Cat bond momentum has short-term impetus, if not a structural shift
The cat bond share of overall ILS capacity rose to around 40% by year-end 2022 – its highest proportion of the market since private ILS took off in the early 2010s and began dominating the market.
But it remains unclear how much this is a fundamental shift in the dynamics of ILS – a true reversion to the market's earlier shape – versus a time-limited trend for cat bonds.
Sources suggest that many ILS managers are now chasing the cat bond segment, even where they haven't historically offered the product, because it's where investor appetite for ILS is currently most alive.
Inflows to existing cat bond strategies have been evident, with Fermat adding $110mn since January, bringing its total AuM to $2.61bn and Scor's Atropos cat bond fund surpassing $1bn for the first time.
This is partly because the harder market for cat risk has reduced the yield differential between private ILS and cat bonds. Where historically private ILS offered double-digit yields but low liquidity, now the cat bond segment is rivalling this with its own double-digit expected return story, as well as tradeability.
Liquidity is especially highly valued right now, in light of economic volatility generally and the impacts of fast-rising interest rates. The rate hikes have driven sell-offs in the bond markets, particularly pension funds following liability-driven strategies, including in the UK and elsewhere.
In the traditional reinsurance market, cat premiums have stayed high. Meanwhile, cat bond pricing came down a little in Q1 from a peak at around the turn of the year, making bonds look appealing to sponsors and driving ongoing demand.
Cat bond managers speculate that reinsurers may now look to place retro bonds in the market, where they did not buy all the cover they wanted at 1 January because retro market pricing was so punishing.
They also suggest that shorter-duration bonds providing coverage over one year could emerge, with a bigger market by volume helping to bring down transaction costs. Additionally, competitive pricing versus traditional market placements will help to offset cat bond structuring expenses.
Private ILS track record
Looking at the performance track record, private ILS bore its heaviest losses in 2017 and 2018. On a five-year basis, there remains some time to unfold before the losses have fully rolled through and these funds get back to looking more competitive.
One investor added that in the case of indemnity-based sidecars, it would be "a long time before they come back”.
Some sources suggest that investors who are now looking to take advantage of returns on offer in the cat bond market make may later pivot to private ILS. The rationale is that it's still important to offer a full suite of ILS products because these are what existing and more sophisticated new investors want.
As a corollary, the slowly growing universe of non-cat ILS offerings, which is expanding into casualty risk and cyber, is seeking to develop another angle for investors looking to access (re)insurance risk.
Much of this side of the market is more suited to the private ILS strategies where most development has taken place so far, although Beazley's Cairney Re cyber bond in January showed the public market also taking on new risks.
From an ILS manager's perspective, the shift to cat bonds presents a challenge in the shape of fee income, with management fees most competitive in this sector and performance fees rarer.
At a time of overall fee pressure for ILS firms, this could further tighten already limited budgets, potentially leading to leaner staffing or even consolidation.
That's balanced out by the potential for scalability of a cat bond portfolio, where it's possible to grow to a chunky size without requiring too many additional portfolio managers. For the winners able to capture new cat bond-friendly capital, the coming market phase may bring exciting developments.
It could be harder going for strategies with little or no cat bond offering to entice investors.