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

The catastrophe bond market is perfectly all right, don't get us wrong. It, however, often gets hyped and does not live up to the hyperbole. So with optimistic year-ahead reports being released from the likes of Willis Re and Guy Carpenter and everyone in between, it helps to start out asking: is 2011 the breakout year that the CAT bond market lives up to its hype?

Peter Nakada, managing director at Risk Management Solutions Inc., is usually a bull on the CAT bond market, but even he forecasts a market not fully living up to its potential in 2011. He sees the market fluctuating around $5 billion in issuances for a number of years to come--$7 billion in a great year or $3 billion in a bad one--until the market reaches a "tipping point."

"I would say, unless it reaches that tipping point, it will swim around where it as been," Nakada said.

Ever the salesman for the market, Nakada quickly added that the "stars were aligning" and we could be approaching that tipping point.

One thing that could push the market over the hump would be a hardening of the reinsurance market. Reinsurance is essentially competition. Whereas traditional reinsurers use their stores of cash in Bermuda or Europe to bet on other insurers' exposure to hurricane, earthquake or other disasters, bonds are designed to allow the capital markets to wager. Whereas reinsurance contracts are arcane, complex deals that can lead to messy claims, the bonds are triggered by events on the ground, producing clean payouts. Plus, the capital markets can provide multiyear deals versus typical one-year reinsurance policies, capital diversity versus a small reinsurance market where one big cataclysm could wipe out major players. When the capital-markets capacity becomes reliably cheaper than the reinsurers' capacity, well then, all the advantages could be in the bond market's court.

"You see a lot of what I could call hot money sitting on the sidelines," said Judy Klugman, managing director and head of insurance-linked securities distribution for Swiss Re. That hot money is waiting for the hard market.

As it is, spreads on CAT bonds in 2010 narrowed to the point to compete with a soft reinsurance market.

"The CAT bond market is giving it a run for its money," Nakada said.

But as it is, the reinsurance market might stay soft forever in this current wacked-out insurance market and economic stagnation.

Two things are going for the market, though. Two of the main complaints about catastrophe bonds in 2010 could be overcome.

The first complaint is that there wasn't enough demand from issuers (typically primary carriers and reinsurers) to match investors' supply of cash. The bright side here is two-fold, according to Hum.

For one, he believes that "we've reached an inflection point" with primary carriers appreciating the market. You have the large, forward-thinking insurers--the Travelers and the USAAs of the world--led the way into a market now integrating bonds into their overall programs, typically at the tops of their reinsurance towers. Nearly 80 percent of issuance in 2009-2010 was from primary carriers, many repeat customers.

You also now see smaller primaries dabbling in the market, even state residual pools such as those in North Carolina and Massachusetts, Hum said.

"We're getting a lot of interest in the smaller companies as well," he said.

Klugman reported that her firm is in active discussions, for example, with some small Florida insurance companies.

"You will see many other household names," she said. For 2011, Klugman is optimistic that in the very least the market will be a roll-over of the $4.6 billion in bonds maturing this year. It is too soon to tell, she said, how many more issuances will occur beyond that.

Reinsurers are also renewing interest in ceding their catastrophe exposure to the capital markets, according to Hum. Reinsurers have been out of the market for about two years but because pricing has come down, bonds are interesting again.

The other complaint was diversity, as in not enough of it when it comes to the underlying catastrophe exposure. Most of the bonds issued in the first half of 2010 were for U.S. hurricane risk, explained Hum. The market did respond though, after investors "filled up their U.S. wind buckets"--by providing bonds for European wind. Hum foresees more European risk, as well as possibly Asian perils, in 2011.

But there is another way around this diversity problem: embrace it. As Nakada explained, the catastrophe bond model was initially conceived as one of concentration.

"I was troubled by what happened this last hurricane season," he said about those filled U.S. wind buckets. "I cringe when I hear fund managers ask for more diversified perils."

Luckily, mainstream pension-fund managers and other institutional investors are starting to enter the market, Nakada said. This new money is interested in the diversifying quality of catastrophe risks as a whole versus their traditional investments, so it is not interested in how diversified the CAT bonds are across perils.

"It's all the same. It's just CAT," Nakada said.

"Traditional money managers don't really need the same diversification," agreed Klugman.

This pension-fund money is where it's at, that tipping point.

"It is what will take this market from a niche to something major," Nakada said.

January 1, 2011

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