Spotlight: CAT Bond Market on a Quest for New Balance
Dear Ladies and Gentlemen
Trigger of the Current Quest
Currently, the CAT bond market is in a period of recalibration and on a quest for a new bal-ance. This quest started already in December 2018 and the driving forces behind it are pri-marily found in the loss-making insurance years of 2017/18, namely the severe California wildfires of November 2018 and the unexpected levels of loss creep from the 2017 hurricane season.
Increasing Price Pressure in Q1 2019
In the months of February and March of this year, loss estimates again were higher than an-ticipated due to major loss adjustments from the prior year and other minor loss adjustments which have eroded the aggregate retention layers beneath the attachment point of CAT bonds designed to trigger on an annual aggregate basis. The process of claims settlement for the 2017 and 2018 events is reaching its conclusion, so that we do not expect any more big surprises. The question arises whether the major price adjustments have created an upside potential as certain bond prices are hardly justified by the current loss estimates. For the Plenum CAT Bond Fund this upside potential could reach up to 50 basis points, depending on the scenario.
Divergent Forces
We are currently seeing interfering price effects such as the Atlantic hurricane seasonal be-havior which first causes prices to fall prior to the US hurricane season and then to rise again significantly once the US hurricane season has started.
A factor contributing to price increases on CAT bond positions is the fact that CAT bond spreads are higher than spreads of US corporate bonds in the same rating band. Another upward price driver is the currently very low emission volume.
In the course of 2019 only about 15% of the total CAT bond market volume will mature. Con-sequently, the reinvestment demand is below the annual average, which can be explained by the strong market growth of the past years. The resulting demand is lower in relation to pre-vious years and the total market size. Irrespective of that, the reinvestment volume of ap-proximately USD 4.5 billion for the year 2019 represents a challenge in view of the anticipated below-average emission volume.
Premium Situation
Since December 2016 risk premiums have increased significantly by more than 50% in an unchanged interest rate environment. There is still uncertainty with respect to the future pre-mium development which weighs on the current prices. We believe, however, that for the most part, premium expectations are already accounted for in the current prices. Therefore, we consider the potential for further premium increases such as we have seen in 2006 or 2009 to be small. This view is substantiated by the fact that the CAT bond market has reached again the average long-term risk premium. While an overshooting of premiums, which would put further pressure on the prices, is possible, there is an upward price potential, assuming that the so-called “new normal” level (new average price on the basis of a new prolonged low-interest phase and intermediately increased market efficiency) has already been markedly overshot.
Insurance Premiums and Expected Loss
Market Reaction
The UCITS-CAT bond fund market has been stagnant since January 2018 in terms of the size of industry’s fund assets and remains at an average level of USD 5.25 billion. Losses were compensated with new money.
It is apparent that demand dynamics in the CAT bond market as well as in the non-securitized insurance risk transfer market have decreased significantly.
In that period and particularly at the beginning of this year we perceived the following invest-ment pattern:
• Larger institutional investors have entered the UCITS-CAT bond market or stocked up whereas
• Retail clients have turned their backs on the market.
Pimco’s recent announcement to invest again in the CAT bond business fits the picture. It suggests that a comparison of the risk-return ratio of CAT bonds and that of traditional bonds is in favour of the alternative risk transfer and premiums have reached a level that makes market entry attractive.
Outlook
At this time, opposing forces are impacting the prices of CAT bonds. However, some of the negative influences are phasing out, so that in our opinion the CAT bond market will have completed the period of recalibration for the most part by June/July.
Starting from the “new normal” scenario, there is an upside potential in the medium term which would be supported by a possible revaluation of bonds exposed to losses.
The shift in the premium level also has an impact on the risk-return profile of the Plenum CAT Bond Fund. The portfolio is positioned so that it generates a return before cost of approximately 7% p. a. in USD at an expected loss of 1.91%.
We closely monitor the market development and will keep our clients up-to-date. We hope we have been able to provide an insight into the current situation. If you have any questions or concerns, please do not hesitate to contact us.
Best regards
Your Plenum Team