Maturing Process

The insurance-linked securities (ILS) market has experienced significant growth over the last few years. A number of insurance and reinsurance companies have accessed it as a complementary source of capacity, and investors have allocated additional funds to the sector.

To understand where the market is today, and the direction it may take in the future, it is first important to understand how it came to be in the first place.

In 1992, Hurricane Andrew devastated the state of Florida, causing approximately US$17 billion in industry losses. At the time, that scale of loss was virtually unthinkable.

In the years leading up to Andrew, insurers had struggled to accurately evaluate the impact of increased population densities and rapid concentration of insured values in disaster-prone areas with catastrophe models in their infancy. The losses from Andrew turned out to be more than twice the figure insurance risk managers expected and several insurers were ultimately forced to file for bankruptcy protection. This event was, in many ways, a wake-up call.

Andrew resulted in a constraint on capacity as many insurers and reinsurers were either unable or unwilling to offer the same level of coverage. With the scarcity of traditional coverage, the market was forced to innovate and seek alternative sources of capacity. Thus, ILS, specifically catastrophe (cat) bonds, emerged as an attractive source of capacity for the industry and a diversifying asset for investors.

After a slow start, the case for ILS strengthened in the wake of the heavy hurricane season of 2005, when hurricanes Katrina, Rita, Wilma, Ophelia and Dennis contributed to a record US$80 billion in insured losses. Once again, re/insurers approached the broader capital markets in response to capacity constraints in the traditional reinsurance market.

Consequently, 32 sponsors issued US$8.5 billion of cat bonds during 2007, the year with the largest amount of newly issued ILS capacity.

Though the following couple of years saw a slight slowdown in new issuance as a result of the financial crisis, the ILS sector for the large part was able to withstand much of the pressure in the broader capital markets during the period, proving that the true foundation of the ILS market remains intact.

Sponsors with increased awareness of credit exposure value the collateralized, multi-year capacity from an alternative source, while investors are attracted to this non-correlated asset class, which offers potentially superior risk-adjusted returns.

AN ATTRACTIVE PROPOSITION

More recently the market has seen an influx of new capital to the space that has further fuelled demand for issuance. Investors appear to be interested in the asset class for its relative value, especially as interest rates remain at historic lows, along with its diversifying qualities given that ILS is largely uncorrelated with other capital markets instruments.

Meanwhile, as the market matures, sponsors can benefit from market innovations, such as the shift in popularity from industry index triggers to indemnity and the introduction of reset notes, both of which allow the sponsor to reduce basis risk and better match its insured portfolio. On the heels of this increased demand, the market has grown to a record US$18.37 billion of outstanding bonds, with the first half of 2013 producing almost US$4 billion in new issuance, the second largest first half since the market began.

While nearly two-thirds of the market offers peak United States wind exposure, non-peak perils such as European windstorm and Japanese earthquake or Canadian earthquake have taken on increased importance. These diversifying perils are instrumental to the dedicated investor base as they allow the portfolio managers to reduce their concentration to U.S. hurricanes.

As the pace of issuance picks up, so does the issuance of diversifying perils. Over the last year, the market has had Turkish, Canadian, Japanese and Mexican earthquake, as well as European, Australian and Mexican Pacific wind bonds to go along with the abundance of U. S. wind issuance.

CANADIAN CATASTROPHE APPEAL

One such bond that offered exposure to Canadian earthquake was Lakeside Re III Ltd. Issued late December 2012, the US$270-million offering, underwritten by Swiss Re, provided its sponsor coverage for both U.S. and Canadian earthquake. Since the Lakeside issuance, there have been at least three additional bonds which offered partial exposure to Canadian earthquake, and there is no reason why this trend should not continue.

Along with new issuance, secondary trading of cat bonds has also greatly improved since the early days of the market. Swiss Re estimates that approximately US$3 billion to US$4 billion in bonds trade annually on the secondary market. This increased liquidity is another significant factor attracting new investors to the cat bond space.

Since the cat bond markets inception, the innovation, increased transparency, improved coverage for sponsors, and greater funds available to purchase bonds have all helped contribute to the growth and strength of the space. Swiss Re expects to continue to see the catastrophe bond market as a sturdy complement to traditional reinsurance in order to provide potential sponsors with an alternative source of capacity, and investors with a diversifying asset class that continues to evolve and become more mainstream.