession market therefore play an important role across the (re)insurance market. According to rating agency Moodys, "The reduction of available retrocessional capacity will result in higher retro pricing and is likely to have a ripple effect that also drives property catastrophe reinsurance rates even higher.”
     Decreasing supply of retro & reinsurance protection / strong pricing pressure
  • As with any major natural catastrophe, the question regarding the impact of climate change is once again taking center stage. It is becoming increasingly clear that further premium increases are inevitable to counteract climate inflation.  Pressure on pricing

What does this mean for the Cat Bond market?

We expect the issues described above and the resulting imbalance between supply and demand to cause (re)insurance premiums to rise and (re)insurance coverage to become significantly more expensive. 

Given the expected decline in traditional reinsurance capacity, the alternative risk-transfer (via Cat Bonds) will become increasingly more important, and we expect a strong pipeline of new transactions. However, these will only be able to be placed on investors' terms. The need to recover the losses associated with Hurricane Ian, but also the strong pursuit for sustainable returns on capital for Cat Bond investors over the long term (considering topics like inflation or climate change) will dominate the pricing discussions. One big question remains, however: Can (re)insurers, who have already suffered significant capital losses from Hurricane Ian, afford paying such high prices? And how is the Florida (re)insurance industry, which was already severely weakened before Hurricane Ian, dealing with this event?

The Louisiana Citizens Property Insurance Corporation, for example, has received approval from regulators to increase its rates for homeowners insurance by 63%. An increase that was necessary to maintain operations due to the increased cost of reinsurance. It remains to be seen if Florida will take similar action. Florida's reinsurance costs are already significant. However, further increases seem almost inevitable for the insurance industry, while becoming almost unaffordable for homeowners. In general, it can be said that the entire industry is on the verge of an upheaval, which can offer interesting market opportunities for Cat Bond investors. 

The increase in the yield spread indicated in the illustration below already includes the increase to date of approximately 60% (as of Q2 2022). Consequently, we expect a further increase of approximately 50-80% in 2023. The extent of the final premium increase will depend primarily on the ultimate losses caused by Hurricane Ian and the level of demand or inflow of new capital into the Cat Bond market. In addition to rising risk premiums, also the collateral return, which is generally invested in money-market funds, has risen sharply in the face of the increasing interest rates, and is expected to rise even further, bringing the total return of new Cat Bonds likely to new high.

Illustration of the projected development of the yield spread, risk and collateral yield for Cat Bonds for 2022 and beyond

Cat Bond market outlook 2022 and beyond vs 2021

1 The collateral is typically invested in money-market funds, therefore the figures illustrated are based on the short-term USD interest rates and anticipated developments thereof.
* The illustrated numbers are assumptions only. It is not a projection, forecast or guarantee of future performance. 
Source: Credit Suisse. For illustrative purposes only.

Return Developments

Looking at the overall Cat Bond market return over the last 20 years (i.e. since the inception of the Cat Bond Index), we see a relatively stable performance, despite some difficult years with relatively high insurance losses. However, Hurricane Ian, which will go down in history as one of the costliest storms, left a significant mark on performance - the largest negative impact since the inception of the index. Comparison with other asset classes also underscores the negative correlation properties of catastrophe bonds, which perform independently of economic developments. This is particularly evident in times of financial market turmoil, such as during the global financial crisis (2007/2008) or the first wave of the COVID-19 Pandemic (2020).

Line chart showing the Cat Bond market vs. other asset class and the relating risk/return data from 2002 till Sept 2022.

Historical performance of Cat Bonds vs. other asset classes

(since inception of the Swiss Re Global Cat Bond Index)
Cat Bond and reinsurance market composition

U.S. HY corporate debt: S&P U.S. High Yield Corporate Bond Index Total Return (SPUHYBDT); Emerging market debt: J.P. Morgan EMBI Global Total Return Index (JPEIGLBL); Global equity: MSCI World Net Total Return USD Index (NDDUWI); Cat bonds: Swiss Re Global Cat Bond Index (SRGLTRR); U.S. REIT: Bloomberg US REITs Index (BBREIT); Leveraged loans: Credit Suisse Leverages Loan Total Return (CSLLLTOT); U.S. IG corporate debt: (LUGCTRUU)
Sources: Credit Suisse, Bloomberg. Period: Januar 2002 – September 2022

Impact of climate change and inflation trends on the Cat Bond market

Looking at rising insurance losses worldwide, investors are increasingly concerned about the potential impact of climate change on the Cat Bond market. Indeed, looking at historical data of insured losses, there is a clear trend towards higher insured losses. However, most of the increase in losses is not due to climate change, but to demographic trends, namely steep increases in population density, insurance density, inflation, wealth, and building quality in exposed areas (e.g., coastal regions of the U.S.). Catastrophe risk models - used to value Cat Bonds - reflect these developments by continuously adjusting the underlying risk assumptions. 

With regard to climate-related trends, we conducted a detailed analysis in 2021 based on the latest IPCC report, with the aim of quantifying climate trend risks and the corresponding loss inflation per year and risk category (where relevant for Cat Bonds). Based on this, we conducted various stress tests to understand the extent to which risk models already take climate-related loss inflation into account, and we have taken various measures to minimize climate-related inflationary trends*.

Looking at non-climate-related inflation trends, notably current increases in construction or repair costs can have a significant impact on the amount of insurance claims in the event of a natural catastrophe. Therefore, it is critical to adequately consider these trends and trend forecasts in the risk assessment process.

Consequently, in order to properly assess the risks, it is critical to closely analyze and understand the features and weaknesses of the risk models. Where appropriate, Cat Bonds should be remodeled to incorporate specific factors (both climate and non-climate inflation trends) to obtain a realistic, risk-adjusted valuation to better assess the attractiveness of cat bonds.

Conclusion

* The Credit Suisse ILS team has written a comprehensive article on this subject, which can be found on the corresponding website (www.credit-suisse.com/ils