Catastrophe Bonds As An Investment

In today's low yield environment, some entities are willing to take a chance, including reinsurers and even primary insurers.

The placement in June of a $250-million catastrophe bond to provide payment for the potential insured losses from northeastern U.S. hurricanes, marked $3.4 billion in new coverage so far this year, more than double the amount issued a year earlier.

The Long Point Re III cat bond was the 15th issued this year. Such bonds offer risk management for sponsors and investment opportunities for specialized insurancelinked securities funds, hedge funds, banks, insurers and reinsurers that are willing to accept some risk of principal loss in return for higher yields. "We are seeing an uptick in the dollar amount of assets under management for most of the dedicated ILS funds, but the tremendous interest from the pension industry is also contributing to the increased demand," said Asha Attoh-Okine, managing senior financial analyst of insurance-linked securities at A.M. Best.

"Pension administrators, especially in the European region and Canada, have investment mandates for ILS products, including cat bonds." These "non-specialist investors," which include mutual funds, have increased their investments in insurance-linked securities, he said.

Reinsurers and life insurers are among the buyers from the insurance industry. Life insurers consider cat bonds to be part of their broader asset allocation, said Cory Anger, managing director and global head of ILS Structuring of GC Securities, which provides investment banking services to the insurance industry and extends the traditional reinsurance services of Guy Carpenter & Co.Marsh & McLennan.

Anger said investors "like the diversification benefits that this asset class brings relative to traditional capital markets products where equities, interest rates, credit, commodities and foreign exchange are all more highly correlated over the last several years." But they also value the high interest rates that cat bonds offer, she said.

Cat bonds allow reinsurers to gain exposures that they may not have been able to fully obtain in the traditional reinsurance markets, Anger said. "They can get a larger placement, or add on to a placement," she said. "They may also like the pricing of this program relative to other opportunities. It's very situational-specific why they would consider investing in these."

As a result, it is more the underwriters of reinsurers that are evaluating the purchase of cat bonds than their asset managers looking for diversification, she said.

The coverage provided by Long Point Re Ill's$250 million principalat-risk, variable rate notes collateralize a three-year, per-occurrence reinsurance agreement to Travelers against hurricanes affecting the northeast region of the United States. It is based on the actual reported losses from Virginia to Maine from certain Travelers' business units. The risk profile of the coverage is primarily exposed to personal rather than commercial property, Anger said.

Only two cat bonds issued this year have a lower risk profile than Long Point Re Til's. According to GC Securities, its expected loss is 0.88%, and it carries a risk interest spread of 6%. A.M. Best Co. has seen spreads this year ranging from 3. 75% to 22%, with the average about 10%, Attoh-Okine said.

"Given the fact that most of the rated cat bonds are below investment grade, spreads in the high teens are not unusual," he said. "The cat bond ratings are generally based on the probability of first-dollar loss, i.e., the attachment probability." This probability represents the perceived risk associated with the potential trigger of the cat bond. High attachment probabilities are associated with lower ratings and higher spreads, he said.

As the sponsor, Travelers designed the product to fit into its broader risk transfer program, Anger said. Investors bear the risk of losing some or all principal if the bond is triggered. In this bond, the trigger is indemnity based, meaning that it is based upon the actual reported losses from certain Travelers' business units, subject to exclusions for certain types of losses, she said.

"And they're called variable rate notes because the interest isn't a fixed rate," Anger said. "It's a combination of the earnings off of Treasury money market funds, which fluctuate based on the earnings of short-dated Treasuries, plus the static spread of 6%." In late June, the threemonth Treasury yield was 0.1%.

Favorable Record of Returns

Anger estimated there have been 10 to 12 transactions fully or partially triggered in the cat bond market since 1997. Three transactions were fully triggered last year totaling $500 million of capacity, but those types of major events have been uncommon, she said. "If you look at the cumulative performance since the beginning of 2002, this asset class has returned a little more than 110%," Anger said. "That's a better risk profile over the same period of time when compared against the cumulative return of the S&P 500 Index or global corporate bonds and even the hedge-fund index, plus it has had less volatility."

Sponsors of cat bonds are generally ceding part of their peak exposure to the capital market as opposed to the traditional reinsurance or retrocession market, according to Attoh-Okine. Retrocession is reinsurance for reinsurers. Most sponsors of cat bonds still use the traditional market and other insurance-linked securities to manage their catastrophe exposures, he said.

Reinsurers often have units or subsidiaries whose purpose is to invest in insurance-linked products, including cat bonds, Attoh-Okine said. It is difficult to quantify the number of primary insurers that buy cat bonds, but he said that number could be very small, or even "minuscule."

But while reinsurers have had an

interest in cat bonds, their investment in the general insurancelinked securities market, including cat bonds, has declined since 2010, whether for asset allocation or other purposes, and not many are currently investing, Attoh-Okine said. However, there is "quite a lot" of investing activity by insurers and reinsurers in other insurance-linked securities, especially industry loss warrants.

Cat bonds are offered and sold to U.S. investors that are (or are deemed to be) qualified institutional buyers and qualified purchasers under Rule 144A of the U.S. Securities Act or by the issuer for non-U.S. purchasers, AttohOkine said. Generally, an investor presentation is made by the structuring agent/manager- in most cases, an investment bank- to potential investors, in what is generally referred to as "the road show." The notes are issued in minimum denominations of $250,000 and integral multiples of $1,000 in excess of the minimum amount, he said.

Interest is usually paid to investors quarterly with a return of full principal at the end of the risk period if the cat bond has not triggered as a result of a catastrophic event or a collateral mishap, he added.

Cat bonds often are issued with three-year terms, which Attoh-Okine said is "more coincidence" than regulation. "A cat bond with a three-year maturity may lead to expense savings when compared to similar three-year traditional reinsurance transactions that may be of one-year duration each," he said. "The sponsor is able to lock in the price or rate of the ceded exposures over a three-year period for the cat-bond program." Some cat bonds have been issued with one-, two- or five-year maturities, he said.

Key Points

* The Trend: Catastrophe bond issuance has increased through the first half of 2012 with $3.4 billion in new coverage as compared to $1.6 billion through the first half of last year.

* Behind the Trend: The bonds provide sponsors a capital-market way of ceding risk and gives investors a diversification tool, as well as the potential for better returns.

* What It Means: If the cat bond market continues to grow, more insurers and reinsurers may choose to invest.

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Travelers Group

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