More risk, more reward: the catastrophe bond business is booming this year, as insurers and reinsurers securitize greater amounts of risk at lower layers.

Catastrophe bonds are on target to set another record in 2006, thanks in part to insurers and reinsurers securitizing deeper layers of risk, while offering hungry investors higher returns for taking on that greater risk.

"This will certainly be the largest issuance year in the history of the market," said Mike Millette, managing director of Goldman Sachs.

At the end of May 2006, including both private and publicly disclosed transactions, $1.9 billion in cat bonds were being issued, compared with $2.3 billion for the full year 2005, Millette said.

"In addition, we see a lot of planning. More companies are considering using the market," Millette said. "Typically, we see a lot of activity in the second quarter--before the hurricane season starts--and the fourth quarter--before year-end. Now we are seeing more of a year-round market."

In addition to new issuers, there's a flood of new buyers.

"A great many new investors have entered the market over the past three quarters. There's a genuine diversity among them: quite a few hedge funds and some new speciality catastrophe funds. Money managers have reviewed this market in the past and have decided the level of spreads available following Katrina means it's an excellent time to enter," Millette said.

Because cat bonds are not issued to the general public, but usually placed privately with qualified institutional investors, many transactions are not made public until after they are completed. Some are never made public at all.

Issuers of wind-exposed deals include large global reinsurers, U.S. and even non-insurance corporations that are exposed to Gulf winds, said Dan Ozizmir, managing director of Swiss Re Capital Management and Advisory.

"In terms of size, we expect this will be a record year" Ozizmir said. "We've had the most active first quarter ever."

In a report, The Catastrophe Bond Market at Year-End 2005: Ripple Effects from Record Storms, Guy Carpenter reported a total of $1.99 billion in publicly disclosed cat bonds issued in 2005, a 74% increase over the $1.14 billion issued during 2004 and a 15% increase over the previous record of $1.74 billion issued in 2003.

More Competition

The sheer volume of deals coming to the market recently has swamped the investor community, and some cat bonds are having difficulty getting the investors to provide the capital they seek, said Christopher McGhee, head of Guy Carpenter's Investment Banking Specialty Practice and managing director of MMC Securities.

Before 2005, demand for cat bonds in the investor community had outstripped the supply, but 2005 has reversed this trend, McGhee said.

"For a properly priced, well-structured deal, there's definitely capacity available, but it's maybe not the full capacity that the client had gone for. Most clients understand there's a capacity constraint, and are taking the capacity that is available to them," McGhee said.

There's more competition among cat bonds to find investors, he said.

"Now investors have the ability to compare and pick what bonds they find the most attractive. The transaction price is clearly the major factor," McGhee said, noting if everything about two bonds is equal except for price, investors will take the bond with the higher return.

Go Deep

Insurers and reinsurers are also securitizing deeper layers of risk, reaching down to the working layer, or earnings layers, vs. the traditional high catastrophic, or solvency layer, Ozizmir said.

"In the past, if we spoke about the working layer, we were talking about something like the embedded value life securitization or the securitization of [auto] risk that Axa did out of Europe ... the basic working cash flows of insurance. It's like an asset-backed security. It's selling cash flows to investors, and they are receiving a spread on those cash flows. If the assets don't perform well, then ultimately they might have some losses," Ozizmir said.

When it comes to cat bonds, however, historically the bonds would have been triggered by very extreme events carrying a 1% to 2% chance of loss. Such a cat bond would protect a company from becoming insolvent during an extreme loss, but wouldn't be likely to impact its earnings during less-than-extreme events.

"What is currently happening in the cat bond market is issuers, both insurance and reinsurance companies, are focusing on what I would call the earnings layer," Ozizmir said.

The bonds are written to be triggered by 5%, 10% and even 15% chance of loss. These riskier issues bring lower ratings--but higher returns for investors.

"This is the layer that impacts the earnings of reinsurers. It is not the layer that protects the solvency," Ozizmir said.

The reason for this trend is twofold: first, insurers and reinsurers want more earnings protection than they did in the past. Secondly, the retrocessional market is much weaker than it was in years past, Ozizmir said.

Ann Northrop, senior insurance analyst with Zachs Investment Research, noted that just one cat bond--Kamp Re 2005 Ltd.'s $190 million transaction--suffered a total loss from Hurricane Katrina. It's the first total loss to a publicly disclosed cat bond, according to Guy Carpenter.

"To date, we've only had one cat bond that's had a loss triggered, and there have been more than 70 issued," Northrop said. "Insurers and reinsurers that need protection appear to be seeking lower layers of covers so that their losses don't have to be as severe to trigger an event."

Reinsurers are being forced to diversify their risks to meet the demands of rating agencies, Northrop said. "There's a growing demand for capacity in the market, at the same time the capital requirements are growing. Some reinsurers will be constrained from growing too much in the property catastrophe market, so the cat bond area is clearly a growing demand."

To take on this additional risk, investors are being offered returns two to three times greater than before.

"On the investors' side, many think that if you are taking U.S. wind risk, you might as well go for as much return as you can get," Ozizmir said.

Still, investors often have a menu of risk options. Bonds are often issued in tranches with different levels of risk and different rates of return. "You can limit your risk exposure to just losing your interest payment, or a dollar amount corridor, depending on your risk appetite," Northrop said.

This is a market full "of fear and concern, given the last few years," Ozizmir said. "What is heartening to see is that the investors are responding to pricing. The pricing has been increased dramatically, reflecting the greater uncertainty and risk. Investors are willing to continue to provide the capital, but at higher rates of return. Investors understand that the next six months will be quite stressful."

Cat bonds typically have lifespans of one to five years. For the higher risk bonds, deals are generally limited to one to two years, Ozizmir said. "Investors are reticent to take this risk for longer maturity," he said.

Even with the growth of the cat bond market, it is still a relatively small area of the reinsurance market, said Paul J. Kneuer, senior vice president and chief reinsurance strategist with broker Holborn Corp.

"The cat bond capacity issued in 2005 was less than 2% of the traditional reinsurance market," Kneuer said.

As a pure reinsurance broker, not a broker/dealer, Kneuer isn't in the cat bond market itself, but helps clients who have placed cat bonds as part of their reinsurance package. He explained the growth in cat bonds is a supply and demand issue. "The relative supply at different levels of traditional reinsurance capital and alternative capital comes together in a mosaic in different layers in different parts of the cycle," he said.

Even with cat bonds reaching into deeper layers of risk, it's still not likely that they'd be triggered in a typical year, Kneuer said. "They are lower [triggers] than they have been, but it's fair to say that they're at or above the size of a Katrina loss," he said.

McGhee of Guy Carpenter said while it's true that 1-in-50-year triggers have become more common, those riskier "working layer" cat bonds are still exceptions, not the rule.

"It's definitely true that the layers of risk being covered are riskier than they were before. It is not accurate to say that in general, you are at working layers. It's accurate to say as investors have become more comfortable with the sector they are willing to take on riskier and higher-yielding transactions," McGhee said.

To issue a cat bond, an insurer or reinsurer needs to have a buyer with a clear interest and a willingness to pay a reasonable amount of money, Kneuer said. It wouldn't make sense to issue a cat bond for $10 million stretch of coverage; it would make sense for $100 million and up, Kneuer said.

Repeat issuers often start working on the next cat bond almost as soon as the last one is done, he said. "There's a fair amount of regulatory, legal and accounting work to create the bond," Kneuer said.

But more recently, "the ones that were reacting to changes in the reinsurance market got done and fully funded in about two months," Kneuer said.

That's a sign of the appetite investors have for cat bonds, Millette said. "The rate of growth appears to be continuing to pick up," he said. "There's an enormous pipeline right now in the marketplace."

McGhee of Guy Carpenter also expects the demand from the investment community will expand to eventually balance the growing supply of cat bonds.

"Investors haven't quite caught up with the demand [for investors], but we think they will" McGhee said.

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New Players

A number of first-time cat bond sponsors have recently come to the market, including:

* Aura Reinsurance plc, a 68 million euro (about $87 million) transaction to provide a reinsurance subsidiary of Axa with coverage for European windstorms.

* Cascadia Ltd., a $300 million transaction to provide FM Global with coverage for Pacific Northwest earthquakes.

* Avalon Re Ltd., a $405 million transaction to provide Oil Casualty Insurance Ltd. with third-party liability from refinery disasters.

* Kamp Re 2005 Ltd., a $190 million transaction to provide Zurich American with coverage for U.S. hurricanes and New Madrid earthquakes.

* Atlantic & Western Re Ltd., a $300 million transaction to provide PXRE with coverage for East and Gulf Coast hurricanes, European windstorms and California earthquakes. That November transaction was followed a month later by Atlantic & Western Re II, a $250 million transaction to provide PXRE with coverage for the same perils as the first one, but on a "second-event" basis only.

* Champlain Ltd., a $90 million transaction to provide Montpelier Re with coverage for East and Gulf Coast hurricanes, U.S. and Japanese earthquakes.

Source: Guy Carpenter and MMC Securities Corp.

ANTICIPATING A RECORD YEAR: The number of issued catastrophe bonds is poised to outpace 2005's number. "We've had the most active first quarter ever," said Dan Ozizmir, managing director of Swiss Re Capital Management and Advisory.

Key Points

* Catastrophe bonds issued for the first half of 2006 have almost reached the record amount issued in 2005.

* Driving this growth are insurers and reinsurers securitizing deeper layers of risk for greater returns to investors.

* New investors, including hedge funds, have flooded the cat bond market in recent months.

Definitions

Catastrophe Bonds: A type of insurance-linked securities issued by a special purpose vehicle and then sold to institutional investors. Interest and/or principal can be delayed or even lost if a specific catastrophe strikes, A bond can be triggered by a predetermined indemnity loss or a parametric trigger, such as a specific wind speed or a Richter scale reading.

Sidecar: A new venture funded by third-party institutional investors. Existing insurers provide the underwriting for a fee and often off-load some of their riskier business onto the sidecar.

Sidecars and Cat Bonds

Just as important as the growth of catastrophe bonds is the growth in third-party investors funding sidecars, said Mike Millette, managing director of Goldman Sachs.

Millette estimated counting cat bonds, sidecar investments, and life insurance and auto insurance securitization, capital markets raised about $7 billion in capital for insurers in 2005. That broke down to include $2.3 billion in cat bonds, $1.8 billion in side cars and about $2.9 billion for life insurance and auto insurance securitization in 2005, Millette said.

By the end of May 2006, in addition to the $1.9 billion in cat bonds, another $1.1 billion in sidecar funds was raised, Millette said.

Cat bonds are to excess of loss what sidecars are to quota share, Millette said. "Cat bonds are situations where you create a special reinsurer, sufficiently funded, to back an excess of loss layer for reinsurers. In a sidecar, you have a special purpose reinsurer to back up a quota-share of an insurer or reinsurer."

While cat bonds are being issued at lower layers of risk, for higher returns for investment and more coverage for insurers, investors are also taking on a true equity-level of risk in a sidecar.

"We're seeing bonds go from 1-in-100-year or 1-in-200-year events down to 1-in-50-year, 1-in-25-year and 1-in-10-year events ... even down to side-by-side participation in a sidecar," Millette said.

Also, while cat bonds can have either an indemnity trigger or parametric index (for example, a measure of the wind speed or specific number on the Richter scale for earthquakes), sidecars are indemnity transactions.

"We completed an $840 million sidecar transaction at the end of the year. That was one of the largest transactions ever, and it was very popular with investors," Millette said.

For more information on the recent development of sidecars, see "New Ventures, New Vehicles" in the May 2006 issue of Best's Review.

2006 Could Set New Cat Bond Record

As of June 7, 2006, with six months to go, this year is poised to
outpace the Cat bonds issued for the full year 2005, which also was
a record-breaking year

Risk Capital Issued ($ Millions)

        Risk Capital    Number

1997        $633.0
1998        $846.1
1999        $984.8
2000      $1,139.0
2001        $966.9
2002      $1,219.5
2003      $1.729.8
2004      $1,142.8
2005      $1,991.1
2006      $1,762.5
YTD

Note: Table made from bar graph.

Source: MMC Securities Corp. and Guy Carpenter & Co.