The appetite for cat bonds has continued unabated in 2007, despite other non-traditional products being wound down. But are they here for good, asks Nick Thorpe, and why is everyone going cat bond crazy?

“The seal has been broken on cat bonds.” Only Grahame Chilton, CEO of Benfield, could sum up the current cat bond situation in such a way. The broker, speaking to Global Reinsurance at this year’s Rendez-Vous in Monte Carlo, neatly captured the feelings permeating the industry concerning insurance-linked securities.

Catastrophe bonds turn ten this year and although somewhat of a slow starter, they look set to grab a growing share of the traditional reinsurance market. Some predict, however, that the recent credit crisis sparked by the subprime debacle in the US will hit the capital markets and may jeopardise the future of cat bonds. Even so, with the growing sophistication of investors and the meteoric rise in issuances, it is fair to say that catastrophe bonds have come of age and are here to stay.

Up, up and away

The history of cat bonds can be traced all the way back to Hurricane Andrew in 1992. The second most costly hurricane to hit the US after Katrina, Andrew’s losses prompted the first foray into the securitisation of catastrophe risks. There are many who claim to have worked on the first cat bond, but it wasn’t until the mid-1990s that AIG and Hannover Re completed the first real transaction.

The vehicles have since evolved considerably. “Cat bonds are a far different beast now than they were six or seven years ago,” agrees Milan Simic, UK managing director of AIR Worldwide. Cat bonds found a niche and issuances began to increase markedly. Willis Capital Markets estimates that there has been an “annual compound growth rate in excess of 33% in the volume of securities outstanding” since the late 1990s.

In a report on the cat bond market in 2006, Guy Carpenter said that “since 1997, the first year in which multiple transactions occurred, 89 catastrophe bonds have been issued with total risk limits of $15.35bn.” Certainly the growth in recent years has been staggering (see below).

The storms of 2004 and 2005, and particularly Hurricane Katrina, had a big impact on the market and increased the popularity of alternative risk transfer solutions. Sidecars emerged soon after Katrina as a viable and popular vehicle for reinsurers to add risk-bearing capacity. Cat bond issuances, spurred on by the hardening market, doubled to a record $4.69bn in 2006.

While many sidecars and other risk transfer products are being closed down, having plugged the “hard market hole”, cat bonds show no sign of losing favour. In fact, in two years the total cat bond issuance per year has more than tripled, according to Guy Carpenter. And issuance so far in 2007 has already exceeded total issuance for the full year of 2006.

“There is more interest in cat bonds than ever,” confirms Chilton. “In fact, this year, for the first time, cat bonds are effectively cheaper than traditional reinsurance at certain levels.” And according to Simic, the trend looks set to continue. “Some admittedly optimistic projections suggest that cumulative cat bond issuance could reach $200bn to $300bn by 2017, if market conditions remain the same.”

Not everyone is jumping on the bandwagon just yet though. Nick Frankland, CEO of Guy Carpenter UK, actually thinks issuances may fall in the future. “Investors in cat bonds are getting more comfortable with the risks they are assuming. However I do think that cat bond issuance will die down – they are a bit of a fad at the moment.” Frankland adds that cat bonds remain largely untested as few have been triggered.

“Catastrophe bonds turn ten this year and although somewhat of a late starter, they look set to grab a growing share of the market

From an investor’s perspective, it could all change come the next active storm season if more do pay out. “Cat bonds will thrive because they appear to have no security problems and are therefore very attractive,” says Seymour Matthews, head of reinsurance at Heath Lambert. “However, doubt will come with a big event when two or more are triggered and the modelling is queried. That will be the real test.”

Ian Dilks, global insurance leader at PricewaterhouseCoopers, puts it more bluntly. He believes the perception of cat bonds is favourable because “no one has lost any money”. He warns that investors could withdraw their money if bonds are triggered as the result of a major event.

John Spencer, group chief executive of reinsurance broker BMS Associates, has another take on the situation. He thinks that if a large catastrophe came along and a lot of cat bonds were triggered, rather than scaring off investors it could even have the opposite effect. “It could validate cat bonds. It could bring a whole new level of maturity to the actual market to have these products tried and tested. They could become more mainstream and proven somehow.”

One or two cat bonds were triggered by Hurricane Katrina, Rita and Wilma (KRW) in 2005, but most were not. It could therefore be argued that they have been tested and failed because they did not pay out when they should have. It is generally agreed however that cat bonds have become more sophisticated since KRW and triggers are now dealing with the basis risk issue.

Basis risk hurdle

There are essentially two traditional types of catastrophe bond – indemnity and non-indemnity. Non-indemnity triggers vary throughout the industry but commonly include those based on the parameters of an event happening (parametric), those indexed to an industry loss as calculated by ISO Property Claim Services (PCS), for example, and those based on modelled losses.

Non-indemnity trigger mechanisms generated over $2.83bn in risk capital in 2006 and almost $10bn in the last ten years, according to Guy Carpenter. However Europe still lacks an index to which sponsors can correlate their probable losses like PCS. Although Swiss Re has the highly-respected Sigma, many participants view the lack of market-agreed indices as a major stumbling block on the road to a larger cat bond market.

The most common complaint about catastrophe bonds is the basis risk cedants are exposed to. For capital market investors, non-indemnity risks are the most attractive option as they traditionally avoid a company’s underlying risk. However, basis risk – the risk that a buyer incurs losses but the industry’s losses (such as those calculated by the PCS) fall short of the trigger used in the cat bond – is a big concern for many reinsurers.

Indeed, Guy Carpenter went as far to say that for most sponsors, “basis risk was their primary concern when using the capital markets to manage catastrophe exposures – and in some cases – basis risk was more important than price.” The fact only one or two cat bonds (depending on definition) were triggered by KRW, illustrated the concern was founded.

It has led to a two major developments in the cat bond market: the rise in popularity of indemnity-based triggers and the introduction of hybrid mechanisms. “Indemnity cover is often preferred by primary insurance companies as they know exactly what they will, or won’t, get back at the end of the day,” explains Simic. “For indemnity bonds the basis risk for insurers is relatively small.” Indemnity bonds are essentially securitised reinsurance. They are triggered by the issuer’s actual losses, just like traditional reinsurance. If the specified layer is $100m excess of $500m, then any claims over $500m enable the bond to be triggered.

“Reports are starting to filter through that the crisis has caused some cat bonds to be put on ice while sponsors and investors wait to see the wider implications

These deals are clearly popular with reinsurers, who prefer the traditional structure and lower risk. Over the last ten years, indemnity and parametric bonds have accounted for around a quarter of the market each. In fact, 2007 is so far showing a distinct preference for indemnity-based bonds. “The majority of bonds this year (42%) had indemnity triggers,” confirms Simic, “while only 17% or so were parametric.”

Addressing basis risk concerns more directly, meanwhile, are catastrophe bonds built around hybrid triggers. Put simply, these minimise the risk borne by the sponsor while still remaining non-indemnity based. They are usually “formed from the combination of two or more existing trigger types within a single transaction or tranche… eg a single tranche with exposure to both US wind and Japanese earthquake perils could rely on a PCS-index trigger to establish US wind losses, and a parametric trigger to establish Japanese earthquake losses,” according to Guy Carpenter.

Although hybrid bonds only emerged in 2006, they accounted for a substantial portion of the year’s total issuances, with four bonds worth $1.68bn. They signify the willingness of the market to adapt in order to continue utilising cat bonds. It also bodes well for the increasing number of primary insurers which are starting to utilise cat bonds, such as State Farm who earlier this year issued $4bn in bonds through its Bermuda-based Merna Re vehicle.

Capital solution

The development and rise in popularity of cat bonds has been largely down to the convergence of the capital markets and the insurance industry. Spurred on by the post-Katrina hard market, ART solutions have matured almost beyond recognition in the last 20 years. The portfolio of solutions now encompasses anything from cat bonds to sidecars, industry loss warranties to loss prevention programmes. Goldman Sachs estimates that along with record cat bond issuances, 2006 saw $3.8bn come into the market through sidecars, up from $2.3bn the previous year.

Despite being competitors to property catastrophe reinsurers, for the most part the industry seems happy to welcome cat bonds with open arms, in addition to other risk transfer products. As PwC’s Dilk’s says, “There is a long-term trend for greater use of capital markets. Capital is needed to support business and used to retain more risk. If there’s a need to get risk off the balance sheet, it would be surprising if the capital markets didn’t respond.”

While insurers clearly have appetite for alternative risk transfer, there could be a dry spell ahead from a capital market perspective. The subprime crisis in the US and resulting global “credit crunch” has raised the first fears that investors could lose interest in insurance investing. “As reinsurance rates continue to come down, cat bonds could become more expensive than traditional reinsurance again,” says Simic. “One school of thought is that the subprime crisis has the potential to increase the cost of cat bonds while the other suggests that they are completely uncorrelated with the subprime crisis, making them even more attractive.” Several sources have stated that the crisis has already caused some cat bonds to be put on ice while sponsors and investors wait to see the wider implications.

Concerns have also been raised about “notoriously fickle” hedge fund investors. Paddy Jago, CEO of Willis Re, points out that the capital markets are relatively new to insurance investing and may not be as au fait with all the risks. “While the traditional market is aware of unforeseen losses – eg terrorism, flooding, the size of Katrina and the fallibility of the models – the capital markets have got to be jolly careful that they understand these unforeseen things.”

New asset class

Cat bonds have come a long way in the last ten years and with issuances this year already exceeding the 2006 total, the future looks certain for this new asset class. “I think cat bonds are here to stay,” confirms Mark Talbot, global head of group reinsurance at Zurich Financial Services. “I look at them as a good complement to traditional reinsurance and a viable long-term alternative to reinsurance.”