Staging for the recovery in cat bond prices: Lohmann, Schroders Capital ILS


According to Dirk Lohmann, chairman of Schroders Capital ILS, the stage is set for catastrophe bond prices to return from their current levels to the long-term average over the next six to nine months.

In a recently published article, Lohmann identifies some interesting dynamics in the insurance and reinsurance industry, discusses the broader macroeconomic influence on cat bond spreads, and concludes that the effect all of this has had on the Catastrophe bond market in recent months is expected to attract new capital inflows.

Lohmann and the Schroders Capital ILS team believe that cat bond yield spreads are the highest they have been in more than a decade.

“The last time the cat bond market saw spreads similar to those seen today was in the spring of 2009,” Lohmann explained.

He highlights some interesting dynamics in re/insurer demand for reinsurance cover in the current macro environment, which he says has contributed to widening spreads.

Rising interest rates and the resulting pressure on insurance and reinsurance balance sheet assets have played their part in the dynamics of cat bond spreads, Lohmann believes.

“This increased volatility on the asset side, combined with greater uncertainty about the quality of reserves on the liability side of the balance sheet, will make raising additional capital – if needed – very difficult. “Be possible only with greatly reduced entitlement issues. It’s no surprise that many reinsurers seek to reduce their exposure to liability volatility on their balance sheet by reducing their catastrophe aggregates,” Lohmann explained.

Adding that “For (re)insurers, reinsurance protection is an alternative source of risk bearing capital to equity and debt. Reinsurance can be used to manage earnings volatility and exposure to capital-destroying events, thereby protecting the all-important credit rating of the reinsured. Faced with reduced financial flexibility in the current environment, it is no surprise that the demand for reinsurance, both traditional and in the form of ILS, has increased dramatically.

Referring to 2009, he pointed out that, “Then, as now, reinsurers faced a challenge on the asset side of their balance sheets.”

But, in 2009, it was the credit quality of their investments that was causing uncertainty in the global insurance and reinsurance market.

Now, with interest rates expected to continue rising for some time, “it’s more about the prospect of further market valuation losses as central banks raise their interest rates to fight inflation,” Lohmann said.

But there is another factor, related to inflation expectations, which also scares some re/insurers.

“In recent years, the reinsurance industry has been able to rely on the releases of reserves for losses from previous years to offset some of the impact on earnings from losses related to catastrophes in the current year,” he said. -he explains. “The prospect of higher inflation means that the cost of settling open claims could turn out to be higher than originally expected, leading to a loss of this potential buffer.”

Later, he states that there is a risk that “reserve layoffs could become reserve shortfalls due to high inflation.”

This is very interesting, as it highlights a dynamic in the reinsurance market that has led to more de-risking, with catastrophe bonds being one of the beneficiaries.

That likely partly explains the wealth of new, first-time cat bond sponsors that have entered the market in recent months as companies turned to capital markets to manage their global exposures.

This happened during a period when the catastrophe bond market had little new inflow to deploy, which contributed to the observed spread widening.

This has led to a situation where yields are high in the cat bond market, at the same time as the yields on the collateral investments that underpin the cat bonds are also increasing thanks to interest rates.

“We anticipate that the high yields currently offered in the catastrophe bond market will eventually begin to attract new flows. As a result, the stage is set for prices to return from their current levels to the long-term average over the next six to nine months,” Lohmann said.

The stage is therefore set for potential inflows into catastrophe bond funds, which we have heard has already started in some sectors of the market and has helped to slow or stop the widening of spreads in recent weeks, which has led to a more balanced market environment.

But timing is also important for investors and Lohmann rightly points out that the hurricane season is just beginning, but points out that there have only been four years in the over twenty of the market’s history. cat cat bonds during which total returns were negative from June 30 to December 31. time of year, so investors should perhaps not let the time of year deter them from making an allocation to the cat bond market.

“Indeed, in the more than 20-year history of the catastrophic bond market, there has not been a nine-month period beginning June 30 that has produced a negative total return,” the article explains. Lohmann.

He concludes: “In summary, we think the time is right to consider entering or adding to an existing allocation. The new bond issuance window will close soon as we get closer to the peak of the hurricane season. From this perspective, little additional pressure will come from the demand side and the stage is set for prices to gradually recover. »

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