Are the toughening market and huge loss exposures stimulating interest in catastrophe bonds?

In the early 1990s, the property catastrophe reinsurance market was hit by a series of catastrophes. In particular, Hurricane Andrew and the Northridge quake pounded the industry, forcing premiums to double in many cases. Buyers reeled from the sudden rocket in prices, and looked to alternatives to provide the necessary cover – and catastrophe bonds were born

Surpassing predictions
Since then, cat bonds have accounted for around half of the alternative risk market. But they have never really taken off in the way some of their champions predicted, probably a factor of the soft market in the ‘traditional' reinsurance sector in recent years. Nevertheless, at the beginning of this year, Lehman Brothers was suggesting 2001 could become the ‘year of the cat bond'. In a research report, it predicted cat bond issuance would rise to $2bn in the year, up from an average annual volume of $1bn between 1997 and 2000. This rise in cat bonds' popularity would be a reflection of their increased cost-efficiency, commented the report. “Cat bond issuance is largely dependent on the price of alternate forms of loss coverage for both primary insurance companies and reinsurance companies,” it said. “Primary insurance companies increase their catastrophe bond issuance when reinsurance rates rise Similarly, reinsurance companies issue cat bonds when high quality retrocession.... becomes more scarce and/or expensive. With reinsurance and retrocession rates currently on the rise, primary insurance and reinsurance companies are focusing unprecedented attention on the capital markets for their risk transfer needs.”

Come the beginning of September, and cat bonds had not quite fulfilled that promise. Nevertheless, Lehman had at that point been appointed the capital markets adviser to the California Earthquake Authority, which will be restructuring in 2003. In addition, Lehman had proven itself the market leader in cat bond issuance and secondary trading, and was seeing a lot of interest from bond investors who wanted access to non-correlated risks, which it foresaw, when combined with the hardening reinsurance market, as potentially leading to increased activity in the cat bond market.

With the traditional re/insurance market still reeling from the impact of the 11 September events, and rates rocketing, the interest in cat bonds has increased exponentially. Lehman is expecting activity in the sector, and said it has three deals in the pipeline. Rating agency Fitch expects a significant rise in volumes, “potentially exceeding £2bn in 2002,” while Goldman Sachs has coyly admitted to interest in insurance securitisations increasing “materially” in the last few weeks.

The combination of large increases in re/insurance rates, reduction in available capacity and “modest declines in insurer financial strength” following the 11 September disaster will hike the desirability of cat bonds, Fitch commented. “The changes in these three factors will tend to make cat bonds a more competitive alternative, quite simply because traditional insurance is becoming more expensive and less available.” Even so, rising rates in the cat bond market may somewhat dampen the enthusiasm for the products, Fitch predicted. “On the pricing front, however, bond spreads have also increased in the wake of the disaster, which partially offsets the increase in re/insurance rates,” it commented. “Cat bonds tend to trade at wider spreads than traditional corporate bonds with similar credit ratings.” The higher premium reflects the more esoteric nature of the instruments, and has lifted since 11 September, reflecting “the general market trend of a flight to quality.”

Although cat bonds can be used to replace traditional capacity in any part of the insurer/reinsurer/retrocessionaire chain, Fitch predicted it will be at the top end that activity will start, if, indeed, there is the predicted “surge” in the market. “Most of the cat bond activity thus far has been at the retrocessional level with substantial activity at the reinsurance level and very little at the primary insurance level,” it explained.

Exit of terror coverage
But cat bonds will not address the major problem currently facing the market; the withdrawal of terrorism coverage from programmes. By their very nature, the bonds only cover specified natural perils. As Fitch explained, “in order for cat bonds to work, independent modellers must be able to estimate a probability of loss that both the sponsor and investors accept as reasonable. Such models for earthquake and wind risk are well accepted and have been in use by both the traditional insurance and cat bond market for a number of years.

“However, Fitch believes it is nearly impossible to credibly model the human behaviour element as it relates to events like those of 11 September.” And, more to the point, the sponsors and investors agree. The dreadful events of 11 September do not mean the ground will shake any less, nor will the wind blow any less fiercely; natural perils will always be with us. It's just the risk capital that may change.