Issuance of cat bonds subdued amid model changes, losses

The issuance of catastrophe bonds has been uncharacteristically low in the second quarter of 2011, following unprecedented natural catastrophe losses in the first quarter and changes to the US hurricane model used to predict hurricane activity and potential losses, according to a market update published by insurance broker Willis.

Only four new cat bonds totalling $592 million were issued between April and June of this year, during a period, which prior to the start of the hurricane season, typically sees more activity in the insurance linked security market.

In the second quarter of 2010, in comparison, eight new cat bonds totalling $2.1 billion had been issued.

Meanwhile, $2 billion in net catastrophe bond capacity left the market in 2011 so far, as bonds came due for repayment and investors lost $300 million in a deal related to the earthquake in Japan, according to the report.

The quarterly market update concluded that the light activity in the ILS market in part reflects that issuers took advantage of favourable conditions in the two previous quarters.

However, while the capital markets were able to deal with first quarter losses from natural disasters, including the Japanese earthquake, in an orderly fashion “with relatively little disruption”, the latest update to the RMS model for US hurricane risk “appears to have caused uncertainty among market participants”, the report noted.

This influenced the capacity and pricing of cat bond deals in the second quarter to some degree, the report said.

In May, Risk Management Solutions released a newly calibrated catastrophe model for Atlantic tropical storms. The changes to the model, based on new data from the record storm seasons in 2004 and 2005, have significant implications for property insurance capacity, underwriting and pricing.

The new model projects greater potential for losses due to an increase in Atlantic hurricane activity, particularly the frequency of major hurricanes, and a better understanding of how seemingly unrelated factors can amplify severe catastrophe losses in metropolitan areas. It also adjusts the vulnerability of properties according to occupancy, construction type, year built and number of stories.

In addition, the model takes demand surge into account to a greater extent. This is the increase in construction and other costs after a natural disaster, because labour and materials are in short supply.

Bill Dubinsky, head of ILS at Willis Capital Markets and Advisory, nonetheless maintained a positive outlook for the sector saying “investors have cash to invest and remain keen on risk in cat bond form, but are somewhat starved of new issuance, particularly non-US wind exposed deals”.

He believes the cat bond market should see an uptick in deals in the second half of 2011 as investors get more certainty around how the new RMS hurricane model will affect pricing. “It will also benefit from the increase in ex-US catastrophe reinsurance pricing,” he noted.

However, as 71 per cent of outstanding cat bond limits is exposed to US hurricane risk of some form, the report warned that the market’s performance in the remainder of 2011 will rest on what happens during the current US hurricane season.