Cat Bond Sales Seen Slowing

June 27, 2008

Catastrophe bonds, which allow investors to make bets on disaster, have thrived in recent years, but a number of factors are seen cooling this obscure part of the debt market in 2008.

The growth of catastrophe, or “cat,” bonds has been tracking closely with the record levels of 2007, but this year is likely to be flat or below last year’s more than $7 billion in issuance, as excess reinsurance capacity makes it cheaper for insurers to avail themselves of traditional markets.

“We expect growth to be more gradual, unless or until there are additional events,” said Michael Millette, head of structured finance at Goldman Sachs.

Reinsurers provide insurance to other insurers. But when major catastrophes strike, such as Hurricane Katrina in 2005, reinsurance capacity becomes constrained, driving up pricing.

In times like those, insurers seek capital markets alternatives, such as cat bonds. But with few costly disasters since 2005, reinsurers have lowered pricing to try to increase business.

Cat bonds remain only a fraction of traditional reinsurance, but experts expect growth to surge when disasters create disruption. And there is much room to grow — about 8 percent of global catastrophe limits are covered by cat bonds, according to Standard & Poor’s.

More and more companies outside the insurance sector could tap into this market as they seek new ways to stabilize the financial impact of increasingly uncertain weather patterns.

“Cat bonds, by their very nature, are designed to address a gap,” said Lindene Patton, chief climate product officer for Swiss insurer Zurich Financial Services.

Generally an offshore entity holds a cat bond’s principal in trust and invests it to make lofty interest payments. And while not cash in hand, an insurer can usually count the potential payout as capital for regulatory purposes, freeing it up to sell more policies.

Investors, especially hedge funds, are interested, having earned high returns on cat bonds and other insurance-linked securities even as the bottom fell out of the rest of the structured credit market last year.

“Spreads of cat bonds remained stable,” said Aspen Insurance Holdings Ltd. Chief Operating Officer Julian Cusack. “We always said that it is a non-correlating asset class.”

The random nature of natural catastrophes means the bonds are little-influenced by wider market forces. But investors are at risk of losing their entire investment should a severe natural catastrophe trigger a payout.

Last year Aspen issued a cat bond designed to pay out in the event of total losses of $25.9 billion or more from a California earthquake.

Pricing has fallen 20 to 25 percent from the highs seen after Katrina, Jay Green, a vice president at Swiss Re’s capital markets unit, said on a panel at an S&P conference earlier this month.

But despite lower demand from insurers, he said there are still strong benefits to securitizing insurance risk. “One of the key benefits is you get multiyear (coverage).” By contrast, traditional reinsurance contracts are renewed each year.

Besides investing in cat bonds, hedge fund and private equity investors in 2005 poured money into an insurance-linked vehicle known as a “sidecar” — a specialized reinsurer set up for a short period to be a source of extra capacity when the market becomes constrained.

Although the money going into sidecars dropped to about $1.8 billion in 2007 from $4.4 billion in 2006, those who track the industry say these vehicles will be back in vogue as soon as the next costly disaster strikes.

Some say sidecars have not only given insurers new sources of capacity, but they could depress reinsurance start-up activity that has often occurred after costly disasters.

Reinsurers such as IPCRe Holdings Ltd. and PartnerRe Ltd. formed after 1992’s Hurricane Andrew, for example. Another pack, including Axis Capital Holdings Ltd. and Allied World Assurance Holdings Ltd., came to market after the Sept. 11, 2001, attacks. And after Katrina, Validus Re Holdings Ltd. and Flagstone Reinsurance Holdings Ltd. were among the reinsurers to open up.

But because of cat bonds and sidecars, Dowling & Partners Securities Managing Partner Vincent Dowling said he does not expect a new crop of traditional reinsurers to follow the next disaster.

“This is the classic roach motel — you can get money in (to a start-up) but you can’t get it out,” he said at the S&P conference. “A sidecar is accordion capital; it expands and contracts, and makes a lot more sense.”

(Editing by Lisa Von Ahn, editing by Gerald E. McCormick)

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