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Cat bond ballou 2006 was a record-breaking year for cat bonds, but the future remains cloudy By Michael J. Moody, ARM, MBA Catastrophe bonds (cat bonds) have been growing in market share since they were introduced about 10 years ago. And now they are poised to grow even faster as the convergence of the capital markets and insurance markets quickens. 2006—A watershed year? The success of cat bonds is hard to deny. In the short span of 10 years, they have moved from a novel approach as a replacement for high-level excess property coverage to a growing trend in catastrophic property protection. According to Guy Carpenter, 2006 was yet another record year for cat bonds. The broker reported that the annual issuance for the cat bond market was $4.69 billion in new transactions. This figure more than doubles 2005, which held the prior record at $1.99 billion. Carpenter also notes that the total capital outstanding increased to over $8.48 billion, which compares favorably to 2005 when it was $4.90 billion. By any measure, it would appear that interest in the cat bond market is increasing significantly. One of the more interesting things about last year’s cat bond market was the expanded use by non-insurance entities. Obviously, the largest industry group that used cat bonds was the reinsurance segment. However, last year two non-insurance-related entities began utilizing cat bonds as part of their overall risk financing strategy. One of the non-insurance entities was FONDEN, a facility created by the government of Mexico. It issued a $160 million bond to cover earthquakes in Mexico City or along the Pacific Coast. The other entity was Dominion Resources, Inc., a U.S.-based energy company. Interest grows Certainly the insurance industry is interested in finding a reliable method of filling potential gaps in the higher layers of their catastrophic property programs. This has become much more important in the past few years since the retrocessional reinsurance market has been of little or no help in this area. Obviously, reinsurers must find another way to resolve this problem. At this point, resolution of this issue is paramount for many of the key reinsurance players and as a result, they have a keen interest in cat bonds. While it is easy to see why the insurance industry is interested, what is the attraction for investors? Basically, there are two key reasons why the investment community has gravitated to the cat bond market. First and foremost is the returns generated by the investment in cat bonds. While each deal is different, recent cat bond transactions have netted rates that are 10% to 15% higher than traditional benchmarked interest rates. As a result, the current cat bond market is among the highest yielding investment in the fixed income area. The second reason why cat bonds are gaining in popularity within the investment community is that they are “zero beta” investments. This is important since most investors need to maintain portfolios that meet their diversification requirements and cat bonds are perfect for that. In fact, cat bonds are largely uncorrelated with returns of other investments in fixed income or in equities. It’s this uncorrelated nature of cat bonds that institutional investors as well as hedge managers are looking for. Cat bond basics Cat bonds are risk-linked securities that transfer a special set of risks from the “sponsor” to investors. The “sponsor” forms a captive insurance company known as a “special purpose vehicle” (SPV) which undertakes two simultaneous actions: It issues the cat bonds to investors, and it enters into a reinsurance contract with the sponsor. Typically, the bond proceeds are invested in high-quality, short-term securities which are deposited into a trust account to collateralize the transaction. Over the term of the bond, periodic interest payments are paid by the SPV to the investors. At the end of the bond term, assuming that any covered event has not occurred, the principal will be returned to the investors. Tricky triggers Just as with any insurance product, a key feature of the cat bond is what triggers a payment in the event of a loss. As the cat bond market has unfolded over the past 10 years, several unique methods have been used as the triggering mechanism. The following are the primary triggers that are currently being used. Indemnity Triggers—The key feature to this approach is that the trigger mechanism is an actual loss sustained by the sponsor, with the amount of that loss determining the amount to be paid out by the cat bond. Of course, this approach closely replicates traditional insurance coverage and was an early attempt to make the sponsors comfortable with the concept. And while the indemnity approach was initially favored by the sponsors, its use quickly pointed out several significant shortcomings. First, just as with a traditional insurance loss, the potential claim presentation could be quite labor intensive. Sponsors were also concerned about providing confidential information that may be required to be included in the bond’s offering circular. Investors also had problems understanding the sponsor’s business and how it would relate to a loss settlement. As a result, as the market has matured, settlement options gravitated away from the indemnity triggers. Index Triggers—These triggers are based on widely accepted, manipulation-proof industry indices. Generally, this approach eliminates the need for the sponsor’s disclosure of proprietary underwriting information as well as investor knowledge of the sponsor’s business. The major advantage to this approach is that the sponsor does not have to provide a “proof of loss.” Or even incur a loss for that matter. As long as the triggering event occurs, the payment is made. Today, there are several variations on the index trigger: • Parametric trigger—These indices provide for the payout of a loss which is predicated on the occurrence of a catastrophic event with certain predefined physical parameters. A typical triggering event may be the wind speed and location of a hurricane, or the magnitude and location of an earthquake. • Industry-loss trigger—This trigger uses an estimate of loss for the insurance industry as a whole for a catastrophe event. Estimates of loss would be derived from some widely recognized reporting service such as the Property Claims Services (PCS). • Modeled-loss trigger—This payout trigger is calculated by running the event’s actual physical parameters against a modeling firm’s database of total industry exposures. This will then provide an estimate of the modeling firm’s industry loss. This is then used to determine the sponsor’s loss compared to the total industry’s loss. Today, a number of hybrid triggers are being introduced that would include two or more of the above noted triggers. These would require that more than one payout trigger would be required prior to any claim payment. Typically the purpose of such hybrids is to cover two peril transactions, such as U.S. hurricanes and Japanese earthquake perils. Where do we go from here? Last year’s lack of catastrophic events, particularly Atlantic hurricanes, has left the cat bond business in somewhat of a quandary. Coming on the heels of the record-setting loss years of 2004 and 2005, last year’s experience is unique. However, the projections for 2007 are as bleak as the projections were for 2006. For example, the Hazard Research Centre at University College London has recently increased its forecast for Atlantic hurricane activity in 2007. The Centre indicates that U.S. land falling hurricane activity will be about 75% above the 1950-2006 norm. It should be pointed out that this is the highest March (most recent available at the time of this writing) forecast for activity in any year since they began real-time forecasts in 1984. The Centre goes on to note that it is predicting 17 tropical storms in the Atlantic, with nine being hurricanes and four, intense hurricanes. Further the Centre indicates that five will be tropical storms that strike the U.S., of which two will be hurricanes. Two major trends that account for these projections are: the expected values in August and September for the speed of trade winds which blow westward across the tropical Atlantic and the increasing temperature of the sea waters between West Africa and the Caribbean where hurricanes develop. Basically, this bleak forecast has arisen because the El Nino conditions present since September 2006 dissipated rapidly during February 2007, according to the Centre. Conclusion While 2006 was a record-setting year for cat bonds, smashing every prior measurable sales record, the long-term view for the cat bond market is still cloudy. Because 2006 saw no U.S. hurricane activity, it is unclear if the previous momentum in the cat bond market will continue. Will 2007 be another record year for cat bond issuance? Only time will tell. However, several important lessons can be taken from the cat bond market. First and foremost is that we can see that the capital markets can play a more important role in the insurance industry. Investors have gotten more comfortable with the insurance industry in general and, more specifically, with the cat bond concept. As most experts agree, the cat bond movement is just further evidence of the overall trend of convergence of the insurance and capital markets. We are now seeing that the degree of interchangeability between these two markets has risen over the past few years. And as a result, at the end of the day, the capital markets will continue to find ways to supplement the traditional insurance market. Cat bonds are just one example of this convergence. * |
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