Softening rates and ample capacity have done nothing to stem the unstoppable pupularity of catastrophe bonds, discovers Lindsey Rogerson

The announcement by investment bank Goldman Sachs that it is setting up a fund to take maximum advantage of the opportunities presented by catastrophe bonds is positive proof that the market for these risk-offsetting tools has come of age. The announcement was made just as the 2007 Atlantic hurricane season got underway in June.

Cat bonds first came into play 15 years ago after the devastation wrought by Hurricane Andrew, and have covered everything from typhoon risk to terrorism to bird flu. But it is only since Katrina that they have really come into their own.

Two separate outcomes from Katrina have conspired to boost both demand and supply of cat bonds in the intervening months. Firstly the hike in reinsurance premiums for affected risks post-Katrina increased the demand for alternative risk-mitigating tools. And this has not been dampened by a levelling-off of rates after a benign storm season in 2006. In addition, the fact that existing cat bond investors for the most part came out of the 2005 storm season intact has increased investor appetite.

Indeed according to a recent Guy Carpenter report, the new issuance of cat bonds more than doubled in 2006 from $1.99bn in 2005 to $4.69bn last year. The number of transactions also doubled year-on-year from ten to 20, by the end of 2006, and in all there was more than $8.48bn of bond principal outstanding at the end of 2006 – a 74% increase over the year-end 2005 total of $4.9bn – suggesting a healthy future for the sector.

Supply-side

The prospects for 2007 thus far look good. After all, Goldman Sachs could not have launched its vehicle if there had been no cat bonds around to buy. So far European giants Munich Re, Hannover Re and Swiss Re have all issued bonds this year. In March, Hannover Re issued its first-ever traditional cat bond through its Bermuda-based special purpose vehicle Kepler Re. The bond covers severe windstorm events in Europe for a term of roughly three years, and it proved immediately popular with investors.

According to PricewaterhouseCoopers’ partner Paul Delbridge, the oversubscription of Hannover Re’s catastrophe bond is a clear indication that the appetite of investors for insurance products is continuing into 2007. He believes all this interest might see them “morph to make them more acceptable to the capital markets” and says the fact some cat bonds were triggered in 2005 has made investors more wary. They are demanding more detailed risk information. “Investors are much shrewder. They want to know the risk,” he explains. “But there’s certainly some naivety still.”

“Two separate outcomes from Katrina have conspired to boost both demand and supply of cat bonds in the intervening months

Rodgerigo Araya, a vice president at rating agency Moody’s, recently told an Organisation for Economic Cooperation and Development conference that the market for cat bonds would continue to grow. But this is contingent on new perils and structures being identified. Such new risks are already emerging in 2007 with Swiss Re securing $100m protection against earthquake risk in Greece, Turkey, Portugal and Cyprus via a cat bond issued in June.

In 2006, two non-insurance groups issued cat bonds – the Government of Mexico and a US-based energy company, Dominion Resources – also issued their own vehicles. Araya believes that additional new sponsors from outside the insurance industry will emerge to offer cat bonds in the near future.

Demand-side

It is easy to see what reinsurers and other issuers get from cat bonds – security. But to fully understand why cat bonds have taken off it is important to grasp who is buying them and why. For the most part they have been snapped up by hedge funds, pension funds and high-net-worth individuals. Increasingly they are being bought by advisers looking for single themes to add flavour – and boast returns – on their client’s portfolio.

A cat bond gives a purer form of exposure to a particular risk than would be possible through purchasing the stock of a diversified reinsurer. A further bonus being that, for the most part, the type of risks underwritten through cat bonds means that they are not correlated to equities. A further plus for investment managers.

But lets be clear. One of the key drivers, if not the key driver in their growth has been, and continues to be, the possibility they present for superior investment returns. Before Katrina, cat bonds typically offered interest rates of 7% above the three month Libor rate. Munich Re’s recently issued note protecting its exposure in 26 US states, had a spread of 15.25% above Libor. Potentially a hefty profit for someone.

When shopping for a cat bond, investors have to consider the trigger of a particular bond. It was “the triggers” which, according to Standard & Poor’s, protected investors holding US hurricane-related cat bonds in 2005 (for the most part). Triggers can be very specific, detailing not only the exact level of hurricane but also where it has to hit or alternatively the exact magnitude of losses as measured by an accepted index (such as ISO’s Property Claim Services).

“Increasingly they are being bought by advisers looking for single themes to add flavour – and boast returns – on their client’s portfolio

Ratings can help investors gauge the relative risk of a particular bond issue. Most cat bonds are rated “BB” or below. This puts them in the sub-investment grade category in terms of retail investment bond funds. But last year, two made it to investment grade: Foundation Re was rated “BBB+”, and Arbor II Series 1 notes were rated “A+” by S&P. The latter required three separate triggers to line up before the bond would have had to pay out, hence the higher rating. With Guy Carpenter identifying a move towards more hybrid, complex triggers it seems likely that further cat bonds could be awarded investment grade ratings in future. This could open them up to retail investment bond funds, many of which are restricted to investing in issues rated “BBB” or above.

Prospects

With weather forecasters once again predicting a high (84%) chance of an above-average hurricane season, the prospects for cat bonds look quite rosy (unless of course they are triggered by a large loss). Indeed, as long as catastrophe reinsurance rates remain high and capacity remains scarce, cat bonds will continue to thrive, say analysts.

They do not see any threat from new vehicles such as sidecars, believing they can co-exist quite happily. Christopher McGhee, an analyst at MMC Securities, says: “The increased flexibility and transparency of the market, making it better able to meet the objectives of both investors and sponsors, is a strong signal that the capital markets will continue to develop into an increasingly vital, and perhaps less distinguishable, supplement to the traditional reinsurance marketplace.”

Silke Brandts and Christian Laux, academics at the Goethe University in Frankfurt, go further. They believe cat bonds exert a welcome disciplinary effect on the catastrophe reinsurance market. In their recent paper they said: “We carve out a novel benefit of cat bonds that arises even in the absence of credit risk, transaction cost, monitoring cost, or moral-hazard problems. An interesting observation is that the benefit arises solely because of the potential availability of cat bonds, which has a disciplining effect on the premiums in the reinsurance market.”

Lindsey Rogerson is a freelance journalist.