Insurance-Linked Securities (ILS) Market Update Q1 2013
News Save the date... to discuss the state and future of the ILS market 5th ILS Round Table in Monte Carlo hosted by Munich Re 9. September 2013 10:30 am The Fairmont Hotel, Room Grand Prix B Rendez-Vous de Septembre Monte Carlo Join us on this exiting and informative event, with a mixed panel of major representatives from the ILS community sharing their individual views on issuance activity, key developments in ILS structures, pricing, cat modeling and ILS portfolio management, and specific topics raised by the audience. Please visit also our website for more information: www.munichre.com/rtu
Market review Q1 2013 Sponsors benefit from excess liquidity as the market continues to grow The cat bond market continued to outstrip all records, reaching a new record size with $16.37bn of outstanding capacity. Sponsors brought a total of five issuances with an aggregated volume of $1,031m to the market during this year s first quarter, as compared with nine issuances and a total volume of $1,493m in Q1 2012. Nonetheless, with total maturities in Q1 2013 amounting to only $285m, the market once again experienced an inflow of capital from investors and now stands at $16.37bn in terms of outstanding capacity. ILS market in- and outflows ($bn, excl. mortality bonds)* 1.03 16.37 1.89 15.62 0.29 $3.6bn net capital inflow from investors 2.10 0.53 1.08 1.49 1.37 12.78 0.71 Outstanding Maturities Issuances Year-end 2011 Q1 2012 Q 2 2012 Q3 2012 Q4 2012 Year-end 2012 Q1 2013 2013 YTD * Cat bonds denominated in euros have been converted into US dollar amounts using the exchange rate on the respective date of issuance. Munich Re ILS Market Update Q1 2013 1
Market review Q1 2013 Three of the five transactions in the first quarter were renewals of expiring cat bonds. State Farm, Nationwide and Aetna benefited from the excess liquidity in the market due to a relatively small amount of competing placements and an ongoing capital inflow into dedicated ILS funds from end investors. As a result, these issuances were priced significantly below their precursors (see graph below). In addition, Florida s residual market carrier, Citizens Property Insurance Corporation, successfully sponsored $250m of hurricane risk after issuing its first cat bond last year with $750m of capacity. The second Everglades Re cat bond now provides coverage for a slightly higher expected loss of 3.18% (vs. 2.89%), but was priced at a substantially lower risk spread of 1,000bps (vs. 1,775bps). Finally, Cincinnati Insurance tested the ILS market for the first time through a club deal with a limited number of participating investors. This transaction locked in $61.2m of per-occurrence cover for New Madrid earthquake and aggregate cover for severe thunderstorms. No modeling agency was appointed, as participating investors conducted their own risk assessment. Despite its private placement format, signing a confidentiality agreement still allows investors to purchase Skyline Re in the secondary market. Pricing of Q1 issuances vs. previous transactions Risk spread (bps) 1,000 Risk spread: 1,775bps Merna Re IV Merna Re II Caelus Re 2013 Caelus Re II 2010 Everglades Re 2013 Everglades Re 2012 Vitality Re IV 2013-1 Class A Vitality Re III 2012-1 Class A Vitality Re IV 2013-1 Class B Vitality Re III 2012-1 Class B 500 600 400 200 0 0 0.5 1 1.5 2 2.5 3 3.5 4 Expected loss (%) 2 Munich Re ILS Market Update Q1 2013
Market review Q1 2013 Indemnity triggers on the rise The broadening of the ILS investor base over the last few years has enabled insurers to create excess demand during a cat bond s bookbuilding process. Oversubscription has mainly been used to upsize initially planned volumes without having to raise risk spreads above price guidance. However, in the first quarter, sponsors mainly used excess demand to decrease risk spreads while maintaining initial volume targets, as seen in the chart below. Q1 issuance volume ($m, excl. mortality bonds) Initially planned volume 1,493 Issued volume 1,015 1,163 911 1,031 550 575 650 350 400 In % of issued volume Indemnity Non-indemnity 2009 2010 2011 2012 26% 74% 54% 46% 47% 53% 62% 38% 2013 100% 0% As for the types of triggers utilized, issuance in Q1 was UNL-based only. This underscores the shift towards an increasingly sophisticated investor base with sufficient reinsurance expertise to assess insurance portfolios in combination with an increased willingness of sponsors to share exposure information with the buy side of the market. From a risk management standpoint, this is a favorable development for the ILS sector as basis risk becomes less of an issue in the decision-making process of sponsors. Munich Re ILS Market Update Q1 2013 3
Market outlook 2013 US insurers expected to renew several maturing cat bond covers Maturities of $2.54bn point to a heavy deal-flow for the second quarter of 2013. Over 90% of maturing volume will come from US insurers, the majority of whom are expected to tap the cat bond market again for collateralized covers. With maturing volumes also leading to increasing reinvestment need among ILS funds, we expect to see sufficient liquidity in the market to absorb this sponsoring activity. Pricing for US perils is therefore expected to remain near the levels of the first quarter, with a potential for further decrease. Upcoming cat bond maturities ($m) Expected loss (%) 10 9 8 7 6 5 4 3 2 1 0 Q2 2013 Q3 2013 Q4 2013 Q1 2014 US wind 455 US multi-peril 1,505 US earthquake 350 Multi-peril Multi-region 230 US wind 96 US multi-peril 250 US wind 250 Multi-peril Multi-region 106.5 Health 300 US wind 180 US multi-peril 1,291.2 Multi-peril Multi-region 230 Europe wind 371 Total 2,540 Total 346 Total 656.5 Total 2,072.2 US multi-peril Multi-peril, multi-region US earthquake US wind Health Europe wind 4 Munich Re ILS Market Update Q1 2013
Market outlook 2013 Investors remain hungry for paper and seek diversification within their US-dominated ILS portfolios With only $1bn of maturing volume during the second half of 2013, we expect issuance to slow down, as generally seen every year subsequent to the issuance crowding during the first and second quarter. The bulk of issuance in the first months of 2013 has provided coverage for US perils. Investors will therefore be keen to diversify their portfolios, which are strongly overweighted in US hurricane and US earthquake (cf. chart at bottom on page 6), with non-us perils. The current market structure therefore implies a chance for insurers seeking to place non-us perils into the capital markets. The graph below provides a forecast for pricing over the next months and shows a difference of roughly 200 basis points between US hurricane and diversifying issuances at the 1% expected loss level. This discount in pricing should apply to issuances covering European windstorm, Japanese typhoon, Japanese earthquake, Pacific hurricane, and other perils which are currently rare in the ILS space. Cat bond pricing forecast* Risk spread (bps) 1,200 1,000 800 600 400 US wind US earthquake Diversifying perils 200 0 0 1 2 3 4 Expected loss (%) * Diversifying perils are Pacific hurricane, European and Japanese windstorm, and Japanese earthquake and Mexican earthquake. Munich Re ILS Market Update Q1 2013 5
Market factsheet 2013 Cat bond risk spreads (indexed)* 200% 180% 160% 140% 120% 100% US wind US earthquake US multi-peril Multi-peril, multi-region Europe wind Japan perils Cat bond market total 80% 60% 40% 20% 0% Jan 10 Feb 10 Mar 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10 Sep 10 Oct 10 Nov 10 Dec 10 Jan 11 Feb 11 Mar 11 Apr 11 May 11 Jun 11 Jul 11 Aug 11 Sep 11 Oct 11 Nov 11 Dec 11 Jan 12 Feb 12 Mar 12 Apr 12 May 12 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12 Nov 12 Dec 12 Jan 13 Feb 13 Mar 13 * Based on spreads derived from secondary market trades. Outstanding cat bond capacity split into perils US wind US earthquake Europe wind Japan perils Other Health % 100 90 80 70 60 50 40 30 20 10 0 2010 2011 2012 2013 YTD 6 Munich Re ILS Market Update Q1 2013
Market factsheet 2013 ILS issuances 2013 YTD Q1 2013 Transaction Cedant Size ($m) Vitality Re IV Ltd. Skyline Re Ltd. Caelus Re 2013 Ltd. Series 2013-1 Class A Series 2013-1 Class B Series 2013-I Class A Covered perils Trigger Coverage structure Aetna 105 Health Medical benefit ratio Cincinnati Financial Annual aggregate Pricing (bps) 45 MMF + 625 61.2 US earthquake/ severe thunderstorm Nationwide 270 US hurricane/ US earthquake Indemnity Indemnity Annual aggregate Per occurrence Merna Re IV Ltd. State Farm 300 US earthquake Indemnity Per occurrence Everglades Re Ltd. Series 2013-1 Class A Citizens 250 US hurricane Indemnity Per occurrence Maturity MMF + 425 January 2017 MMF + 1,500 January 2014 MMF + 525 March 2016 MMF + 250 April 2016 MMF + 1,000 March 2016 Munich Re ILS Market Update Q1 2013 7
Knowledge box Liquidity injections by central banks lead to a hunt for yield in alternative investment markets The subprime crisis during 2007 resulted in the mortgage-backed securities market to collapse and several financial institutions to suffer from significant losses. In an attempt to restore stability in the financial market and stop a systemic crisis from leading to a default of one bank after another, the Federal Reserve Bank significantly lowered interest rates, as can be seen by the path of the US T-bill three-month rate in the graph below. 3-month US T-bill rate 6% 5% 4% 3% 2% 1% 0% Dec 02 May 03 Oct 03 Mar 04 Aug 04 Jan 05 Jun 05 Nov 05 Apr 06 Sep 06 Feb 07 Jul 07 Dec 07 May 08 Oct 08 Mar 09 Aug 09 Jan 10 Jun 10 Nov 10 Apr 11 Sep 11 Feb 12 Jul 12 Dec 12 Source: Bloomberg While these actions managed to provide the markets with tremendous liquidity and prevent further damage, the downturn in interest rates has led to diminishing yields in corporate bond markets since 2008. With pension funds and traditional asset managers struggling to uphold prevailing return guarantees, substantial capital has been shifted to alternative fixed-income segments that are expected to generate a yield advantage. 8 Munich Re ILS Market Update Q1 2013
Knowledge box Investors switch their attention to the ILS market, given its attractive risk-return profile and excellent diversification effect Among the spectrum of alternative investment segments, the ILS market has been increasingly attracting attention from investors, as it provides for a range of benefits: Uncorrelated with overall financial market developments: In particular, the shift in collateral management towards US T- bill-based structures have further decoupled the investment performance of ILS from other assets and events in the banking sector. Relative value of risk spread: Despite decreasing risk spreads in the cat bond space, a well-managed cat bond portfolio will still provide for a better return than a US corporate bond portfolio with a similar risk level, as seen in the graph below. This yield advantage can be attributed to the ILS market s niche status and its lower liquidity. Compliance with investment guidelines of large pension funds: With an expected loss sweet spot of 1 3%, the ILS market is highly compatible with the risk profile that pension funds generally look for under their respective investment guidelines. As a result, significant money has been shifted to the ILS market and other sectors of the alternative risk transfer (ART) space. In the cat bond market alone, total new capital inflows allocated between 2008 and the end of March 2013 amount to $5bn. Relative investment value of ILS Risk spread (bps) 1,000 800 600 400 200 0 BB US corporate bonds BB cat bonds Dec 07 Feb 08 Apr 08 Jun 08 Aug 08 Oct 08 Dec 08 Feb 09 Apr 09 Jun 09 Aug 09 Oct 09 Dec 09 Feb 10 Apr 10 Jun 10 Aug 10 Oct 10 Dec 10 Feb 11 Apr 11 Jun 11 Aug 11 Oct 11 Dec 11 Feb 12 Apr 12 Jun 12 Aug 12 Oct 12 Dec 12 Feb 13 Source for BB US corporate bonds: Bloomberg Munich Re ILS Market Update Q1 2013 9
Knowledge box Capital movements lead to changes in the ILS investor base, with significant implications for sponsors The ILS investor base, which can be split into (re)insurers, dedicated cat funds, hedge funds, and asset managers/pension funds, has undergone significant shifts as a result of the financial crisis and the subsequent developments (see chart below). ILS investor base composition* % 100 90 5 % 15 % 80 70 25 % 5 % 15 % 60 50 30 % 40 (Re)Insurers 30 65 % Hedge funds Traditional asset managers/ pension funds Dedicated ILS funds 20 10 0 40 % 2007 2013 * Estimate based on deals with Munich Re participation. Aside from their enhanced use of the ILS market as a source of capacity, (re)insurers have also increased their role on the investment side, as ILS provide for an additional instrument to underwrite risk. The majority of reinsurance-sided capital in the ILS space comes from Bermuda reinsurers. Hedge funds, which were key for the early development of the market, were widely forced to fire-sale their ILS investments to obtain liquidity during the financial crisis. While nowadays some hedge fund money keeps coming into the market, many of the earlier players have shifted their attention to other, higher-yielding fixed-income sectors, i.e. distressed debt and government debt with junk status. 10 Munich Re ILS Market Update Q1 2013
Knowledge box The bulk of the market s buy side now comes from pension funds and dedicated cat funds. A recently conducted roadshow by Munich Re underlined considerable interest in the ILS asset class from Australian and New Zealand pension funds, too. These funds generally have substantial volumes of liabilities to be met with investments, and while some of these are invested in ILS already others are currently assessing ways to enter this market. While the previous chart shows a decreased share of pension fund money, this is mainly due to the fact that most pension funds currently prefer to channel their cat bond investment via dedicated cat funds. These funds have built up substantial resources over the past few years to better assess insurance risk portfolios, utilize and understand the relevant risk models, maintain close relationships to cat bond sponsors and attract further capital from end investors. They generally provide the initial bids during bookbuilding and are therefore key for pricing. As such, the shift towards this kind of cat bond buyer has significant implications for sponsors: Even though ART products provide uncorrelated results per se, dedicated cat funds try to diversify within the sector and to minimise tail risk, thus driving reinsurancelike behaviour in running portfolios with diversification over perils and geographies; hence the market is currently highly attractive for non-us perils. An increasing range of available ART products (cat bonds, sidecars, ILWs, CWILs, etc.) and exposures allow for diversified strategies and allocation weightings to be varied over time, further increasing the attractiveness of the ART space. In order to comply with the risk appetite of pension funds, demand is increasingly concentrated around risks with return periods between 30 and 100 years. Enhanced placement conditions for indemnity triggers, as managers of dedicated cat funds are better equipped to assess UNL-based structures. For peak perils, there is a good market for risk transfer yielding more than 7%, as maturities and lack of higher-yielding securitisations has led to a further decrease of portfolio returns over the past six months and many investors require minimum, unlevered returns of 5% post fees on a portfolio level. Munich Re ILS Market Update Q1 2013 11
Contacts Risk Trading Unit Munich Reinsurance Company Königinstrasse 107 80802 München Germany Dr. Andreas Müller Head of Origination Distribution ILS Investments Tel.: +49 89 38 91-92 94 anmueller@munichre.com Dr. Steffen Hinss Manager Origination Tel.: +49 89 38 91-49 19 shinss@munichre.com Daniel Stadtmüller Manager Origination Tel.: +49 89 38 91-47 03 dstadtmueller@munichre.com Dr. Christian Heigl Chief Actuary Tel.: +49 89 38 91-95 19 cheigl@munichre.com Natalie Kraus Manager Origination Tel.: +49 89 38 91-94 97 nkraus@munichre.com Dr. Robert Herde Manager Distribution Tel.: +49 89 38 91-51 19 rherde@munichre.com Bernd Günther Actuary Tel.: +49 89 38 91-52 24 bguenther@munichre.com Sebastian Vogel Analyst Tel.: +49 89 38 91-29 83 sevogel@munichre.com Marius Müller Manager ILS Investments Tel.: +49 89 38 91-35 64 mmueller@munichre.com Disclaimer Munich Re Group is not a legal, tax or accounting advisor and makes no representations as to the accuracy of any data or information gathered or prepared by Munich Re Group or advisors hereunder. Your company should therefore consult with its own tax, legal or other advisors and make its own independent analysis and investigation of the proposed transaction, as well as the financial, legal, accounting and tax consequences thereof, the creditworthiness of the parties involved and all other matters related to the transaction prior to its own independent decision whether or not to enter into any agreements in connection with the transaction. This analysis and proposal contains indicative terms for discussion purposes only. Munich Re Group gives no assurance that any transaction will be consummated on the basis of these indicative terms and no specific issuer is obliged to issue any security or instrument on such indicative terms. This presentation does not constitute an offer to sell or any solicitation of any offer to buy or sell any security or instrument or to enter into any transaction on such indicative terms. The data and analysis does not assure that securities can be issued at certain terms and conditions. All terms and conditions are subject to a mutually agreed engagement letter. This document is not intended to provide the sole basis for any evaluation by you of a transaction, security or instrument and you agree that the merits or suitability of any such transaction, security or instrument to your particular situation will be independently determined by you including consideration of the legal, tax accounting, regulatory, financial and other related aspects thereof. In particular, Munich Re Group owes no duty to you to exercise any judgement on your behalf as to the merits or suitability of any transaction, security or instrument. The information contained herein is provided to you on a strictly confidential basis and you agree that it may not be copied, reproduced or otherwise distributed by you (other than to your professional advisors) without prior written consent. 12 Munich Re ILS Market Update Q1 2013
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