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Catastrophe bonds drive down disaster reinsurance rates

Tuesday, 9 Oct 2012 | 9:41 AM ET

* Rise in companies using cat bonds instead of reinsurance

* Using capital market investors to keep expensive reinsurance costs down

* High investor demands keeps costs down for sponsors * Issuance may hit $7 bln this year By Sarah Mortimer

LONDON, Oct 9 (Reuters) - The market for catastrophe bonds has boomed in the past year and is likely to keep growing as investors search for higher returns.

The volume of outstanding bonds is set to reach $15 billion this year, a near 30 percent increase from 2011, say investors. Sales of new bonds doubled in the first six months of 2012, falling just short of 2007's record for first-half issuance, according to Swiss Re .

Known widely as cat bonds, these securities are typically issued by big reinsurers to cover a low-probability, high-loss event, such as a destructive hurricane, thereby freeing up capital and allowing them to underwrite more basic business.

The latest trend is for big primary insurers and U.S. publicly funded disaster agencies to issue them as well.

Investors receive a high rate of interest by buying the bonds but risk losing part or all of their money if a catastrophe occurs. The attraction is that the risk of a cat bond triggering is small.

Such bonds have become more popular since reinsurers - which insure insurance companies - last year suffered their second-worst annual losses from natural disasters ever, including a $116 billion hit from the Japanese earthquake.

That disaster was so severe it triggered a cat bond issued by Munich Re that forced investors to pay $300 million to the reinsurer.

Regulators are also adding to demand by forcing reinsurers to set aside more capital to cover disaster risk under the Solvency II directive.

Demand from capital markets investors has helped keep overall catastrophe insurance costs from rising.

"By adding a cat bond to your portfolio of reinsurance protection, a sponsor (issuer) can keep costs in line over time and place subtle pressure on traditional reinsurance pricing, keeping it more competitive," says Michael Halsband, director at Deutsche Bank Securities Inc

The lure for investors is the high return offered by such bonds, which are rated below investment grade - an average 7.4 percent this year, although yields have come down with rising demand.

The chances of the bonds being triggered, meanwhile, are relatively remote because they cover very specific risks in specific geographic areas.

For example, only one of the nine cat bonds covering the Gulf region was triggered by Hurricane Katrina, the insurance industry's most costly natural disaster.

NEW SPONSORS

The market has attracted two to five new issuers in each of the last 10 years, including in recent years large primary insurers and U.S. state government entities with massive exposure to natural disasters. These include the Louisiana Citizens Property Insurance Company, Florida's Citizens Property Insurance Company and the California Earthquake Authority.

Last year's heavy disaster losses and the Solvency II directive have forced reinsurers to either pull out of providing some catastrophe insurance or charge more to cover the risk.

"Capital markets capital provides a diversification of sources and extra competition, which means we can find the right level of pricing," said Tim Richardson, chief financial officer at the California Earthquake Authority (CEA), which purchases up to $3.5 billion of reinsurance cover each year to pay potential claims against earthquake damage from California homeowners.

The CEA started sponsoring catastrophe bonds last year under a reinsurance deal with Bermudan entity Embarcadero Re, and has sold a total $600 million of cat bond notes to date.

Being able to access the capital markets "helps to keep everyone honest about pricing," said Richardson.

FURTHER GROWTH

"The insurance-linked securities market is no longer seen as hot money," says Rick Miller, senior vice president at Towers Watson Capital Markets, whose parent helped to sell an $11.95 million bond for an undisclosed middle-tier Florida-based insurance company - underlining the interest from smaller companies.

Catastrophe bond issuance is likely to grow by 25 percent in 2012, reaching up to $7 billion by the end of the year, according to brokers and investors.

Chi Hum, managing director at GC Securities, part of brokerage Guy Carpenter , reckons the market for insurance-linked securities - of which cat bonds are the major part - could grow from $30 billion to $45 billion by 2015.

"In the current economic environment, there is more than adequate capital from investors to meet the sponsor's present needs .... which ought to attract yet more new sponsors," adds Deutsche's Halsband.

- For more details on cat bond transactions, see the Thomson Reuters Insurance Linked Securities Community .

(Editing by Jeremy Gaunt)

((sarah.mortimer@thomsonreuters.com)(+44)(0)(20 7542 9619)(Reuters Messaging: sarah.mortimer.thomsonreuters.com@reuters.net))

Keywords: INSURANCE BONDS/INVESTMENT