The global catastrophe market has proved itself a powerful force in reinsurance.Thomas Johansmeyer reports on its performance
With more than US$10bn in original issuance last year, the global catastrophe bond market is making a huge impact in reinsurance. While 2018 activity trails last year's year-on-year, it still saw a record-setting first quarter and continued strong issuance. Big numbers no longer impress, many said - until last year's milestone, at least. Instead, the future of this market will be measured in broadened geographic scope, expansion to absorb risks beyond property catastrophe, and the ability to serve the needs of both investors and cedants directly.
An already-impressive year
Since the beginning of the year (as of 5 May 2018), sponsors have either completed or announced 21 catastrophe bond transactions, representing nearly $6bn in limit. Coverage areas include Latin America, Japan and North America - which remains the focus of issuance activity. However, the market's reliance on the US and Canada has lessened in the year to date. The average catastrophe bond size, $297m, is in line with last year's first-half average of $303m.
A 'mere' 57% of transactions include the US (and may have other risk areas, such as Western Europe). More than $1.2bn covers Japan, and a new series of catastrophe bonds provides nearly $1.4bn in cover for risks in Latin America.
With this in mind, it's clear that the catastrophe bond market still shows a bias toward the property-catastrophe markets that it has focused on historically, where well-established models provide a common language for both sides of the trade.
While 2018 trails 2017's record-setting first half, issuance remains far above the previous five-year average of $5.1bn. At time of writing, the first half of 2018 is already the second most active in catastrophe bond market history, edging ahead of 2014's $5.7bn. Last year, the market was pushed higher by six transactions of at least $400m (taking the two Kilimanjaro Re transactions by Everest Re together at $1.25bn).
For catastrophe bonds to deliver fully on the expectations of end investors around the world, capital market capacity needs to find its way to new lines of business. A range of issues can make this a challenge, although some structural changes in the market may help to accelerate the proliferation of this relatively new form of capacity.
Why is expansion so important?
To some, it may seem that the catastrophe bond market is a solution in search of a problem. Worldwide, the reinsurance sector has been plagued by 'excess capacity' for decades, and access to new forms of capital could appear to be of limited value. One can make the argument that, even if new forms of capital weren't currently necessary, it would be prudent to develop and test the market ahead of a spike in demand due to a major natural or man-made catastrophe event.
This is great in theory, but developing a market always comes at a price. Those allocating capital require a return, and the notion of waiting years to deliver for end investors represents the height of wishful thinking. Ultimately, the broadening of capital sources available to cedants has resulted in favourable risk-transfer pricing and greater opportunity for improved risk and capital management.
Price may be the issue everyone loves to discuss, but the benefits of catastrophe bonds are far broader. These transactions are collateralised, so there are implications for counterparty credit risk. For investors, they have the benefit of very low correlation to broader financial markets. Furthermore, the transfer of reinsurance risk to the capital markets takes it out of the global insurance system, which provides an important safeguard against systemic risk.
Catastrophe bonds have been tested outside the traditional property-catastrophe reinsurance market, but successful innovation efforts have not yet gained broad appeal. Transactions covering workers' compensation losses from earthquakes (which retain a property-catastrophe flavour), some casualty losses (more than a decade ago) and speciality lines losses have been completed, although not necessarily publicised.
Of course, the global insurance industry is famous for, and famously self-aware of, its resistance to change. That alone is a barrier to the adoption of new forms of risk transfer. Other challenges have also hampered the broadening of catastrophe bond coverage into new lines of business. The ability to model casualty and speciality lines risks remains difficult, and historically, the market has lacked reference tools and industry loss index triggers to facilitate risk transfer, without requiring a granular understanding of the underlying risks.
Visible change on the horizon
Over the past year, we've seen a significant increase in interest in new lines of business for the catastrophe bond market - and the broader insurance-linked securities (ILS) market overall. Since launching our first speciality lines industry loss index in April 2017, PCS Global Marine and Energy, cedants and markets have begun to explore index-triggered risk-transfer programmes, particularly for speciality lines retrocession.
ILS investors, in fact, have seen industry loss triggers as a way to expand their participation in new lines of business without taking on the underwriting risks associated with traditional reinsurance. When there is an industry loss index trigger, the cedant's book of business is not relevant to the market's analysis. While industry loss triggers haven't featured in speciality lines focused catastrophe bonds yet, the first industry loss warranty (ILW) was completed by ILS fund Twelve Capital last summer, using PCS Global Marine and Energy as the trigger.
Industry loss index-triggered capacity has helped open the door to market expansion for other speciality lines as well. The launch of PCS Global Cyber was quickly followed by the announcement of available capacity and pricing from Hiscox Re ILS. Trades involving other risks, including global terror, have also been bandied about the ILS market.
Industry loss index triggers provide an easy-to-understand common metric for triggering cover, requiring an attainable level of analysis that does not involve digging into the guts of a cedant's diversified speciality lines book. While plenty of people in the industry describe cyber as 'difficult to understand', wrapping your head around an industry loss index for cyber isn't as difficult. Additionally, they come with methodologies and operations that are more disciplined than the public sources of information used as ad hoc triggers in the past.
First steps toward a bigger future
The global catastrophe bond market took clear steps toward maturity in the first half of 2018, with a never-before-seen level of geographic distribution. This is an important precursor to further expansion, including into speciality lines and casualty classes of business.
An estimated $1trn in global end-investor assets is interested in consuming insurance risk. The only way to put that capital to work - in an industry it currently dwarfs - is to find new forms of original risk to bring to the table. New regions and lines will help solve that problem, and this year, our market has shown an ability to move in the right direction.
Thomas Johansmeyer is assistant vice-president and co-head, PCS, at Verisk Insurance Solutions