U.S. insurance industry turns to catastrophe bonds

In the wake of the worldwide surge in natural catastrophes over the past few years, the insurance industry is turning more frequently to catastrophe bonds, according to a Standard & Poor’s report.
The bonds are designed to mitigate the catastrophe risk in insurer and reinsurer portfolios by shifting a portion of it to the capital markets. Designed to cover a range of naturally occurring catastrophes, catastrophe bonds are often privately placed and bought by investors and investment groups such as hedge funds.
When investors buy the bonds, the funds are immediately deposited into a trust account, so insurers bear little or no credit risk. For investors, the main risk is the possibility of a catastrophe pulling a bond’s trigger. If that happens, bondholders lose part or all of the bond’s principal to the issuer.
“So far, no catastrophe bonds rated by Standard & Poor’s have been triggered,” the report notes. “However, in the wake of the damages from Hurricane Katrina, the US$190-million KAMP RE 2005 Ltd. bond (CC/Watch Neg), which covers U.S. hurricane or New Madrid quake activity, is in serious danger of doing so.”
Nearing their first decade of existence, these bonds are becoming an increasingly attractive alternative to reinsurance as a means of managing insurer risk exposure, S&P’s analyst Amy Friedman observes. “Demand for them has been stimulated not just by the current high prices but also by the tight terms and conditions of traditional reinsurance cover.”
In 2005, bond issues surged by 74% over the prior year, as reinsurers sought to replenish capital lost from Hurricanes Katrina, Rita, and Wilma. “About US$1.99 billion was issued in 2005 in 10 separate transactions by nine issuers, several of which were first-timers,” the report notes. “And 2006 might be shaping up as an even more vigorous year. Since 1997, 69 cat bonds have been issued with a total of US$10.65 billion in risk limits.”
Used in moderation, catastrophe bonds can be an effective tool for managing portfolio risk, the S&P report says. But there are many risks associated with issuing cat bonds.
Among other concerns the S&P’s report cites, the bonds “for the most part, cover only one event and only one loss on that event. Reinsurance, on the other hand, might cover two or more losses, as long as reinstatement provisions are in the contract (which normally require payment of additional premium).”