Surging ahead (ILS)
The insurance-linked securities (ILS) sector produced a stellar new issuance performance in the first quarter of 2012, beating previous records to achieve the strongest three-month issuance period in history, with the successful closing of $1.49 billion of new catastrophe bonds.
Sponsors’ eagerness to bring new transactions to market was evident, matched by investors’ appetite to deploy additional capital into ILS structures, and we are already confident in our expectations that 2012 as a whole will be another strong year for the sector.
The enthusiasm for investing in ILS was highlighted by the upsizing of several first quarter transactions, which secured more additional capacity than had initially been requested.
Slow start, strong finish
Despite a very active fourth quarter of 2011, in which many deals were upsized and priced at the low end of launch guidance, 2012 began on a cautious note following the spread increase on Loma Reinsurance Ltd Series 2011-2 at the end of 2011.
Additionally, industry loss warranty (ILW) markets had repriced materially, partly due to the elevated level of global natural catastrophes in 2011, which produced an estimated $107 billion in insured losses and caused the full loss of principal on the Mariah Re Ltd Series 2010-1, Series 2010-2 and Muteki Ltd positions.
Capacity concerns were again heightened early in January, with lower than expected participation in, and cancellation of, certain offerings of bonds.
However, the market gradually regained its footing in January after the successful closing of transactions within launch guidance, and then moved from strength to strength.
As expected, the European capital markets experienced a relatively benign first quarter following an active primary market in the fourth quarter of 2011. Two European sponsors closed transactions during the quarter. Swiss Re issued two tranches totalling $63 million from its Successor X Ltd programme to cover US hurricane and European windstorm.
This was followed by Munich Re which issued the $75 million Queen Street V Re Limited bond also covering both US hurricane and European windstorm. Although Allianz’s $240 million Blue Danube Ltd bond was priced in the first quarter, it did not settle until after the quarter-end. Munich Re and Allianz both elected for the first time to use Bermuda-based special purpose insurers as issuers. Economic losses in Asia alone accounted for 65 percent of total losses for 2011, more than six times the average annual economic loss for that region in recent years.
Perspective on Asia
In 2012, Japan insurers returned to the more customary April 1 renewal date after sensibly extending their contracts to July 1, 2011, in an effort to gain a better understanding of the scope of losses from the March 2011 earthquake and tsunami. In addition, the impact of the Thai floods during the second half of 2011 triggered further reinsurance payments to Japan insurers. Reinsurance combined with pre-event catastrophe reserves helped insulate Japan insurers’ earnings and capital from substantial direct volatility.
The Japan-related pre-renewal discussions centred on the possibilities that Japan insurers may (i) see a substantial erosion of terms on their long-standing proportional covers; (ii) demand new excess of loss covers to replace lost capacity from proportional programmes; and (iii) demand more significant limits for higher magnitude earthquake events as well as a better understanding of the extent of damage that can be caused by largely un-modelled tsunami losses.
While these potential demand drivers will continue to be considered, almost no new demand materialised for capacity at this renewal. Substantial reinsurance capacity continues to be available for Japanese programmes and the market remains competitive. This capacity allowed for a very orderly renewal. Japanese insurers continue to access reinsurance capital to support their underwriting operations at accretive terms.
"Munich Re and Allianz both elected for the first time to use Bermuda-based special purpose insurers as issuers."
Major catastrophe events were absent in the first quarter of 2012. The Thai floods and a series of land-falling typhoons caused losses forthe top five Japan insurers, reducing their cat reserves by more than 10 percent year-on-year as of March 6. Aon Benfield’s Impact Forecasting revised the estimate of total economic losses for the Great East Japan Earthquake to ¥16.3 trillion ($210 billion), while total insured losses will exceed ¥2.7 trillion ($35 billion), up from its September 2011 estimate of approximately $32 billion. Impact Forecasting revealed that the Thai floods affected 65 out of the country’s 77 provinces and damages were significant in many locations. Estimated economic losses by the World Bank reached THB1.4 trillion ($45.7 billion), making the Thai floods one of the top five costliest natural disasters in modern history.
Two Japan sponsors returned to the catastrophe bond market in the first quarter of 2012. Kibou Ltd was upsized to $300 million, replacing the Muteki Ltd bond, which provided beneficiary, Zenkyoren, with a full recovery in 2011. This transaction utilises a top-and-drop structure where the coverage drops to a lower attachment level upon the occurrence of a qualifying activation event. Final pricing of the top layer went at the high end of launch guidance, while pricing on the drop-down layer had to be widened to close.
The second Japan sponsor that returned to the market was Mitsui Sumitomo Insurance Company with Akibare ll Ltd, which priced just prior to the quarter end, upsizing from launch size of $90 to $130 million. To achieve the upsize, the spread was increased from launch guidance.
A secondary glance
Secondary prices were under selling pressure throughout the first quarter as catastrophe bond investors took mark-to-market losses on many of their positions.
Several large investors lowered their allocations to bonds in order to take advantage of opportunities in other collateralised markets, thus exacerbating selling pressure even further.
Although several small to mid-sized investors had cash inflows at the beginning of the year and deployed capital at higher rates, the market lacked significant depth and selling pressure from large bid lists overshadowed the market. The majority of the market focused on the primary issuance pipeline and looked to add positions in the secondary only opportunistically.
The secondary market was fairly active throughout the first quarter of 2012 and experienced a broad decline in pricing. US hurricane and multi-peril bonds were affected most as both experienced price declines of more than 2 percent on average (excluding short-dated transactions) with some of the more actively traded issues being Johnston Re Series 2010-1 A and classes of Compass Re Ltd Series 2011-1.
The declines were also felt in other perils with Japan declining 1.3 percent and US earthquake declining 1 percent, with actively traded issues being Kizuna Re Ltd and Embarcadero Re Ltd Series 2011-1. Europe bonds fared the best as price declines were only 0.3 percent, with the most actively traded issue being Calypso Capital Limited Series 2011-1.
On March 20, a 7.4 magnitude earthquake struck Mexico. Although no bonds were triggered, a payout on MultiCat Mexico 2009-I Ltd Class A, which covers earthquake risk on a parametric basis, was narrowly avoided. If the earthquake had occurred only a small distance to the north, the bond would have suffered a full loss of principal. Shortly after the quake, a small lot of the notes traded at par, below our previously marked prices of 101.94. The trade, however, also represented confidence from investors that the bonds would not suffer a loss of principal. Given the loss activity in 2011, some investors breathed a sigh of relief.
Spreads continued to widen at the end of the quarter as many deals priced towards the high end of, or above, launch guidance. Investors called up additional capital to meet demand and further cash inflows are expected. As such, the secondary market appears to be stabilising and we expect trading levels to resume a more typical level in the second quarter of 2012.
A bright outlook
The primary pipeline remains strong as we move forward into the year, with a number of deals that were marketed in the first quarter closing in the second quarter, including the Blue Danube (Allianz) and Akibare II (Mitsui Sumitomo) bonds described above.
Meanwhile, in the second quarter first-time sponsor Louisiana Citizens secured $125 million of capacity with Pelican Re Ltd, after initial capacity expectations of $100 million with a single tranche of notes. Pelican Re provides indemnity (UNL) cover on a per occurrence basis for hurricanes impacting Louisiana State over a three-year period.
With an active pipeline and market momentum that carried from the fourth quarter of 2011 into the first quarter of 2012 and now beyond, annual issuance is set to exceed $5 billion. We are very confident that ILS has forged a strong position in issuers’ mindsets, and that the industry continues to view the product as a highly complementary and transparent risk transfer mechanism.
Paul Schultz is chief executive officer at Aon Benfield Securities. He can be contacted at: paul.schultz@aonbenfield.com
