Cat bonds had a miserable 2008. But that doesn’t mean you should ignore them
About $7bn (£4.9bn) of cat bonds (insurance-linked securities that provide transfer of natural catastrophe risk to the capital markets) were issued in 2007 – a record year. But only $2.7bn of the bonds were issued in 2008, all in the first half of the year as the market closed for the final six months.
Few industry observers will stick their necks out and offer a prediction for the year ahead. Not least because most of them got it wrong on 2008, with many forecasting about $5bn of new bonds. If a prediction must be made, however, it looks like the value of bonds issued will be similar to last year.
What went wrong in the second half of 2008? And does the shortfall mean there is roughly $2.3bn ($5bn minus $2.7bn) of bonds waiting in the wings? The secondary market – where already-issued cat bonds are traded – will be crucial. But it has been weakened by troubled non-specialised investors liquidating their cat bond positions. These investors have been troubled, let it be said, by the general financial crisis, not by cat bonds. Indeed, cat bonds were some of the best-performing assets in their portfolios. Nevertheless, their actions depressed bond prices, allowing investors to get higher yields in the secondary market rather than in new issues.
Whether the secondary cat bond market bounces back will depend on general improvement in the economy, but also on sector-specific factors, such as redemptions. More than $1bn of cat bonds have been redeemed since December last year; more are now due. Redemptions make more money available to investors, so leading to a possible improvement in the secondary market.
New issues were also delayed last year by potential issuers having a good alternative in the softening traditional reinsurance market; however, a recent hardening could lead to renewed interest.
The Lehman bankruptcy last September must also be considered. Willow Re Series 2007-1, a cat bond for which Lehman was guaranteeing interest payment, recently defaulted on its payments. However, only four cat bonds have been directly affected out of more than 100. They still offer good uncorrelated risk and have outperformed both equity and bond markets.
The $200m issue of Atlas Reinsurance V for SCOR by Deutsche Bank and BNP Paribas in February this year breaks the ice for the first cat bond new issue since August last year. This bond is notable for its tight collateral structure. The collateral for Atlas Reinsurance V may be invested only in a defined list of secure assets, such as government bonds. It is likely that future cat bonds will be designed so as to withstand events such as the Lehman bankruptcy.
david.sandham@globalreinsurance.com
Key points
• Last year was disappointing for cat bonds
• There were several reasons for this, including a weak secondary market, the Lehman bankruptcy and softening reinsurance rates
• Although the first cat bond for many months closed in February, prospects for 2009 are uncertain
