Cat bond market a leading indicator of where traditional rates will head

The catastrophe bond markets represent the leading indicator of where catastrophe pricing is heading, with the rates and trends driving this sector often not reflected in the traditional market for up to two years, John Seo, founding partner, Fermat Capital Management, told Monte Carlo Today.

Seo explained that such a dynamic is inevitable given the gulf between the two markets in terms of how often the risk is traded: cat bonds change hands on an almost daily basis, each trade reflecting investor sentiment towards that risk, while traditional reinsurance contracts are renegotiated much less frequently.

“The cat bond market is the leading indicator of where pricing is going,” Seo said. “Prices are negotiated and settled on very frequently. In contrast, the traditional market is very relationship-driven and trades two or three times a year at most.

“It is also always looking in the rear-view mirror. As you would expect of any market that trades that infrequently it is much more slow-moving in the way it reacts to sentiment, events or any factor that may influence the price.”

He said this thesis holds true if pricing in the two markets is examined over the past two years. Rates in the cat bond market hit a floor and started to turn in October 2014. In contrast, the traditional market endured more price cuts in the next renewal a few months later.

In the two major renewals since cat bonds reached a floor, the traditional markets have since followed suit.

“The traditional market is also now starting to turn. Because cat bonds are testing and sampling the market on such a regular basis, trends there emerge first,” Seo said.

Some observers in the traditional market have suggested that, rather than indicating any trend, cat bond rates are simply more stable than in the traditional sector because investors are so closely tied to following the data output by risk models and the associated expected loss and pricing. In other words, they have less room for manoeuvre on rates because they are more committed to following data and analytics.

Seo rejects this assertion, arguing that such comments misunderstand the markets.

“I suppose that is a very catty way of spinning the fact that we have price discipline,” he said. “It is like saying cat bond investors are nothing more than robots working within pre-set narrow parameters. I would argue that is far from true and that we actually lead pricing in the market.”

He agrees that cat bond pricing has been stable and that most deals are genuinely priced within their price guidance ranges. This may seem surprising to the traditional markets, he admitted, because of the imbalance of supply and demand in the cat bond markets, “but investors are used to this situation and it is genuine price discipline that is holding pricing steady”, he explained.

“On one hand, potential demand outstrips supply by a mind-boggling degree, so the market supply is not even close to satiating the potential demand for insurance-linked securities (ILS),” he said.

“On the other hand, the ILS market is used to this lack of equilibrium; it is accustomed to not getting all the ILS it desires. So we have quasi-equilibrium, where investors desire more ILS, but they see no point in mindlessly bidding for ILS.

“In the short term, if the ILS market shrinks or grows, there is not much of an effect on ILS prices because it is all the same quasi-equilibrium to ILS investors whether we have X or Y billion ILS issued in a given year.”