By MATTHEW BRODSKY is senior editor/Web editor of Risk & Insurance®
Risk & Insurance® published an article waaay back in 1999 titled "Time for the Corporate CAT Bond?" More than a decade later, we're still asking the same question.
Back then, Japan's Oriental Land Co., owner/ operator of Tokyo Disneyland, made headlines in the (re)insurance world and capital markets by issuing two $100 million bonds to transfer its concentrated earthquake exposure. Since, a handful of big noninsurance corporations have followed suit--Vivendi's Universal Studios, France-based IDF, Dominion Resources and Japan-based JR East Railway, to name biggies--but really, hardly enough to say the time of corporate CAT bonds has come.
Yet buzz over them persists, like the sound of snowblowers in the mid-Atlantic this winter.
Why? For starters, the catastrophe bond market is an exciting place these days in general. The market rebounded in 2009 and is expected to have an average or above-average year in 2010 in the range of $5 billion to even $7 billion in new issuances. The cost of bonds has dropped, making them more attractive for corporate risk managers as well reinsurers and primary carriers.
There's also the credit-risk benefit, a topic fresh on the minds of risk managers. CAT bonds are collateralized, now mostly with treasury money market funds, and they diversify risk capital. What's more, they provide longer-term security; many bonds cover three- to five-year periods. And as any risk manager who's ever dealt with a large property claim can appreciate, mechanical and quick payouts follow a bond being triggered.
Another thing to keep in mind, added Paul Schultz, president of Aon Benfield Securities: Those proceeds can be used any way you want.
A few new technical developments have come along to make catastrophe bonds a more viable option. For one, issuers can use new types of triggers and models to lessen the basis risk inherent in most corporate CAT bonds. Up to this point, all corporate CAT bonds have used parametric triggers, which are based on weather- or geological-related indices, say, the wind speed of a hurricane or the strength of a temblor. That's because corporations have typically looked to protect highly complex assets that are not easily modeled--think a railway network or collection of offshore oil platforms. Had they been more easily modeled, the issuers could have used an indemnity trigger, based on actual losses, explained Pascal Karsenti, senior risk consultant at Boston-based catastrophe modeling firm AIR Worldwide.
Now, specialized models exist (such as offshore energy models) to help risk managers understand their exposures. For intricate industrial properties, engineering and modeling firms like AIR also offer engineering services to better understand and measure how an asset will respond to a catastrophe, including business interruption.
"That allows the owner of the assets to have much more confidence in the detailed modeling of their properties," said Karsenti.
Newer hybrid bond triggers have also arrived so that risk managers can apply the more nuanced modeling and better data, hybrid triggers that can be based on modeled losses to the assets themselves, more granular parametric structures, and industry losses down to a county or sector level.
"Really, it's opening up an entire universe of organization that up until now couldn't really justify a CAT bond play," he said.
A CONDITIONAL ANSWER
Yet the trickle of corporate issuances over the last decade, and the lack of action on this front today, demonstrates that corporate risk managers are not diving into this alternative to the traditional insurance and facultative reinsurance market.
As Chi Hum, managing director at GC Securities, the capital markets arm of Guy Carpenter & Co., explained, there have been continuing discussions with corporations but developments are "not as advanced as we all hoped," adding that we'd need to speak Japanese to talk with the corporates closest to moving forward with a deal.
William Dubinsky, director of insurance-linked securities at Swiss Re, explained it: "What I can say, as in other years, we continue to talk to any number of corporates where they're interested in learning more about this market."
"People are looking at both markets, and what they're finding is that there is a lot of capacity in the traditional side," he said.
According to Dubinsky, a 12-year veteran of the CAT bond market who's talked to "many, many" corporates over that span and participated in some of the biggest deals, traditional insurance markets can write many times the limit of their capital, whereas bond investors only provide dollar-to-dollar limits.
That gets to the gist of why, or why not, a corporate risk manager would use a CAT bond. One, price. In today's soft market, forget about it. Two, capacity. Which can come into play for specialized, concentrated or difficult to understand risks.
Take Universal Studios, which issued its bond in Dec. 2002 and whose location in the heart of earthquake country was nearly "an absolute peak exposure," explained Dubinksy.
Or consider the JR East Railway deal of 2007, where the Japanese transport company sought to transfer its business-interruption exposure related to quakes.
Capacity also can dry up like a lake in the Southeast in summer. Perhaps a classic, recent example of this is the offshore energy market after Katrina-Rita-Wilma in 2005.
This is the primary reason that Dominion Resources did its bond deal, DREWCAT, back in 2006.
Risk management representatives contacted at the Richmond, Va.-based energy firm refused to comment about the bond, but the company discussed it in its 2007 10-K.
As the report details, hurricanes Katrina and Rita caused $272 million in after-tax losses related to interruption in gas and oil production.
"The increased level of hurricane activity in the Gulf" prompted the company's insurers to "terminate" coverages for its Exploration and Production (E&P) unit.
"Efforts to replace the terminated insurance for our E&P operations for offshore property damage and offshore business interruption with similar insurance on commercially reasonable terms were unsuccessful," the report states.
In June 2006, the company entered into a six-month weather derivative contract with a special purpose entity (SPE) that was "an alternative to traditional business-interruption insurance." The SPE issued $50 million in CAT bonds, which matured in Dec. 2006 without any triggering.
The deal cost Dominion, according to its SEC documents, $5.2 million in fixed payments to the SPE, which were used in part to pay interest payments to investors, and an additional $1.3 million to pay the SPE for "certain operating costs."
Cory Anger, the managing director at GC Securities who helped set the Dominion deal up (while she was at Lehman Brothers), considers such an arrangement a success.
"Absolutely, the fact that they were able to obtain coverage from the capital markets," she stated.
Yet for other corporate risk management teams to go this route, will we need another dislocating, even cataclysmic, event? Another KRW (or worse) to dry up capacity?
The general consensus among experts is that, yes, such a catalyst might be what brings more corporate issuers into the CAT bond market.
"It's easier for them to justify turning to alternative sources when there's a capacity issue," Anger said.
But this should not stop--and doesn't seem to stop--companies from exploring this option even when capacity and price in the traditional market are way too easy to pass up.
Even as an iterative step, considering a CAT bond can be a valuable way for risk managers to get a better handle on their property-catastrophe exposure.
The way it works at Aon, for example, according to Schultz, is that the brokerage brings together everyone at its disposal who knows about every form of insurance-related capital. Together with the client, they figure out which forms of capital would be the most efficient and "avoid the bias of any one market," he explained.
If risk managers take the next step and attempt to calculate possible bond triggers, this can help better model and understand their underlying risk, and even lead them to finding other ways to mitigate it, agreed Swiss Re's Dubinsky.
Some corporates are thinking way out of the cat in the box, so to speak, considering bonds for something like business interruption from pandemic. Hmm, is it time?
March 1, 2010
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