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Aspen Opinion

How Low Can They Go?

March 15, 2016

Brian Tobben

Managing Director - Aspen Capital Markets

Tel: +1 646 289 4943

Taking a closer look at the capital markets' return requirements for catastrophic risk.

Download a PDF of this Opinion to read later

Are We There Yet?

The recent price stabilization in the ILS sector has led many to wonder whether the market has found a permanent pricing floor. This possibility is bolstered by reports that capital inflows into the largest ILS funds slowed to a single digit percentage increase in 2016.1 Further, Aon Securities recorded 2015 cat bond issuance of $6.9bn, well below the $8.3bn of issuance in 2014.2 Some have concluded that the capital markets appetite for catastrophe risk is waning.

ILS market promoters counter that the market is still growing and now manages $70bn of catastrophe risk according to Willis.3 They argue the slowing growth of the catastrophe bond market masks gains in collateralized reinsurance. According to a Guy Carpenter report following the January renewals, the collateralized reinsurance market is now almost 40% larger than the catastrophe bond market.4

Although the dissection of this constant flow of data provides ample fodder for industry publications, the ILS market is small relative to other capital markets segments where the unit of measure is trillions of dollars. The reality is that the participation of a single large investor can swing the ILS market from "stagnating" to "growth". Instead of focusing on the size of the ILS market, one should consider the relative value of the catastrophe asset class from the perspective of institutional investors.

A Different Perspective

A significant investment trend over the last decade has been the pursuit of returns that are less correlated to the bond and equity markets through alternative investment strategies. Capital has poured in to market neutral hedge funds, hard assets, absolute return strategies and emerging markets. But, during a significant downturn, most of these asset classes will still be correlated. In essence, the peak exposure of the capital markets is a global economic slowdown.

Similarly, catastrophe risk, and in particular US catastrophe risk, is a peak exposure for the insurance industry. For insurers, incremental units of catastrophe risk require a significant amount of additional capital which in turn demands an equity cost of capital return. However, catastrophe risk is not a peak exposure for the capital markets. The global catastrophe reinsurance market's outstanding limit is roughly equivalent to 1% of global pension fund assets.5 Since catastrophes are not economically sensitive and are not a peak exposure for investors, they can view and price catastrophe risk as a diversifier.

Where is the Bar?

The return required for investments with similar risk profiles is a good starting point when considering how the capital markets might price a diversifying asset class such as catastrophe. The B and BB corporate bond indices have been selected as a proxy for economically sensitive investments with a similar risk profile to natural catastrophe reinsurance. This makes sense as most catastrophe bonds are rated either B or BB.

There are a number of reasons catastrophe risks should price differently than corporate bonds. In general, corporate bonds are more liquid than catastrophe risks, suggesting investors should demand slightly higher returns from ILS. On the other hand, catastrophe is a diversifier to the peak economic risks that investors face with other asset classes, suggesting ILS can price below corporate bond spreads. Further, the rating agencies’ stated policy is to haircut the ratings of catastrophe bonds relative to corporates. Given the same expected loss, a corporate bond is rated higher than a catastrophe bond.

In the long run, it is not unreasonable to suggest that catastrophe risk will price below the long term average for similarly rated corporate bonds. It is unlikely to be an immediate transition, however, as the investor base needs to mature and to transition further from the opportunistic investor to long term allocators who view catastrophe as an alternative fixed income product. Chart 1 compares recent pricing between catastrophe risk and corporate bond spreads. Despite the recent uptick in B rated corporate spreads due to energy market driven stress, the ILS market still has scope to fall before pricing tighter than the long-term average corporate bond spreads.

Chart 1: Comparative Catastrophe Bond and High Yield Corporate Bond Spreads

Chart 1

Source: Swiss Re, Insurance Linked Securities market update, Volume XXIV, January 2016, Figure 5, includes Swiss Re Capital Markets pricing indications; Aspen Capital Markets

What About Rising Interest Rates?

One of the most dramatic growth periods in the ILS market followed the 2008-2009 financial crisis. Market observers vary in their view as to why the ILS market found favor with investors. Some argue that the Fed's accommodative monetary policy pushed investors into high yield alternatives such as ILS. Others contend the growth in the ILS market was driven by the lack of correlation of ILS to the capital markets during the credit crisis. Chart 2 demonstrates the stability of ILS asset values during the 2008-2009 crisis.

Chart 2: Comparative Index Returns (2002-2015)

Source: Swiss Re, Insurance Linked Securities market update, Volume XXIV, January 2016, Figure 19, Swiss Re Global Cat Bond Index Total Return includes Swiss Re Capital Markets pricing indications; Aspen Capital Markets

This debate still continues with some suggesting that investors will exit the catastrophe asset class as interest rates rise. It seems reasonable to agree that some absolute return investors will allocate to other asset classes if the Fed continues to raise rates. However, for many investors, the issue is not rising risk free rates, but rather spreads relative to other fixed income segments. Cat bonds are floating rate notes and pay a coupon that is composed of a US Treasury return plus a spread that is similar to a reinsurance rate on line. As rates on US Treasuries increase, cat bond coupons will also rise. So, most sophisticated fixed income investors will compare the relative spread of ILS to Treasuries versus the option adjusted spread (OAS) to Treasuries on corporate bonds as shown in Chart 1.

What About the Big One?

Any comparison of the ILS market to corporate bonds should consider the difference in loss profiles. Losses that impact significant segments of the credit market tend to evolve over time and give investors an opportunity to exit, whereas losses in the catastrophe markets are almost instantaneous. For the sake of simplicity, the counter argument - that the ultimate loss from a large catastrophe can take years to develop - is ignored.

The key question is how investors will respond when they lose a significant portion of their ILS investment to a single catastrophe. Some investors may well have a false sense of security from the low loss activity of recent years. However, other investors have traded through the losses of 2005 and 2011. Most of the latter category are still active in the market and increased their allocations to ILS in the wake of recent large losses.

Most sophisticated investors manage the risk of a large single catastrophe loss by limiting their allocation to the sector. Pension funds generally allocate no more than 2% of their assets to ILS. For example, a 50% overnight loss to the ILS market would result in at most a 1% loss to their fund. This volatility is less than the recent intraday movement of the US equity markets. In short, investors find the uncorrelated relative return of the ILS asset class attractive despite the risk of a large, instantaneous loss.

What About Catastrophe Model Error?

Catastrophe model error is another consideration for investors. Catastrophe events seem routinely to highlight risks that models had not contemplated: levee failures in New Orleans, the magnitude of the Tohoku earthquake and the storm surge of Sandy. Investors are taking the risk that the models are wrong. With the added uncertainties of climate change, poor data quality, growing portfolios, coverage changes and exposure trends, it is natural to ask how the capital markets can invest at such efficient pricing levels with so much uncertainty in the modelling of catastrophe risk.

This topic is regularly discussed with investors and their response is quite simple. They only wish economic models were as robust as natural catastrophe models. While the insurance industry worries about the application of proper building codes in US coastal areas, economists struggle with politically altered data coming from emerging (and even sometimes developed) markets. Where reinsurers fear model error, investors fear policy changes, market psychology and unpredictable geopolitics that are difficult to model. Catastrophe losses are driven processes that have physical limits that can be modelled with a higher degree of accuracy than most economic models. Investors take comfort in our attention to model error at the 100 year event because they have far less certainty what a 100 year loss looks like in many other asset classes. In short, the model error is likely greater in other asset classes.

Long-Term View

It is not unreasonable to argue that there is room for the capital markets to further tighten risk adjusted catastrophe rates in the US and that the ultimate pricing floor will be inside the long term average OAS of corporate credit. This may be expressed as a further tightening of spreads or more likely an increase in the risk profile of bonds if investors continue to require a minimum coupon. However, we do not anticipate ILS rates will fall below long term corporate spreads without a significant catalyst. In the short term, there is a chance economic uncertainty leads to further spread widening in traditional fixed income that could temporarily divert capital away from ILS.

Table 1: Corporate and Catastrophe Bond Spreads

  BB B
20 Yr. Avg. Corp. OAS 3.84 5.71
20 Yr. Median Corp. OAS 3.47 5.17
5 Yr. Avg. Corp. OAS 3.71 5.24
Current Swiss Re ILS Spread 4.9 5.89


Source: Federal Reserve Bank of St. Louis.
OAS: Bank of America Merrill Lynch High Yield BB; Aspen Capital Markets

There are a number of reasons for the current pricing differential shown in Table 1. Reaching the pricing floor is partly dependent on the transformation of the investor base to those that view catastrophe as an alternative to traditional fixed income markets. In addition, we believe ILS manager fees will need to moderate. A few managers are clinging to hedge fund fee schedules of 2 and 20 that cannot be supported by lower catastrophe returns. Fees will slowly decline allowing spreads to further tighten as ILS managers gain greater scale and efficiency. Finally, there is an expectation that, as the investor base continues to mature, they will give credit for the diversifying nature of ILS and price it inside corporate spreads. This all suggests there is room to tighten further. Absent an exogenous event, we expect further rate reductions to be measured and moderate.


References

  1. Trading Risk, Top10 ILS funds reachUSD44bn, 18 January 2016
  2. Aon Benfield Securities, ILS Year End 2015 Update, January 2016
  3. Willis Capital Markets Advisory, ILS Market Update- ILS outlook upbeat amid a persistent soft
  4. market January 2016
  5. Guy Carpenter, The Reinsurance Market 2016: Innovation and Customization, January 2016
  6. Towers Watson, ‘Global Pension Assets Study’, January 2013

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The above article/opinion reflects the opinion of the author and does not necessarily represent Aspen's views. The article reflects the opinion of the author at the time it was written taking into account economic, market, regulatory and other conditions at the time of writing which may change over time and does not constitute an offer or solicitation for the purchase or sale of any security. References to securities or issuers are for illustrative purposes only and are not intended to be recommendations to purchase or sell such securities. Past performance is not necessarily reflective of future results. Aspen believes that the sources from which such information has been obtained are reliable. Aspen does not warrant the accuracy, adequacy, completeness, timeliness or availability of any information provided by non-Aspen sources and does not undertake to update this article.