2005 was a big year for catastrophe bonds but is this set to continue? asks Christopher McGhee.

What a year it was for the catastrophe bond market. Guy Carpenter and MMC Securities' new report – The catastrophe bond market at year-end 2005: Ripple effect from record storms – highlights how cat bonds have continued their steady march toward the mainstream in 2005, with total market issuance soaring 74% over the prior year to $1.99bn.

Hurricane Katrina was a major influence on the market – for better and for worse. It helped fuel the market to reach first-ever highs or tie previous records in total risk capital issued, total risk capital outstanding and the number of sponsors dipping their toes into the market for the first time.

In addition, a tightening catastrophe reinsurance market after Katrina, fuelled by announcements that new insurance rating agency criteria and risk modelling methodologies were on the way, caused many insurers and reinsurers to take a closer look at catastrophe bonds. However, Katrina is also to blame for the first anticipated total loss to a publicly disclosed catastrophe bond: the $190m KAMP Re 2005 Ltd issuance.

The year ended with some constricting of catastrophe bond capacity and increased yields. This was driven largely by pricing that anticipated the model changes as well as supply and demand factors. At the same time that some multi-strategy hedge funds opted for sidecar and other start-up reinsurance companies, a high volume of catastrophe bonds were brought to the market, which further stretched investor resources.

Rounding the corner into 2006, however, the investor base for catastrophe bonds continues to show strong demand. There may even be a silver lining in the KAMP Re loss – assuming the principal payout process from the bond goes smoothly, investors and sponsors will see a catastrophe bond contract work, as it should in a loss situation. New model iterations that will be hitting the streets should boost investor and sponsor confidence in the modelling data used in these transactions. Both events could serve to ease investor or sponsor uncertainty and increase demand for these instruments.

While no one knows where catastrophe bond pricing and issuance will land in 2006, it is clear that the catastrophe bond market has expanded relevance in the risk transfer sector. As a supplement to traditional reinsurance, catastrophe bonds merit a first – or second – look.