Catastrophe Bond Market Hits Target, Records Possible in 2010

Last year, the cat bond market recovered from six nearly silent months at the end of 2008, with approximately $3.4 billion issued. From the beginning of 2009, forecasts were for a $3 billion issuance year, which seemed aggressive given the turmoil visited upon structured financial products and lower than expected reinsurance rate increases a year ago (which made cat bonds seem less necessary).

Not only did cat bond activity surge from 2008, according to Artemis.bm, but the securities themselves improved. This year's cat bonds did a better job of addressing credit risks and issues around market correlation, which undoubtedly made investors more comfortable with these instruments. In fact, demand exceeded supply last year, causing many bonds to "up-size," and this appetite persists.

For 2010, the dueling factors of traditional risk-transfer pricing and investor demand will be at work. The fact that supply wasn't sufficient to meet the interest in the market could lead to more favorable terms for the insurers and reinsurers issuing cat bonds this year, making them more effective for cost-effective risk management than they were in the past. And, cat bond issuers will take a look at more perils, according to Willis Re (WSH), using investor demand for diversification to facilitate the offloading of risks that normally don't get as much love in the cat bond sector.

On the other hand, Aon Benfield (AON) put property-catastrophe reinsurance pricing down 5% to 15% at the January 1, 2010 reinsurance renewal, with Guy Carpenter, a division of Marsh & McLennan (MMC), revealing to BloggingStocks a global average prop-cat renewal rate at 6%. Low pricing for traditional reinsurance usually renders cat bonds less attractive to insurers and reinsurers, though there is a considerable share of cat bonds issued that addresses broader risk management objectives aside from the cost to transfer risk.

Last year was the third-busiest cat bond year on record, following 2006's $4.7 billion and 2007's $7 billion. Predictions for next year have begun already, and the pipeline is said to be strong. Peter Nakada, managing director at Risk Management Solutions, a catastrophe modeling firm, estimates that 2010 could be a record-setting year for the catastrophe bond market, proffering a range of $6 billion to $8 billion. "Now that spreads have returned to precrash levels," he tells Business Insurance, "we would envision volumes returning to precrash levels."

Markus Schmutz of Swiss Reinsurance Co. (SWCEY) says, "There is a lot of optimism. We've seen a very good fourth quarter with virtually all of the deals upsized from their original target."

The consensus appears to be that 2010 will be a strong year for the cat bond market, which will favor some of the most active investment banks in this sector, including Goldman Sachs (GS), Aon Benfield's insurance-linked securities practice, Swiss Re and Deutsche Bank (DB), but it won't reshape the insurance and reinsurance industries as a whole. As to the effect of less expensive traditional risk-transfer alternatives, we'll have to wait until the second quarter to see the effect, most likely, as the first quarter of the year tends to be quiet for cat bond issuers.