By WILLIAM DUBINSKY, director of Swiss Re Capital Markets
In 1999, a transaction called Concentric Ltd. closed. This deal provided $100 million of multiyear capacity protecting Tokyo Disneyland against earthquake risk. The week it closed, I gave a presentation on the potential application of catastrophe bonds to a group of corporate risk managers. At the time, I suggested that Concentric might serve as a blueprint for future deals by corporates.
While CAT bonds for corporates have proved more lasting than earnings protection insurance, the subject of the other presentation that day, the intervening 11 years have seen only a handful of subsequent deals for corporates. The six corporate CAT bond deals placed slightly over $1 billion in bonds representing less than 4 percent of the catastrophe bond issuance during the period.
Other than corporates, reinsurers and insurers sponsor the large majority of catastrophe bonds, with government and quasigovernment entities making up the remainder. Insurers themselves rely on reinsurance and CAT bonds to smooth out peaks in their insurance portfolios.
The main reason for this is that reinsurers and insurers are more likely to find CAT bond pricing attractive. They find that their traditional market alternative is more expensive for a given pure premium or loss-on-line. Reinsurance and retrocessional reinsurance embed a penalty for lack of diversification of risk relative to the overall capital base of insurers and reinsurers. In contrast, insurance policies for diversifying risks will receive a lower rate-on-line. CAT bond investors value diversification but to a lesser degree as many of them are broadly diversified already within the capital markets.
One might ask, "What happened?" Does this mean CAT bonds are irrelevant for most risk managers? The short answer is: CAT bonds are relevant but not exactly in the way one might expect. How so?
The answer boils down to two overlapping points: (a) the direct impact of the CAT bond shadow market and, (b), the indirect impact of the market on insurance pricing and terms.
THE SHADOW MARKET
While slightly under $14 billion in catastrophe bonds are outstanding, a parallel shadow market of similar size coexists and is backed by the same investors. These investors bear risk through derivatives, exchange traded products, industry loss warranties and a bewildering array of customized private deals that do not lend themselves to simple categorization.
Examples of shadow market transactions involving corporates might include a "CAT-in-the box" hurricane derivative for an offshore energy company or a double-trigger derivative where the payout depends on two variables. We find corporates quite active in these types of trades.
An example of a two-variable trade would be one that depends on both hurricanes and energy prices. If you had an energy producer that has not hedged forward, it might want such a contract to hedge loss of production income. It might allow them to collect based on a combination of the parameters of a hurricane (location, wind speed, radius of maximum wind etc.) and energy prices. You might have a large hurricane occurring at a time of very low energy prices where the contract would not pay. Adding the energy trigger would create a discount in the price for the hurricane hedge.
We have even seen corporates begin to look at index-based CAT swaps as an alternative to either mutualization or assuming third-party insurance into a captive. The partner on the other side might be an investor, another corporate, an insurer or even a reinsurer. A simplified example is a parametric swap of New York hurricane for a Tokyo earthquake between a New York insurer and a Tokyo corporate. If a large earthquake occurs, the New York insurer will pay the Tokyo corporate. If a large hurricane passes through New York, the payment would go the other way. The indexed payout levels the playing field by allowing focus solely on the CAT risks and related models. Understanding underwriting standards, loss history, and claims handling becomes irrelevant.
CAT bonds offer many advantages to both investors and sponsors over these shadow market transactions and generally make more sense for larger deals. For example, CAT bonds offer superior disclosure, pricing transparency, documentation, bond ratings and secondary liquidity; however, the shadow market can complement the CAT bond market for smaller and shorter duration deals, where the CAT bond market makes less economic sense.
THE INDIRECT EFFECT
An important point to note is that the catastrophe bond market impacts the insurance capacity made available to corporates. This is because insurers comprise a substantial part of catastrophe bond market sponsors by volume. CAT bonds and to a lesser extent the shadow market play an increasingly important role in supporting capacity for peak natural catastrophe portfolios.
Also, a policy that an insurer can more readily package into its own catastrophe bond becomes more attractive for it to issue. For example, if an insurer sponsors a bond with a parametric trigger, the insurer may find it more attractive to offer an insurance policy with a parametric style deductible. This indirect effect can prove subtle, but over time, it should make insurance more available and affordable.
CAT bonds themselves do have a positive and direct impact on the property insurance market as they can offer certain advantages (collateralization, multiyear fixed pricing, mechanistic payouts, and diversifying capacity for large limits and difficult to place risks). On other hand, the CAT bond market more broadly has an even more positive impact through the shadow market and the indirect effect of CAT bonds on insurance capacity, pricing and terms.
March 1, 2010
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