Cat Bond Activity Accelerates

Speaking of capital markets solutions as an alternative†¦Mainstream, rather than alternative is how the catastrophe bond market can now be described, according to Guy Carpenter. Its sixth annual review of the market reveals a phenomenal level of transaction activity in 2007, even as rates softened for traditional reinsurance capacity. At year-end, cat bond risk capital outstanding reached $13.8 billion, a 63 percent increase over 2006’s record-setting year-end total of $8.5 billion. Cat bond risk principal now accounts for 12 percent of property limits in the U.S., and 8 percent on a worldwide basis. A couple of other highlights: publicly disclosed cat bond issuances totaled $7 billion in 2007, a 49 percent increase over the record $4.7 billion in 2006; some 27 transactions were completed in 2007, up from 20 in 2006 and nearly tripling the 10 placed in 2005. Check out further I.I.I. facts.  

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  1. Our panelist who discussed in January in New York certainly would have agreed that cat bonds have gone mainstream.Some of the key insights from our discussion were:

    The basic value proposition of cat bonds is sound, according to David Lee, Brown Brothers Harriman. A $100 billion catastrophe event in the context of the insurance market would wipe out 20% of the industry’s capital. But when you put a $100 billion into the $14 trillion equity market you barely notice that: $100 billion is less than the daily fluctuation of the S&P 500. So there is a lot to be said for spreading that risk around.

    Investors have a healthy appetite for cat bonds and demand outpaces supply, as David Lee pointed out. There are two basic reasons why investors like cat bonds. First, catastrophe bonds are perhaps the ideal investment because they offer a substantial risk premium: the amount you get paid far exceeds the risk that you bear. Secondly, catastrophe bonds are almost completely uncorrelated with the rest of the financial markets.

    According to Larry Marcus, Zurich Financial Services, Cat bonds (and sidecars) could help dampen the insurance cycles because capital can move out quicker when the market softens. In addition, multi-year contracts, which are usual in capital markets, may become more common in insurance markets as well. This would further help to stabilize prices.

    Chris Hojlo, Principal, Court Square Capital, expects that Private equity firms will invest more in insurance companies since the securitization of insurance risk allows for indirect leverage. This comes in handy in the current credit market.

    Cat bonds are no longer just one-off deals to access critical capacity, as Stefano Sola, Swiss Re, pointed out. More and more carriers have put shelf programs in place making cat bonds part of the their ongoing risk management strategy. A further indication of the maturity of the cat bond market is the increased secondary trading activity, as Stefano Sola highlighted. This is no longer just a buy and hold market. But there are dealers who are dealing in these securities. In 2007 Swiss Re traded about $1.7 billion of Non-Life securities in the secondary market alone.

    The innovation will continue, as Chris Hojlo explained. For example, Gamut Re is effectively a CDO for a diversified book of property and casualty risks. They were able to sell off the four most senior tranches to investors, retaining the equity tranche. Again, this structure generated leverage in a business that investors thought was not leveragable.

    Within the framework of capital management, cat bonds could be considered as junior equity, as explained John Modin, UBS. They bear the first loss in the portfolio and protect the common shareholders. In view of risk-adjusted pricing, the capital structure of insurance companies will probably consist of 70% to 75% of common shareholder equity; the remaining 20% to 25% will be split between hybrid and senior debt.

    The impact of securitization of insurance risks on the insurance business model is to be decided. Some argued that insurers could become originator of insurance risks which in turn would be transferred to capital markets. Some saw the role of reinsurers moving towards becoming the bearer of basis risk while they would transfer the bulk of their cat exposure to capital markets. As a result, reinsurers could start competing with primary carriers in order to get a piece of the primary action so they don’t get disintermediated. Insurance companies may start to “underwrite to securitize” which could lead to greater standardization of insurance contracts and greater efficiency of the insurance industry.

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