Cat bond issuance to accelerate as year progresses: DBRS Morningstar

The market for catastrophe bonds is expected to see increasing levels of issuance and the hardening of reinsurance rates is one factor that could drive the market in 2023 and beyond, alongside a general uptick as exposures rise and large insurance and reinsurance firms continue to source risk capital from institutional markets, DBRS Morningstar has said.

While the rating agency believes catastrophe bond issuance through the first-half of 2023 could be a little subdued, due to higher interest rates holding back the supply of capital somewhat, it expects the pace of issuance could increase as the year progresses.

“If high demand persists and pricing tightens into the second half of 2023, we expect a slight pickup as cedents approach the market in need of coverage,” DBRS Morningstar explained.

The rating agency notes that “a growing percentage of investors have opted to include cat bonds within their portfolios,” and sees this as a trend likely to continue as cat bonds are increasingly mainstreamed as assets on the alternative side of the investment markets.

On the sponsor side, DBRS Morningstar believes the reduction in cost of issuing cat bonds over time has been positive, but notes that the cost of issuance is still a barrier to market entry.

“While cat bonds can be complex and costly to put in place, the cost of issuing cat bonds has decreased by approximately 80 basis points over the last two decades as sponsors and structuring agents become more experienced with capital market risk transfers,” the rating agency said. “Still, the large volume required to make a transaction economical creates a high barrier of entry where cat bonds are only accessible to larger insurers. For illustration, the top 10 largest issuers as of right now have $1.6 billion in bonds outstanding on average, across an average of five deals per sponsor.”

But overall, “The cat bond market is becoming a more and more attractive alternative to reinsurance,” DBRS Morningstar believes.

In addition, after heavy catastrophe loss years of late, catastrophe bonds, “may become an even more important tool for the insurance industry to have the capacity to assume cat risk going forward,” the rating agency said.

Factors that can help to drive more catastrophe bond issuance are a stabilisation of the interest rate environment, which may already have begun, and the elevated costs of reinsurance and increasing catastrophe risk aversion of some major reinsurance firms.

“While issuance volume may be muted in the short term due to the quick rise in interest rates, DBRS Morningstar expects that issuance of cat bonds will pick up as the rate environment stabilizes and demand for catastrophe protection grows long term,” the rating agency explained.

Adding that, “Cat bonds and other alternative risk transfer instruments may have a greater role to play going forward as reinsurers restrict coverage and additional sources of risk absorbing capital are needed.

“Reinsurers themselves may also choose to offload more of their own cat risk exposure to the cat bond market as part of their risk-management strategy.”

But there is still a need to match capital flows with demand for protection in the catastrophe bond market, and DBRS Morningstar alludes to this.

“With higher volumes issued year over year, the question is not whether insurers will continue this trend but whether investors will still be willing to assume such risks, regardless of high yields and portfolio diversification,” they state.

But ultimately and longer-term, “Demand for catastrophe protection is only expected to increase further with the size of the risk exposure. Insurers will have to find solutions to be able to offer this protection either by using traditional reinsurance or alternative risk transfer mechanisms such as cat bonds.

“It is likely that larger insurers will opt for a mixture of both with the use of reinsurance to cover losses up to a certain level and of cat bonds to cover the most extreme events.”

Also read: Potential for cat bond market to double, say ILS NYC 2023 speakers.