The catastrophe bond market will continue to grow by 10 to 20 percent per year, driven in part by the increase in covered perils and the broadening of event definitions, according to a report published by Standard & Poor’s.

But S&P cautioned that any growth of the alternative market should not jeopardize strong underwriting discipline and due diligence. Some (more opportunistic) investors of insurance linked securities (ILS) might not understand certain aspects of the risks they are buying into and could cause market disruptions once they incur losses after a major event, indicated the report titled “Are Alternative Capital and Reinsurance Two Sides of the Same Coin?”

A total of $66 billion of alternative capital was invested in the reinsurance market, as of June 30, 2015, up 12 percent from $59 billion as of June 2014, according to the report, which quoted statistics compiled by Aon Securities Inc.

Currently there are about $24 billion in catastrophe (cat) bonds outstanding, with more than $5 billion of cat bonds issued this year, S&P noted.

“Given the ease and efficiency with which capital has been flowing into this space and the benign natural catastrophe losses during the past few years, we expect the alternative capital market to continue to innovate and push boundaries, which will ultimately transfer into the cat bond market,” the report said.

Definitions Changing, Terms Widening

“Cedants are looking for protection, and this year, there were issuances providing coverage against earthquakes, not only in the U.S., Japan, and China, but also in Italy and the Caribbean. The latest bond coming to market will cover earthquake risk in Turkey,” S&P said.

“In addition, volcanic eruptions, meteorite impact, and wildfire (outside of California) were included in some transactions as new covered perils,” the report continued, noting that modeling is an issue for these types of perils.

“The probability of these events occurring has been for the most part calculated deterministically, and is very small (e.g., the 1908 meteor strike in Siberia is considered a one-in-1,000 year event and the likelihood of a similar event affecting the covered area of a bond is even more remote),” the report said.

Under current market conditions, the report went on to say, reinsurance buyers found it easier to buy protection for such perils, while aligning the coverage with traditional reinsurance contracts.

The report noted that event definitions also have expanded. “For example, a recent transaction widened the event definition for named storms and earthquakes in the U.S. by increasing the duration of the event to 240 hours from 168. Expanding the time clause in the event definition is common in a soft reinsurance market.”

Issuers also have been testing the market by either lengthening or shortening the maturities of their issuances, S&P indicated. While five-year issuances are common, a seven-year maturity deal failed to be placed, and a six-month deal covering one hurricane season was placed successfully, the report said.

A further sign that the ILS market “is currently a buyer’s market is the inclusion of early termination provisions, which make the terms and conditions more flexible for the issuer,” the report said, noting that variable reset options have been part of most issuances for the past two years.

Prudent Risk Assessment?

S&P welcomes these innovations but continues to caution that growth should not jeopardize underwriting discipline and due diligence, said S&P’s credit analyst Maren Josefs in a statement accompanying the report.

S&P cited the fact that there is a drive to reduce costs and increase the speed of execution to connect risks with appropriate counterparties. “As everyone tries to jump on the reinsurance bandwagon, is there a risk of the ILS market overheating and new investors getting burned?”

Major Long-Term Concerns

Over the long term, one of S&P’s main concerns is the lack of liquidity compared to other asset classes. “Although it is improving, we are not sure there will be much left immediately before and after a big event.” Another concern cited by S&P is whether investors fully understand the risks they are underwriting using thorough due diligence, such as running own-risk analysis and reviewing legal contracts.

In addition, the report said, increasing demand for diversifying perils might push rates and returns lower than what the technical price should be.

“It is our understanding that several large ILS [insurance-linked securities] fund managers declined to participate in the new diversifying deals with a low coupon of around 2 percent,” viewed by market observers to be a minimum return target for ILS investors, S&P said.

While the coupon on these issues would not provide enough return to compensate for the risk they would take, these bonds are being placed successfully, the report said.

“This leads us to conclude that there are investors for whom the diversification benefit is more important than the return they will earn,” the report added. “If these end investors are pension funds, the long-term effect should not be of any concern for the whole market. But if these are opportunistic investors, a portion of this capital could leave the market once yield on other assets increases.”

The report pointed to the fact that more structures are coming to market where investors do their own risk modeling and risk analysis is no longer part of the security offering documents.

Market Disruptions Possible

While sophisticated ILS funds have always been able to perform their own risk analysis, the report questioned how new investors are accessing the market. Some investors might follow the lead of other ILS funds when making investment decisions, which means they might be “missing certain aspects of the risks they are buying into and might cause market disruptions once they incur losses.”

What these trends will mean in practice will only become evident “in the aftermath of a big natural catastrophe that affects a number of bonds,” said S&P.

Source: Standard & Poor’s

See related Carrier Management Videos:

Alternative Capital Here to Stay
Arch Capital Explains Watford Re