Vanishing Cat Bonds.

After an initial flurry of interest, the capital market has faded as a long-term alternative to traditional catastrophe insurance.

After Hurricane Andrew in 1992, there was tremendous concern over lack of reinsurance capacity to cover "the big one." Recognizing an opportunity, Wall Street developed catastrophe bonds, including cat-linked securities, as a capital market alternative to traditional catastrophe reinsurance.

When cat bonds first hit the market in 1996 and 1997, there was so much excitement that some even predicted the end of the cat reinsurance market. But a review of the market today indicates that traditional cat reinsurance remains the standard by far. Where are all the cat bonds?

The surprising magnitude of Hurricane Andrew's $18 billion insured loss led many to wonder, "What if Miami? What if Long Island?" The answers weren't too comforting to either insurers or reinsurers. Loss estimates for an Andrew-magnitude storm hitting only a relatively few miles north in Miami ranged from $50 billion to $75 billion--this related to estimated total global insurance surplus of around $250 billion at that time. Similarly frightening was contemplation of multiple noncorrelated catastrophic events occurring in a relatively short period of time; 1994's $11 billion Northridge earthquake soon brought this concern to light.

Besides worries over exposures to these "super cats," this period was also characterized by issues regarding affordability and availability of catastrophe reinsurance from one year to the next. Managing catastrophe risk at primary insurers became a nightmare. For some, desired reinsurance protection was not available at any price.

Against this backdrop, cat bonds, and other catastrophe-related structures, were developed. Insurers recognized that they needed alternative sources of protection from natural catastrophes. Wall Street saw an opportunity to fill that void by creating investment vehicles to transfer these risks into the capital markets.

When the first cat bonds were issued, there was tremendous enthusiasm. For insurers, transferring catastrophe risk to the estimated $30 trillion-plus global capital markets could solve capacity and credit-risk concerns, as well as ultimately reduce the overall costs of reinsurance. Investors were attracted by the opportunity for higher yields plus diversification due to the noncorrelated nature of catastrophic risks. Excitement was so high there were even predictions of the end of the catastrophe reinsurance market; these reinsurers were stating that if the cat bond market took off, they would simply transform themselves from premium-based risk takers to fee-based catastrophe risk consultants. Broader applications of the cat bond concept emerged--if catastrophic insurance risk could be transferred to the capital markets, why not any other insured risks? Insurance securitization was born!

What happened? Newly formed catastrophe reinsurers in Bermuda, the resurrection of Lloyd's, years of relatively low cat loss activity, plus record investment returns have led to excess reinsurance capital chasing too few premiums. The resultant drop in traditional catastrophe reinsurance premiums made the relatively expensive capital market alternatives less attractive--even this year's double-digit catastrophe reinsurance rate increases have not sparked much renewed interest.

Cat bonds are complex and uniquely structured--not a commodity. Underlying insured exposure data is not standardized and is in varying stages of completeness in various parts of the world. There is heavy reliance on computer models wherein each new catastrophic event is apparently "unique" and "not contemplated" by the various models available. Additionally, general investors are not comfortable with the insurance industry as a whole, let alone a specific insurer's catastrophe exposure; as a result, cat bond investors are few and specialized.

It appears that either a "magic bullet" or a "perfect storm" may be necessary to transform the cat-bond market from the experimental stage to a viable alternative. Many draw a parallel between the development of the cat-bond market and the mortgage-backed/asset-backed securitization markets in the mid-1980s. A key component of the development and ultimate acceptance of those markets was the standardization of underlying data so it could be segmented, tracked and analyzed. If catastrophe exposures could be similarly standardized, it would go a long way toward the development of a simpler, more transparent product--a potential magic bullet.

Are cat bonds here to stay? Will the capital markets ever become a viable alternative to traditional catastrophe reinsurance? How about as an option to other types of reinsurance--or even insurance--risks? Only time will tell, but it surely will be interesting to watch.

Perry DeFontaine, a Best's Review columnist, is senior vice president of Willis Re, New York.