Are cat bonds changing course?

Insurance companies have disappointed investors in catastrophe bonds in recent years with only a trickle of new issues. But demand remains strong and signs are emerging that more market-friendly products are on the horizon, reports Alex Mathias

Catastrophe-linked (cat) bonds were meant to be the answer for the reinsurance markets in times of constrained capacity, when they were developed in the mid- 1990s. But, roughly 10 years since their inception, they still have not caught on in the way many expected.

Issuance remains relatively infrequent with only four new cat bonds known to have come to market since the beginning of last year. However, investors that recognise the attractiveness of such bonds for diversifying their portfolios are snapping up any that are available. And although issuance is generally not expected to show substantial growth this year, the market shows signs of maturing and looks set to offer new and cheaper ways for insurers – and even non-financial companies – to transfer catastrophe risk to the capital markets.

Catastrophe bonds win Universal acclaim

Switzerland’s Bank Leu, which in January 2002 launched what it believes to be the first global public fund to invest exclusively in cat bonds, has witnessed first hand investors’ desire for this asset class. The fund was so popular with investors the bank was “forced to close it at the end of December”, says Peter Grunblatt, head of the alternative investment team at Bank Leu. It plans to launch a second cat bond fund before the end of May due to overwhelming demand, he says. The first fund attracted $243 million and he says the second is expected to match this.

But investing the fund has been a challenge in current market conditions, says Daniel Hausammann, portfolio manager of alternative investment at Bank Leu.The existing fund,which holds 30 cat bonds covering eight different perils, is restricted to holding a maximum of 10% of any one issue, according to regulations from the Swiss Banking Commission.With only $3 billion of cat bonds available in the market, the fund holds close to the maximum allowed for every issue, he says. But he expects to see modest growth in the market this year, which he thinks should provide sufficient volume for the second fund.

Cat bonds were designed to allow insurers, or more often reinsurers (entities that effectively insure the insurers so they can take on more business), to tap the capital markets as an additional source of funding when traditional insurance capacity is stretched.The bonds are linked to one or more underlying catastrophes, such as earthquakes or hurricanes and, if they are ‘triggered’ by such an event, the issuer keeps the investor’s coupon and, in some cases, his entire investment. Investors generally benefit from a higher coupon than similarly-rated corporate bonds if the catastrophe does not occur. None of the approximately 45 cat bonds known to have been issued have ever been triggered.

Cat bonds were never intended to replace traditional insurance coverage, but rather to supplement it. This has proved most useful for the ‘peak perils’ such as Californian and Japanese earthquakes, US hurricanes and European windstorms, for example. If a substantial catastrophic event of one of these types were to occur, the payouts faced by insurance companies could be crippling. Reinsurers therefore usually charge higher premiums for such cover than for other areas and events.

Cat bonds are usually issued via special purpose vehicles (SPVs), legal entities created to hold the capital raised from investors, either to pay them off when the bond matures or to go towards insurance payouts if the bond is triggered. The catastrophe risk is transferred through a reinsurance contract from the insurer or reinsurer to the SPV which then usually arranges a private placement of the cat bonds with a selection of institutional investors.

Although issuers are typically insurance or reinsurance firms, last December saw a cat bond issued outside this sector. This issue, from French media conglomerate Vivendi Universal, was only the second by a non-financial company following a $200 million earthquake-linked bond issued in May 1999 by Oriental Land, the operator of Tokyo Disneyland.Vivendi’s $175 million, 42-month bond was linked to earthquakes at various locations around its Universal Studios in Los Angeles, California.The guarantee of collecting cover from its SPV in the event of a severe loss was one of the reasons the company turned to the capital markets instead of traditional insurance, says a source close to the deal. Another factor was the company’s increasing concern that reinsurers could not sustain the resulting losses if an earthquake hit the area.

Market participants are not convinced the Vivendi deal will lead to more corporate issues, although Ming Lee, senior vice president of AIR Worldwide, a Boston-based catastrophe and weather risk modelling company, says he has fielded inquiries from other companies with large property exposures.The deal also shows that the capital markets can supplement corporate property insurance programmes on tailor-made terms, says Andrew Kaiser, New York-based managing director of risk markets at investment bank Goldman Sachs, which lead-managed the issue.

The Vivendi deal also marked the first time a cat bond had a lower coupon – 510 basis points over dollar Libor, the rate at which banks lend to each other – than similarly-rated corporate bonds, says Kaiser.“Investors are starting to fully value the diversification benefits they offer,” he adds. The issue was oversubscribed, notes a company spokeswoman.

Vivendi’s cat bond was only the fourth to be publicly announced last year, however, and most market players do not expect to see significantly more this year. Average issuance has been around $1 billion a year for the past five years, and few expect this year to be any different. One likely issue is a $100 million cat bond in the second half of this year linked to earthquakes in Taiwan, says Ted Liang, vice president of the Insurance Institute of the Republic of China (see Environmental Finance, March 2003, page 11). Rodrigo Araya, a senior analyst at Moody’s Investors Service, expects to see a few cat bond issues in the first half of this year but Richard Godfrey, London-based director of Aon Capital Markets, is more optimistic, saying he has seen “quite an upsurge in interest”.

But SCOR, France’s largest reinsurer, which issued a cat bond in December 2001, will not be among the issuers.The company announced in February that it has closed its alternative risk transfer business. And Munich Re, the world’s largest reinsurer and another former issuer,says: “It is more economical in the current environment for the insured to procure capacity in the traditional [re]insurance market”.

Indeed, the principal deterrent for potential issuers in the insurance industry is that cat bonds tend to be more expensive and time-consuming to issue than taking out traditional reinsurance cover. A single bond can take months to put together and the legal and underwriting costs, combined with the high spreads usually demanded by investors, make it difficult for cat bonds to compete on price.

However, some disagree. Cat bonds are competitively priced if you take into account the longer-term cover they generally provide and the fact that issuers receive “perfect credit” because the bond is fully collateralised, says Aon’s Godfrey. Hiscox, one of Lloyd’s of London’s 71 insurance underwriting syndicates, issued $33 million worth of three-year cat notes in April 2002 because it “couldn’t purchase that cover at that price in the conventional market,” adds Godfrey, who underwrote the deal.“I am not convinced that the cat bond market is expensive.They are difficult to compare,” says Charles Arthur, alternative risk transfer specialist at Hiscox.

Another drawback for issuers is that cat bonds can be an awkward fit for their needs. Such bonds must be linked to a few specific perils whereas reinsurance contracts can “follow the fortune” of the insurer and be tailored more accurately to its needs, says Robert Muir-Wood, London-based managing director of Risk Management Solutions (RMS), a California-based catastrophe and weather risk modelling firm.

A more recent disadvantage to emerge is cat bonds’ reliance on SPVs, which are now regarded with suspicion.“SPVs have a very bad name because of Enron,” says Muir-Wood. Manfred Seitz, head of alternative risk solutions at Munich Re, agrees that investors are “wary of structures involving offshore SPVs”. Grunblatt of Bank Leu acknowledges that investors in his fund have expressed concerns, but it has “never been a deal killer,” he says.

Investors, however, are showing growing interest in cat bonds to diversify their portfolios away from corporate credit risk, particularly during the equity market downturn. A major appeal is the lack of correlation between catastrophe bonds and conventional financial assets. The current environment in the financial markets has helped Bank Leu’s cat bond fund as investors become “more receptive to alternative investments,” agrees Grunblatt. The fund saw its net asset value rise 7% in the 13 months between its launch and the end of January.

A handful of dedicated private cat bond funds have emerged to invest in this asset class. Seitz from Munich Re has identified four or five, representing roughly $500 million in investments. Kaiser from Goldman Sachs counts 12, including dedicated managers within broader-based funds, and says a few have been established within the last year.

But investor involvement is constrained by the lack of supply, say participants. The reason for slow growth in the market is the “classic chicken-and-egg problem,” says Seitz. “The investor base remains small because issuance is low, and issuance is constrained by the small size of the investor base,” he adds. ‘Buy-and-hold’ investors compound the problem of low liquidity in the secondary market.The cat bond market sees half a dozen trades a week at most, says one trader.

More favourable trends for this asset class are beginning to emerge, however. The size of individual issues is growing, with an average size of $174 million last year, up from $138 million in 2001, according to a new report from Guy Carpenter,a New York-based reinsurance intermediary. Araya at Moody’s says that the issuance process is becoming smoother as insurers are now more familiar with the process. “We have decreased the [issue] time significantly,” he says.He adds that he expects to see bonds this year linked to new perils, but declines to elaborate further.

‘Shelf offerings’ – where an amount of capital is pre-registered with the Securities and Exchange Commission so that issues can be offered more quickly when the market conditions are right – are starting to emerge as one way of cutting issuance costs. Swiss Re Capital Markets, which was the most active participant in the market last year, issued a $255 million cat bond in July from its $2 billion Pioneer 2002 shelf offering.The firm will not comment on its plans for 2003, or even confirm that the shelf offering exists, but Bank Leu’s Hausammann expects Swiss Re to issue a bond every quarter this year.

Many market participants see the pooling of catastrophe risks as an attractive option and say they expect a few new issues this year using this approach. Risk would be collected from different parties and would be packaged into a ‘collateralised debt obligation’ (CDO) so that an investor’s risk would be spread across a number of different perils. Swiss Re was one of the first issuers to use this approach, when it launched a $40 million CDO of cat risks in May last year. CDOs are a way to get smaller players involved in the cat bond market, who might not be able to achieve the economies of scale themselves, says AIR’s Lee.

However, Kaiser at Goldman Sachs is not convinced this will be a significant trend.“Most investors would still rather accumulate risk individually and develop their own portfolios,” he says.“There is a desire for single-peril transactions so investors can create their own portfolios,” agrees Judith Klugman, senior vice president at Swiss Re Capital Markets. Swiss Re’s Pioneer deal had six tranches, one each for five different perils (North Atlantic hurricane, European windstorm, and Californian, Central US and Japanese earthquake) and one for a combination of the five. The tranches offered varying risk/return levels for the investor to choose from.

Yet another potential method of transferring insurance risks onto the capital markets is to use industry loss warranties (ILWs), says Muir-Wood from RMS. These are essentially reinsurance contracts that are based on an index of catastrophe losses rather than reinsurer’s actual losses.They are already popular with insurance and reinsurance firms, partly because of their simplicity, and a growing number of cat bonds are based on such indexes.

There is now potential for tradable derivatives contracts to be launched directly on ILW contracts, and a secondary market could be created by selling the basis risk between the index and actual losses, says Muir-Wood.These contracts would work much more simply than cat bonds, because the trigger could be based on a single number, he says. Of the roughly $3 million of catastrophe protection placed via this market last year, about 95% was from the reinsurance industry, with only a handful of fund managers entering into contracts, says Peter Crosby, president of Reinsurex, a New York-based reinsurance broker. Investors are involved in around 20 fairly small derivatives deals each year, he adds.

If the cat bond market is to grow significantly, bringing down the price of issuance will likely be what clinches it. “For cat bonds to be on a more level footing, there would need to be another significant increase in reinsurance premiums or increased interest on the side of investors pushing spreads lower,” says Seitz from Munich Re.