Old cat--new tricks: creative new uses for catastrophe bonds help generate more capital, deals and investors.

Sales of catastrophe bonds, a capital-market alternative to traditional catastrophe reinsurance, grew significantly in 2003, and experts say the main drivers of this upturn were pricing and limited capacity in the reinsurance market, as well as concerns about reinsurers' credit quality.

MMC Securities, an affiliate of reinsurance intermediary Guy Carpenter & Co., reports that the catastrophe bond market in 2003 had a record issuance of $1.73 billion, a 42% increase from the previous high of $1.22 billion in 2002.

"While there's a lot of growth there, it's still a relatively small market,' said Christopher McGhee, head of Guy Carpenter's Investment Banking Practice and managing director of MMC Securities.

Granted, but this new approach to diversifying risk has been drawing increasing interest of late. Its roots go back to 1992, when Hurricane Andrew caused an $18 billion loss, raising worries over lack of reinsurance capacity to cover future mega-catastrophes. To meet this challenge, Wall Street developed catastrophe bonds. Since 1997, when cat bonds first hit the market, 54 catastrophe bond issues have been completed, totaling risk limits of nearly $8 billion, McGhee said. In 2003 alone, eight transactions were completed, three of them from first-time issuers, he said.

One reason for recent interest in cat bonds is the growing concern on the parts of insurers about credit risk, said Richard Clinton, president of Eqecat, one of the three major catastrophe modeling companies. This concern is driven by the decline in the equities market, poor underwriting results and increased scrutiny of reinsurance companies by rating agencies. Even with the recent improvements in the equities market and underwriting results, the credit risk concern remains a major issue.

This scrutiny is encouraging insurance companies to consider buying risk-transfer capacity up to a higher level to lower their probabilities of loss, McGhee said. "Insurers want to find ways to secure their capacity on a fully collateralized basis, and there is an ongoing interest by reinsurers in finding additional, substantial sources of retrocessional capacity--always a smaller, more limited marketplace than is true of the reinsurance marketplace," he said. With retrocession, a reinsurer cedes all or part of the reinsurance it has assumed to another reinsurer.

"Primary companies are looking very closely at the credit risk associated with the reinsurers that they are purchasing their covers through," McGhee said. "That is one area where the bond market has a distinct advantage in that it is one of the more secure ways, probably as secure as you can possibly find, for transferring risk."

With cat bonds, money is placed in a trust and devoted only to a particular event, or events, said Steve Goldberg, who since 2002 has led the actuarial and dynamic financial analysis teams of independent reinsurance broker Benfield. "There's no question about whether there would be any creditworthiness because the money is kept in a very very liquid form waiting for this event to happen," he said. "When it happens, the money goes right" to the insurer, he said.

Spurred by Rising Prices

Clinton also ascribed this growth in the cat bond market to the tighter reinsurance market during the past couple of years, with catastrophe reinsurance prices surging as capacity has decreased. "That makes cat bonds far more competitive from a pricing standpoint, which has always been one of the issues for some companies in the past," he said. "It's also another source of high quality capacity due to its very low credit risk, which enables companies to obtain much needed additional capacity without increasing their overall credit risk."

In 2003, Risk Management Solutions Inc., one of the big three modelers, made a major change in its model, prompting many clients to seek significant additional capacity in the market, Clinton said.

It also has helped that cat bonds have found more acceptance from rating agencies, making it easier from a legal and transactional perspective to get these transactions done, said Geoffrey Etherington, a partner in the insurance and reinsurance department at the law firm of Edwards & Angell LLP. The rating agencies are particularly interested in how the bonds are structured, whether through special-purpose vehicles or Bermuda-based reinsurers, he said.

Catastrophe bonds can be structured in one of three ways, Goldberg explained. One is the indemnity form, which is very similar to reinsurance and provides reimbursement to insurers for losses that occur. "That makes a lot of sense to insurance companies because it looks like, tastes like, feels like reinsurance," he said. "But it's hard for investors to take because of the risk. They think of things like adverse selection, where claims may go up based on the action of the insurance company. So they are not very comfortable with that and, to this day, the indemnity form of catastrophe bonds has not really grown at all."

Instead, investors prefer indexed or parametric deals, Goldberg said. With an index structure, the loss is simply a reflection of another index and is not related directly to the losses of an individual insurance company. The parametric form is based on the probability that a particular event will occur--for example, an earthquake of a certain magnitude at a specific location. But with this kind of transaction, insurance companies have to have a strong belief that their losses would correlate well with those events, and so they don't often choose this form, Goldberg said.

"The problem with catastrophe bonds has been trying to fit a round peg into a square hole," he said. "And while it's been successful to a limited extent and the market has grown a lot, it still needs time to mature."

Firsts Among Bonds

As the cat bond market grew in 2003, there also were some notable developments. These included:

* The structuring of a catastrophe bond that protects the Federation Internationale de Football Association (FIFA) against cancellation of the final match of the 2006 World Cup scheduled to be held in Germany. Credit Suisse First Boston arranged this $260 million equivalent cat bond to aid FIFA, the world governing body for soccer.

The FIFA bond "introduces a new asset class to the capital markets and potentially transforms the insurance market for event organizers," said the Web site of Freshfields Bruckhaus Deringer, whose structured finance team served as advisers for the transaction. "Not only is this the first transaction in which the risk of staging a sporting event has been transferred to the capital markets, it is the first cat bond that has covered terrorism risk."

Part of the financial risk in this arrangement fell on Golden Goal Finance Ltd., a special-purpose vehicle incorporated in Jersey, Channel Islands, under a derivative contract. Golden Goal hedged its obligations under this contract by issuing cat bonds in the capital markets, Freshfields Bruckhaus Deringer said.

"Obviously, there's a lot of money at risk and they had a difficult time placing through the traditional market, so they created a securitization called the Golden Goal to provide them with some cancellation risk transfer," Etherington said.

* The Formosa Re Ltd. issuance, sponsored by Central Reinsurance Corp., was the first cat bond issued for Taiwanese earthquake risk. This was a risk-transfer protection for the government-sponsored Taiwan Residential Earthquake Insurance Plan, also known as TREIP, McGhee said. The $100 million transaction provided risk transfer capacity against an earthquake in Taiwan at a high level.

"This was an interesting transaction because it was the first non-Japanese Asian securitization--all the other securitizations have been done in Japan," he said. "It also was interesting because it wasn't rated by one of the rating agencies but was nevertheless still aggressively subscribed to by investors."

This cat bond had a feature that indexed up the coupon to investors as the calculated loss probability rose, McGhee said. The TREIP program is new in Taiwan, and as its exposures grow, the loss chance under the bond also will grow, he said. "This is a way of allowing the new Taiwan dollar attachment point for the bond to remain fixed but allow a mechanism within the bond itself that provides for an increased coupon if, in fact, the exposures did rise," McGhee said.

* Pylon Ltd., the third-ever issuance by a corporate sponsor, was a $231.8 million special-purpose vehicle sponsored by Electricite de France, the French utility.

The utility undertook this after a series of violent wind storms severely damaged France's electrical grid on Sept. 28, 2003.

"When they went out to put windstorm cover in place, the cost was quite high, and there wasn't a lot of appetite," Etherington said. "So they structured Pylon to protect themselves against windstorm damage. This was an example of a circumstance where capacity or cost in the market made it a sensible thing to do."

But these recent developments in cat bonds don't represent a wholesale change in approach, McGhee noted. "What we're seeing now is a standardization in this marketplace," he said. "We're seeing more tweaking of the basic approach."

Lowering the Cost

As these transactions become more standardized, they also are becoming cheaper to do, Etherington said. "One reason we're seeing more of these deals done may be that insurers, and companies that normally are purchasers of insurance, are seeing that the cost of securitization is getting closer to trying to do a traditional reinsurance program, so they can now cost-effectively transfer risk to the capital markets," he said.

Cat bond transactions have tended to be expensive because many parties, including rating agencies, modeling firms and investment and tax counsel, can be involved in structuring and issuing them. There are a lot of fixed expenses involved in setting up these transactions, mandating that the bond has to be a minimum size to make the effort worthwhile, Goldberg said.

"It also takes a lot of patience and intellectual capital in order for an insurance company of any size to devote itself to these kinds of transactions," he said. "A lot of companies don't want to spend the time to become adept at this when they already have a solution in reinsurance."

Waiting for a Test

Overall, catastrophe reinsurance markets have performed very, well, confounding doubts in the 1990s about their survival, Goldberg said. "If they're around after 9/11, then they're pretty strong, and look at how much capital has come into this industry," he said.

The cat bond market has yet to be similarly tested in the event of a significant loss. "When it happens, I think there may be a lot of surprises," Goldberg said. "Investors ought to be grown up about this, but you just don't know what the reaction is going to be. Will there be a vibrant cat bond market afterwards?"

When cat bonds first hit the market, they generated so much excitement that some thought they heralded the end of the cat reinsurance market. But the catastrophe bond market never was meant to replace the traditional reinsurance market, only supplement it by providing additional competition among capital sources for abilities to transfer or hedge risk, Goldberg said.

Back in 1997 when Goldberg was chief actuary for USAA, he and colleagues traveled the world talking with investors to help launch the first significant size cat bond, Residential Reinsurance. "There was a lot of buzz about it, and I think the reinsurance markets were concerned that we were trying to find a replacement for them," he said. "That wasn't at all the point. We wanted to try to maximize competition out there and let the markets decide the most efficient way to do this."

At present, he added, reinsurance is still the way to go in most cases. Experimentation with cat bonds has been valuable, even though it hasn't resulted in a $20 billion market, Goldberg said. "But the fact that the technology is there now to do these kinds of deals, and that people have done them, has helped the overall situation for risk bearing."

After the huge shock to the reinsurance industry from Sept. 11 losses, those who worked in the cat bond market thought that if ever there was a time for risk-linked securities to grow in impact, that was it, Goldberg said. But it didn't happen. When the markets demanded additional protection, a number of Bermuda start-ups again answered the call. Rather than putting their money into cat bonds, investors put their money directly into buying the securities of these new reinsurance companies, Goldberg said. "Basically, the insurance community is still very comfortable with traditional reinsurance as a hedge," he said. "After all, traditional reinsurance has had a 300-year history."

Slow but Sure

As McGhee sees it, the cat bond market is progressing as expected. "We did not predict that it would be an explosive growth," he said. "We have predicted that it would be an important complement to traditional reinsurance capacity at the upper reaches of catastrophe programs and that is what, in fact, is happening. But we are seeing slowly but importantly increasing interest from investors in this space."

If anything, catastrophe bonds are generating more interest among noninsurance entities such as major corporations, Clinton said. Eqecat worked on the first cat bond for a noninsurance entity a number of years ago, then completed a second one by the beginning of 2003, and is working with another corporation on what may result in the issuance of a catastrophe bond later this year, he said.

Investors like cat bonds because they provide additional diversification for their portfolios and this helps them increase their earnings, Etherington said. "That's where the primary companies and even the reinsurers for retrocessional coverage really need to look at another aspect of what cat bonds bring into the market," he said. "It can help them manage their overall risk by reaching out to new sources of capital that are not impacted by insurance industry cycles."

However, using cat bonds does not provide the same benefits that reinsurance can provide to a company because, with cat bonds, "companies don't get surplus relief for the risk that they transfer," Etherington said.

More Investors

The investor base for this asset class continues to increase at a steady rate, McGhee noted. The most compelling news here is the development of catastrophe bond funds established specifically to invest in catastrophe risk, McGhee said. "They are driving the investor demand for catastrophe bonds to a large extent," he said. "They are all companies with a particular expertise in this area and are interested in investing in catastrophe bonds and, indeed, in other catastrophe risk-transfer instruments."

In viewing the total market for reinsurance and retrocessional coverage, cat bonds remain a small piece and will never really threaten the reinsurance and retrocession markets, Clinton said. "But I think the cat bond market will continue to grow within the industry as a viable option since they help to diversify and supplement reinsurance programs which will ultimately make these programs stronger and more stable," he said. "As a result, cat bonds will become a piece of the overall program for more and more companies."

Spreading the Risk Capital

Potential cat bond sponsors are looking to securitize perils and
locations beyond California earthquakes, East Coast hurricanes and
Japanese earthquakes. The two-fold increase in risk capital for
Japanese earthquakes from 2002 to 2003 was primarily due to the large
Zenkoryen Phoenix issuance.

($ Millions)

                            East/
         California    Gulf Coast     Europe          Japan
Year     Earthquake     Hurricane       Wind     Earthquake

1997           $112          $395         $0            $90
1998            145           721          0              0
1999            227           507        167            217
2000            485           455        481            217
2001            577           552        432            150
2002            502           477        334            384
2003            848           517        575            801
Total        $2,897        $3,624     $1,989         $1,858

              Japan
Year        Typhoon       Other *

1997             $0           $36
1998             80            45
1999             17           292
2000             17           344
2001              0           240
2002              0           253
2003            278           225
Total          $392        $1,436

* Includes catastrophe bonds exposed to Midwest earthquake, U.S.
Northeast hurricane, Monaco earthquake, Puerto Rico hurricane, Europe
hail and Hawaii hurricane.

Source: MMC Securities Corp., "Market Update: The Catastrophe Bond
Market at Year-End 2003"

RELATED ARTICLE: Six years later.

In January 1998, a Business Week article included a number of predictions about the future of the catastrophe bond market. But this was before the troubles of Enron Corp. and WorldCom Inc. and the events of Sept. 11, 2001.

Best's Review asked two experts which, if any, of these predictions have come to pass:

Wall Street will steal market share from reinsurers.

* "It's not so much stealing market share as the market has continued to grow. And a piece of that growth is going to the securities, the bond market. Overall, the capital markets' share of the market continues to be minor, but an important one since it is helping to provide the additional capacity needed within the industry."--Richard Clinton, president of Eqecat

* "That's debatable. If they have stolen any market share, it's not very much. And I'd actually think that what is more the case is that the pie has gotten bigger, not so much that the pie has been recut."--Christopher McGhee, head of Guy Carpenter & Co.'s Investment Banking Practice and managing director of MMC Securities

Primary insurers with large catastrophe exposures will have better access to coverage.

* "It certainly gives them another option for coverage and additional capacity so, in the sense that it gives them another alternative, it does that. Most of the catastrophe bonds with some exceptions have been done outside the U.S. primarily for non-U.S, companies or reinsurers. And part of that is because of how regulators look at the catastrophe bonds in analyzing companies. They recognize them, but only when they are an indemnity cat bond. The problem with this is that the cat bond market is rapidly moving towards hybrid index-based bonds that are preferred by both the investors and issuers.

"The regulators in the U.S. need to reassess their view on catastrophe bonds. And once they do that, more companies would be receptive to the use of catastrophe bonds, which would provide them with access to additional capacity and hopefully make everything more competitive."--Clinton

* "Companies that tend to buy catastrophe bonds tend to be, first, the largest reinsurers and second, the largest insurers with catastrophe exposures. This implies that you have to be a primary insurance company with large catastrophe exposures to get access to this coverage. This is not the case.

"But what I think is true is that the insurance companies with large catastrophe exposures want to buy large transactions, and large transactions are more economically done in the cat bond market than small transactions. It makes more economic sense for companies with big exposures to do transactions than for small ones. It's not as if investors would deny access--there would be receptivity for smaller companies, it just wouldn't make economic sense."--McGhee

Price volatility in the reinsurance market will moderate.

* "There's always price volatility. Starting around 2000, the property catastrophe market started to see more of a leveling out of rates and some increases. Prior to that, for a number of years it was continually going down and very competitive. After Sept. 11, 2001, prices went through the roof and capacity was very limited. Now prices for property catastrophe reinsurance seem to be once again coming down. So, yes, there continues to be volatility."--Clinton

* "I actually think that price volatility in the reinsurance marketplace has moderated, but you can't prove that that has been because of catastrophe bonds. This is simply an opinion. It's complicated by the fact that many factors are at work at the same time. For example, immediately following 9/11, which was perceived as a market-moving event, we saw a very rapid infusion of equity capital into the reinsurance business--the new start-up reinsurance companies.

"That happened more rapidly than the last time in 1992-93. While this inflow of equity capital constrained prices, some reinsurers said they could not raise prices too much in the reinsurance marketplace, particularly for the highest layers where cat bonds are the most likely alternative, because reinsurers knew that clients had the alternative of going into the cat bond marketplace if their prices went up too much. So while this marketplace is still relatively small, I think there is some anecdotal but not strong evidence to suggest that the cat bond marketplace has had some unspecified dampening effect on reinsurance prices."--McGhee

Many reinsurers will transform into intermediaries/consultants on risk-management strategies.

* "No, I do not believe that has happened to any great extent. The one exception is direct reinsurers who are trying to do more in this area, which is really just an expansion on what they have done in the past. Also, all of the current major intermediaries are doing a lot more in this area, which has become one of the essential services that they provide to their clients. So I don't think there's been a dramatic change on the reinsurance side moving toward risk-management services, but certainly on the intermediary side there's been more of a trend in the last few years."--Clinton

* "That's not true. First of all, reinsurance intermediaries--for example, Guy Carpenter--are perceived as even more valuable now than they were then. We judge that because our business is growing rapidly, so I think we can say that with confidence. This statement would suggest that the reinsurance broker's role would change and that hasn't happened--we have always said we were intermediaries/consultants on risk-management strategies, I'd say we've broadened the scope of things we do for clients, but that role at its core basis has not changed, I think it's probably not true that reinsurers have adopted this role. By and large, they continue to play the role of a risk-transfer absorber for insurance and reinsurance companies."--McGhee

RELATED ARTICLE: Securitizing terrorism risk could be next.

It's only a much-discussed concept right now, but the first catastrophe bond devoted to terrorism risk could materialize if Congress fails to extend the national terrorism-insurance backstop beyond 2005. The U.S. Treasury Department also is to decide by September whether to extend the "make available" provision of the Terrorism Risk Insurance Act of 2002, known as TRIA, beyond the end of 2004. The act created a mechanism that shares risk between the insurance industry and the federal government with the intention of allowing the commercial insurance market to continue to function in the face of potential terrorism losses that are both unpredictable and immeasurable.

"If TRIA or some form of TRIA is extended, I think there will be less of a motivation" to structure terrorism cat bonds, said Ming Lee, a senior vice president of AIR Worldwide Corp., the Boston-based risk-modeling company.

But if the federal government decides against an extension, securitizing terrorism risk could appeal to a number of major corporations that think they may be exposed directly to terrorism risk, he said. "If TRIA goes away, insurers and reinsurers are going to reevaluate terrorism coverage," Lee said. "It's possible that some companies will consider cat bonds as a means of getting reinsurance or retrocessional coverage for this peril."

Lee recalled a speech by Wayne A. Abernathy, assistant secretary of the treasury for financial institutions, to the Bond Market Association meeting in March 2003. In his remarks, Abernathy encouraged the financial community to think about transferring terrorism risk to the capital markets, Lee said. "So we know that there's at least one person in the government who would like the industry to consider this," he said. "And we know that the government itself has studied cat bonds--the General Accounting Office has performed several studies on catastrophe bonds at the request of members of Congress."

The structure of any future terrorism cat bonds would have to take into account the high uncertainty, in the frequency of terrorist attacks, Lee said. There is no prototype of cat bond solely for terrorism risk to point to; in fact, only one has been issued with a link to terrorism, he said. This example, involving Federation Internationale de Football Association, was issued in fall 2003 against cancellation of the Final match of the 2006 World Cup soccer tournament in Germany, and it dealt with risks from multiple events, not terrorism alone.

A vital ingredient in issuing a terrorism cat bond would be gaining a rating for it, Lee said. "If the rating agencies rate it, then you would find investors willing to take the risk," he said.

If the need to transfer terrorism risk becomes necessary, AIR could serve to assess that risk for clients, Lee said. Following the terrorist attacks in New York and Washington on Sept. 11, 2001, AIR developed its Terrorism Loss Estimation Model based on the framework that the company has used in assessing other extreme-event risk, he said. This model, which assesses terrorism risk, looks at international and domestic terrorist threats, attacks by conventional and nonconventional weapons, and potential property, workers' compensation and life losses. Insurers, reinsurers, corporations and various branches of the U.S. government currently use the model, Lee said.