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By MATTHEW BRODSKY, senior editor/Web editor of Risk & Insurance®

Give the catastrophe bond market a few years, and you might be looking at $50 billion in issued capacity. So says the bullish Peter Nakada from Risk Management Solutions Inc., who also might be the only one out there thinking so big. But you can't fault him for optimism. And you can't say he's completely out on a limb, because nearly all people in the insurance-linked securities world are upbeat.

All seem to agree that catastrophe bonds survived their scare when counterparty Lehman Brothers tanked and four bonds with the investment bank as a counterparty went with it. Then new issuances dried up in the fourth quarter of 2008, and many investors, mostly hedge funds and other highly leveraged folks, fled the market, selling these relatively valuable assets for the cash to meet margin calls on plummeting securities.

Compared with other asset classes, catastrophe bonds have survived the financial debacle like a home with stilts just high enough for a storm surge.

"This was the mother of all tests of the structure," says Nakada, who as managing director heads the RMS RiskMarkets group.

In 2009, the market has already seen three new issued bonds--Atlas V, sponsored by Scor; Mystic Re II, sponsored by Liberty Mutual; and East Lane Re, sponsored by Chubb--a fourth being put together and additional bonds in the pipeline. The issuers and bankers behind these new bonds have tweaked the structures to minimize counterparty credit and collateral risk.

Investors have responded. As Willis Re summed up in its recent "1st View" report of the reinsurance market, "Structural concerns have been addressed and investor markets (have) settled down."

Investors in the new bonds, primarily dedicated CAT funds and some fixed-income players, can't help but take advantage of the lucrative returns.

HIGH PRICES

The three bonds now out there are priced 30 percent to 50 percent higher than historical average, reports Chi Hum, managing director of GC Securities at reinsurance intermediary Guy Carpenter & Co. Inc.

Great for investors, but issuers are making up that difference, says Gary Martucci, director at Standard & Poor's.

Part of the issuers' response to the markup, according to Pascal Karsenti, has been smaller issuances. Whereas in 2007, a $1.2 billion issuance occurred, the 2009 bonds have been in the $150 million to $225 million range, reports Karsenti, senior risk consultant at AIR Worldwide Corp., the risk modeler that's been involved in every deal so far this year and has modeled more than $10 billion in issuances overall.

Such amounts, and the high pricing, has Karsenti saying that the market is on track to issue only $3 billion in 2009, a figure heard from others as well.

Pricing might lead not only to smaller issuances, but no issuances. Martucci has already heard of a couple of issuers pull out of the pipeline, saying the pricing is "too rich for us."

Sure, by all accounts, the property-catastrophe reinsurance market is seeing a scarcity of capacity, especially in high-risk areas, especially for new business. And when insurers hit the market for spring reinsurance renewals and see their potential bill, they might lean toward catastrophe bonds as a viable alternative.

"Once the renewals come in and you start seeing the price, it might help pick up issuance," says Martucci. "It all comes down to whether cedants want to pay to have these things. If they're too expensive ... cedants will go the traditional reinsurance route."

For reinsurers looking for additional capacity, on the other hand, no traditional retrocessional market exists to speak of, so even at these high prices, CAT bonds are a good deal, says Guy Carpenter's Hum.

More intriguing, Hum also sees sophisticated insurers sticking with the market, even at these prices, for the sake of diversifying capacity.

He points to Chubb as an example, who's pumped out $200 million to $400 million in bond capacity the last few years for this reason. (Chubb declined to comment, as did Liberty Mutual.)

"That's what's going to drive issuance this year," he says. "This is not just a price decision."

These, let's call them, sophisticated issuers see the benefits of diversification (away from reinsurance capital that's correlated to the very same catastrophe risk they're transferring), of collateralization, and of a longer term (say, three years instead of a one-year reinsurance contract).

"We see a lot of discussion of people who have integrated CAT bond capacity into their capacity purchase program," Hum says. "It's no longer an experiment or a patch to fill in a gap."

MIDTERM GROWTH

Still, getting back to that $50 billion figure ... one question mark in the market in the next year or two that Karsenti sees is the expiration of some bonds.

"We are going to see a lot of capital roll off," he says, and it's anybody's guess if investors will roll their money back into new bonds.

As for midrange growth, he sees another limiting factor. Karsenti suggests that the market could be held back ultimately by re(insurer) demand.

"There's only so much U.S. hurricane, U.S. earthquake out there. If issuances are to increase," he says, "you need to have more issuances outside of U.S. earthquake and U.S. hurricane."

Though he calls the $50 billion estimate a "little aggressive," Hum does see potential for significant volume growth if more investment-grade buyers come to the market to meet the need of strategic-thinking primary insurers.

These are insurers looking to protect their company from the "ruin" of the "big one," explains Hum: the 1-in-500-year event.

To make this work and to convince their boards that CAT bonds are the way to go to transfer this risk, Hum believes, insurers will need to look toward investment-grade bonds (not the traditional BB-rated bonds), and they'll need to get $500 million to $1 billion in capacity. There was movement toward this before the financial meltdown.

Another growth opportunity for Hum: "straight corporate issuance," when corporations bypass the traditional insurance markets for the capital markets.

Hum says seven such deals have been done, including an electric utility in France, Universal Studios and Tokyo Rail, which secured $275 million in a three-year deal to cover business interruption for quake.

Another unique market with upside? Governments, says AIR's Karsenti. The World Bank is active here, helping nations like Mexico to transfer catastrophe risk.

"That's huge potential," he says.

But as for the $50 billion in risk transfer, even RMS' Nakada admits that a "perfect storm" of circumstances must occur for this to happen in the next five years.

This vision of the future involves pension funds having these instruments as a standard part of their asset allocation--to the tune of 2 percent for each peak peril, 10 percent total. Investors would get 3 percent to 4 percent over LIBOR (about half of what 2009's are priced at), leaving insurers with a cost that's 1 percent to 2 percent over reinsurance.

That way, conservative investors would accept the downsized returns, but the coverage would be so cheap that "the issuers would be racing to issue these bonds," he says. Then even more than $50 billion could be possible.

We're close, Nakada says. CAT bonds are almost upon the so-called "rule of 10," whereby an investment vehicle reaches $10 billion in issuance and/or 10 years old and becomes mainstream. Catastrophe bonds are 13 years old and had $7 billion in issuance at their peak.

If it wasn't for the financial meltdown, we might well have been on the verge as we speak.

But then again, a lot of things were on the verge before the meltdown.

May 1, 2009

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