Appleby Bermuda, Brad Adderley
22 June 2023ArticleILS

Bullish on cat bonds: Appleby

The insurance-linked securities (ILS) market is on pace for a record year, according to lawyer Brad Adderley, who has been involved with the market since its inception in the early 2000s.

He said that despite economic challenges, along with fears of a lack of capacity in the market, everything he is seeing in his law firm and in published reports suggests the appetite for, and sophistication of, ILS vehicles are continuing to grow.

The managing partner of Appleby Bermuda and the leader of its insurance practice, Adderley said: “We are seeing interest in cat bonds, transformer vehicles and, to a lesser extent, sidecars.

“With cat bonds, every article you read says they are on a record pace. Based on what I am seeing and what we have on the go at Appleby, there is still a lot of interest. I think we will be seeing a record cat bond year by the end of June. Everyone wants to get their coverage by the beginning of the hurricane season on June 1. We will have a lot to do.”

Adderley said the value of cat bonds issued by the end of May was estimated at $8.5 billion, and he expected more issues into the summer months when the market typically goes into hiatus.

“We have new players and sponsors in the market, which is exciting,” he added. “We are seeing an expanded number of risks being covered as well.”

Adderley said ILS growth was being driven by the same hard market that traditional carriers were experiencing.

“The hard market has been driven by several things,” he added. “There have been a lot of losses in the last two years; there’s been an interesting dynamic of losses occurring with high inflation and some cedants have been going under.

“Investors are getting tired of not getting the return for their capital they were expecting—sometimes because of poor underwriting and sometimes because of unexpected losses.

“Florida carriers are struggling and reinsurers are either saying they don’t like catastrophe risk now or their capital is locked up, while investors are sceptical because they have been promised a return for years and it has not happened.”

However, he added, underwriters have maintained discipline and have not chased premiums, which has kept rates high.

Cat bonds are popular

On top of conditions related to the insurance industry, Adderley said, the overall economic outlook was highly uncertain, which in some ways helped the cat bond sector.

Despite interest rate hikes and high inflation, the US economy was still robust and he predicted inflation would remain high for some years.

This has benefited the cat bond market along with the hard market, he said.

“Investors like cat bonds because they offer certainty. Investors have raised capital and the ILS funds have raised money and succeeded. I am sure there are players out there who are happy to invest in catastrophe bonds.

“The market is so fluid that you can get a deal done more quickly than in the traditional market. People like cat bond products because of their transparency.

“You do not hear of many cat bonds not proceeding to closing. As a result, clients know there are ILS funds out there. That gives them some certainty.”

He added: “It may be that the summer months will be busier than usual. You normally see things quieten down in July, August and September while people see what the hurricane season looks like, but it may be busier this year.

“The confidence is there: the top ILS managers have been able to raise capital and have had good returns. Some investors still don’t feel it is priced right or they don’t understand the collateral being placed.”

But, he said, most investors find it easier to put money in and get it out than in the equity markets.

With interest rates rising, it would seem that sponsors would have to raise the coupon on the bonds, but Adderley disagreed, saying a premium over a base rate interest rate had always been built in.

He said: “For cedants, the bigger problem is how they price their risk to protect their balance sheets. With inflation rising, they don’t know if building costs or other expenses will have gone up in the event of a catastrophe, so there is more uncertainty there.”

Affordable protection

Adderley said there was some concern in a hard market about primary insurers withdrawing from markets, as happened with State Farm in California in May.

“What we cannot forget is ‘who drives the cost of reinsurance?’. If the primary insurers can’t afford the rate or the rates are fixed by the state, then I can’t afford my reinsurance protection. I am driven by their pricing and if that is increasing then the cedant says: ‘perhaps I do not want to write the business’.

“The value chain has to work at every step. If State Farm is saying it cannot buy protection and I can’t buy protection, then I can’t write the risk because it is too expensive compared to what I charge the policyholder.

“Can the policyholder afford the cost of insurance? Will it come to the point where the policyholder says: ‘I will do without’?” he explained.

“It will be interesting to see where it goes with the Florida drop-off as well. September in Monte Carlo will be very interesting if there are strains in the summer. What happens if people have major losses before September? Will we see people struggling if they don’t have the capacity to write business and go under, and will we see new players in the market to cover the lack of capacity?”

Adderley said the knock-on effects of a lack of capacity in the market could affect the broader economy. If direct insurers raised premiums due to higher reinsurance costs, this could lead to homebuyers not moving forward with purchases because of the cost of mandatory insurance which, in turn, would lead to a housebuilding slump and an economic crisis, he said.

“Right now there are so many balls in the air with COVID-19, an uncertain economy, inflation, and interest rates rising that it is difficult to predict the future.”

Cyber and more

Outside of property and catastrophe insurance, Adderley said, there is tremendous interest in cyber risk, in the ILS sphere and in the wider market.

He said his firm was seeing an increase in the formation of specialty players in cyber insurance, and also a rise in insurtech firms specifically to service the cyber sector.

He noted the recent issue of a cyber cat bond by Beazley demonstrated how the ILS sector could play a role in cyber and the use of a transformer vehicle—in which the sponsor was able to use an existing third party platform rather than forming its own special purpose insurer—was likely to be replicated in the future.

Adderley said the use of third party platforms through companies such as Artex made sense for investors who were able to control their costs and reduce their regulatory requirements.

This kind of innovation demonstrated why Bermuda was a leader in the ILS sphere.

“Bermuda has the advantage of being a real marketplace,” he said. “You have all the players here and the investors as well. You can’t do that in every other jurisdiction.

“An investment bank can come to Bermuda and meet with all of the parties. Bermuda is the perfect market for all sides of the trade. Not many offshore jurisdictions can do that, and Bermuda can do it for all of the specialties.

“Now insurtech is coming to Bermuda due to the way that fintech and insurance expertise is all in one place. We are very bullish on insurtech.”

Adderley concluded by saying that the suggestion that ILS does not generate high employment numbers is a myth.

“ILS creates a lot of employment,” he said. “A company such as RenaissanceRe has a lot of people doing ILS, and Nephila. How many people do they employ?

“Most ILS funds employ about 10 people each, so you are talking hundreds of jobs. It takes only about 200 jobs to move the needle in Bermuda. All of those people need housing and spend money in Bermuda.”