BIRTH OF THE CAT BOND

Comedian George Carlin once said that if you nailed two things together that had never been nailed together before, people would line up to buy it from you. One wonders if this will soon be true of catastrophe bonds, a marriage of insurance securitization and fixed income investing.

Modern society is a fragile thing, difficult and expensive to rebuild when damaged. Increasing population density, coupled with a growing dependence on technology and industry, has helped to make natural catastrophes all the more devastating. In North America, Hurricane Andrew ushered in a new era of colossal risks, creating $18 billion in claims in 1999, and causing the insolvency of more than 60 insurance companies. Amidst growing concerns for the finite capacity of traditional insurers, the mid to late 1990s saw “cat bonds” touted as an ideal way to transfer risk off the balance sheet and over to capital market investors who were prepared to accept significant risk in for a higher return.

A cat bond is structured through an offshore special purpose vehicle (SPV), which allows the issuing company to transfer the risk to the SPV as a set percentage of business underwritten. The SPV then issues securities to investors, allowing the company to create increased capacity and investors to diversify their portfolios. In many cases, investors are able to choose from several tranches – one tranche may put both capital and interest at risk, while a second may simply put interest at risk.

That an investor should be asked to put 100% of his or her principal at risk in the hopes that a disaster will not occur seems a lot to ask. In a paper written for the International Risk Management Institute (IRMI), Brent Clark, an executive director at Strategic Risk Solutions, a division of the Winterthur Group, says that the “person presenting this proposition to a typical investment banker should probably be prepared to duck, he or she might be surprised to find out how far an offended banker can actually throw a one thousand pound desk across the room.”

Cat bonds, however, are not the fodder of typical investment bankers. In fact, many large cat bond issues are brought to market with insurers and reinsurers involved – either as the actual supporter or as a lead buyer, providing comfort to other investors. That’s not to say that it is impossible for companies to take their risk directly to the markets themselves, thereby “disintermediating” the insurers entirely.

Mickey Mouse enters

In need of earthquake protection, Oriental Land Inc. (Tokyo Disneyland) bypassed both primary and secondary insurance companies in the spring of 1999 to place $200 million of catastrophe bonds directly with the capital markets. Some industry watchers hailed this as the birth of a new competitive threat. “Other non-insurance corporations are expected to follow Oriental Land’s lead and tap the capital markets for insurance coverage,” read one article in the Financial Times. “Traditional insurance and reinsurance companies must clearly prepare themselves for this new challenge.”

But it hasn’t been much of a challenge to date. Beat Holliger, manager at Munich Re’s Financial Reinsurance section, points out that the Oriental Land deal is an exception to the rule. “To my knowledge, it is the only one of its kind,” said Holliger, who went on to suggest that most companies would continue to rely on insurers and reinsurers due to “the cost and complexity of the securitization process”. Munich Re’s recent entrance into the cat bond market in late January with a private placement of US$300 million (the largest placement in cat bond history) seems to confirm that the capital markets are not going to replace, but rather complement, the activities of traditional insurance companies.

“Insurance companies still provide a lot of value through pooling of risk that makes it hard for a bond to be as price-competitive”, said Michael Millette, vice president of Goldman Sachs’ “risk market group” in a recent alternative risk strategies round table at www.risk.net. “I think once you get to peaking-up of risks in the system, particularly in areas like retrocession or concentration, like Florida, the insurance and reinsurance market as a whole needs an outlet, and the capital markets have provided that. In fact, the way the market has developed it’s far more collaborative than competitive.”

Cat bonds “buffeted”

Insurers may like the idea of cat bonds, but will investors respond in kind? Value investing guru Warren Buffet, previously mocked by industry and media alike for refusing to plunge into the high-tech and dotcom markets, had some equally dire predictions for catastrophe bonds. In what is now a famous letter to Berkshire Hathaway shareholders in 1997, Buffet promised that “a truly terrible year in the super-cat business is not a possibility – it’s a certainty”.

Claiming that innocent investors were being unwittingly lured into the reinsurance market because they relied on representations of salespeople rather than on underwriting knowledge of their own, Buffet went on to lambaste cat bond issuers: “This convoluted arrangement came into being because the promoters of the contracts wished to circumvent laws that prohibit the writing of insurance by entities that haven’t been licensed by the state. A side benefit for the promoters is that calling the insurance contract a ‘bond’ may also cause unsophisticated buyers to assume that these instruments involve far less risk than is actually the case. Truly outsized risks will exist in these contracts if they are not properly priced.”

Emilio Fernando, director and head of securitization for Swiss Re New Markets in New York, dismisses the Berkshire letter as purely self serving – an attempt to scare off potential cat bond investors and drive business towards Buffet’s own reinsurance company. Saying that investors are “very aware of the risks involved and are not betting the whole house on a cat bond”, Fernando cites money market managers as an example of an eyes-wide-open investor. “They usually have a chunk of money available to invest in ‘funky’ vehicles in the BB range”. They’ll buy a piece of a cat bond as an expected loss.” Buffet need not have been so concerned about the fate of the average consumer, catastrophic risk securitizations have only attracted large institutional investors who can afford to incur significant losses as part of a hedging strategy.

Ugly models

At a conference on securitization a couple of years ago, Bill Riker, president of Bermuda-based Renaissance Re, made a presentation called “Using Cat Models: The Good, the Bad and the Ugly”. While cat models can provide “answers to ten decimal points”, Riker warned that decimal points are not to be confused with accuracy: “We believe firmly that the only thing that can be absolutely guaranteed is that all models are wrong and that all they can come up with is the best guess of the experts and their estimate of potential exposures”. Other critics of cat risk modeling have pointed out that, while the use of several different models can help to give a broader picture of risk, the effects of global warming and environmental deterioration are yet to be determined. These radical and unpredictable changes in world climate may make accurate prediction virtually impossible. Surely even the most speculative investor who hears this sort of speculative talk is bound to think twice. “Models have improved and they can certainly help make a decision”, says Fernando, but it’s not the only factor. Other reinsurance losses and the track record of that particular area also play an important role. Ultimately, he says, it all “boils down to how comfortable you are with the risk”.

A study conducted by the Wharton School of Finance singles out this sort of ambiguity and aversion to loss as a reason for why cat bonds have not been more attractive to the investment community despite the fact they offer higher returns. Since catastrophe bonds are a new product, the report explains, investors must also invest time and money up front in order to e
ducate themselves. This keeps the number of cat bond investors low and, for the most, restricted to large institutions with massive portfolios to diversify. “The market is still in its infancy”, says Holliger. “At the moment a large secondary market is lacking, so there are liquidity concerns. There is also an absence of standardization. But I believe that the market will grow over the next couple of years.”

Hardening market

More than investor reluctance, it was the softening of the reinsurance market in the late 1990s that put cat bonds into slow motion. Why bother to securitize the risk when traditional reinsurance rates were so low? A report prepared by Conning & Co. in the fall of 2000, “Property-Casualty Reinsurance, Developing the Next Frontier”, shows that 71.4% of primary insurers would not consider replacing their reinsurance with capital market vehicles. Clint Harris, assistant vice president of research at Conning & Co., summarizes the market sentiment of the time: “They’re essentially saying ‘nah, not yet.’ They’re getting everything they want already, at prices they love. We’ll find out in 2001 if that’s good enough”.

“When there’s a cheaper way of doing it, that’s where the most of the money will go, ” says Fernando, who hastens to add, “but the market is hardening again”. A Swiss Re Sigma study of natural catastrophes and man-made disasters in 2000 proves this point, showing that European CatXL prices have risen by 30% overall. France was particularly hard hit last year, and premium rates doubled in response to the Lothar and Martin storms. Long-term bonds rates also appear to be headed downwards, which will make some investors more likely to assume greater risk for the sake of higher returns, these factors combined may help to breathe some life back into the cat bonds market and augment the number of new issues.

If the cat bond market is about to take off, the large reinsurers are ready and anxious to be a part of it. Having established their own new markets divisions in order to serve the securitization needs of both new and existing clients, they will be able to capture business that might have otherwise gone directly to market. There is no risk that they’ll be left behind. Indeed, reinsurers like Munich Re and Swiss Re not only have more interest in securitizing risk, but some suggest that they will be more adept at it than their banking counterparts. “As a general rule, reinsurance is much better than the capital markets for messy, complicated risks” says Christopher McGhee, a managing director at Marsh & McLennann Securities, “Reinsurance is too flexible, too tried and true, and too efficient a tool”. Reinsurance is not about to be replaced by the capital markets, but rather the capital markets are going to supplement the efforts of reinsurers, providing them with new ways to increase capacity and manage catastrophic risks.