Shocks and bonds: Recent events may brighten the prospects for the issuance of catastrophe bonds. (Loss/Risk Management Insight Property/Casualty).

One of the most visible effects of the horrible events of Sept. 11 is the sharp rise in insurance rates. A less-noticed, but equally important, drama is the potential impact of these events on the evolution of the insurance industry itself. Part of this drama focuses on catastrophe bonds.

Proponents of securitization predict that the financial shock waves of the World Trade Center disaster will trigger a long-awaited surge in the issuance of catastrophe bonds. These securities are essentially a capital-market substitute for reinsurance. Investors who buy them receive a return that consists of both interest payments on their investment and insurance premiums paid by the issuer. However, should certain specified catastrophic events occur, these investors stand to lose some or all of these premiums and interest payments to cover claim costs. In some cases, they may lose some or all of their original investment as well.

During the past five years, the issuance of catastrophe bonds initially rose, then stalled as competition intensified in the reinsurance market. But recent events may brighten their prospects in several ways. First, starting even before September, a series of Federal Reserve rate cuts has made investors and portfolio managers hungry for securities that would enable them to maintain portfolio yields without substantially increasing their risk exposure. Catastrophe bonds, therefore, would appear to be attractive to investors for at least two reasons: their higher yield relative to other securities with a comparable risk of loss and the fact that catastrophe bonds, in small doses, add very little additional risk to a portfolio because catastrophe losses are uncorrelated with the economic factors that lead to credit defaults in conventional bonds. These twin advantages may be especially attractive in the current environment of low interest rates.

Second, post-September rises in reinsurance rates may attract the interest of potential issuers. Like purchasing conventional reinsurance, issuing catastrophe bonds can reduce an insurer's need for surplus. But unlike reinsurance, catastrophe bonds also provide the issuer with impeccable security against potential credit risk, since they already have sufficient cash or marketable securities in hand to pay off even the largest permissible claims against them.

But most important, advocates say that issuing catastrophe bonds now may be cheaper than buying the equivalent protection in the form of reinsurance. This claim is the most crucial-and the most dubious-for forecasting a dramatic upsurge in issuance. The cost to issuers of catastrophe bonds is determined by two components: the expected returns offered to investors and the substantial fees required by investment banks, law firms and rating agencies. In the past, potential investors have demanded yields substantially in excess of those on more conventional bonds of equivalent risk. This substantial yield premium was--and still is--essential to overcome the reluctance of fixed-income portfolio managers to devote time and attention to these new securities. Not only must they learn about the intricacies of earthquakes, hurricanes and catastrophe models, but they also must cope with the fact that each issue is in some respects unique, and overall issuance remains minuscule relative to more traditional securities.

The claim that catastrophe bonds may be a cheaper alternative to reinsurance implicitly assumes that the yield premium needed to overcome investor disincentives remains unchanged since September. If true, this would be astonishing. On the heels of a previously unimaginable catastrophe, the most costly that our industry has ever experienced, investors--like underwriters--are surely revising upward the premiums needed to accept catastrophe risk. But increasing the returns for potential investors necessarily creates higher costs for issuers.

In reality, then, catastrophe bonds must satisfy two opposing requirements: Their cost relative to reinsurance must be low enough to attract issuers, yet they must be set high enough to provide attractive returns to potential investors. These two conditions are difficult to satisfy simultaneously, but there are at least four ways to make it more likely. One is to continue to create incentives for investors to become more familiar with insurance risk, so the yield premium they require gradually declines. A second is to streamline the issuance process to lower fee overhead. A third is to repackage catastrophe bonds in familiar forms, such as mutual funds, which increase diversification and add liquidity. And a fourth is to alter the structure or the risk exposures of catastrophe bonds to make them more similar to existing securities.

Long term, securitization of insurance risk in some form may well be inevitable. But short term, even the shocks of September are unlikely to dramatically shorten the process of overcoming all the roadblocks to that ultimate destination.

William H. Panning, a Best's Review columnist, is senior vice president of Willis Re Inc.