Insurance-Linked Risk-Transfer Products: Taking a Closer Look
Insurance-linked securities have been promoted by issuers as being an attractive means of transferring risk to the vast capital markets for the most destructive and rarest catastrophic events. The risk-transfer technique is said to be particularly attractive because transactions are fully collateralized.
When insurance-linked securities were first introduced, the need for greater capacity seemed particularly acute in the aftermath of a number of large catastrophes including the 1994 earthquake that hit Northridge, Calif., and Hurricane Andrew in 1992, according to the New York investment bank Goldman Sachs & Co. While the insurance was backed up by investors' principal, investors were expected to be enticed by high yields and the bonds' lack of correlation with other investments.
Sponsors of insurance-linked securities transfer risk to the capital markets through a so-called special-purpose vehicle. This entity collects premiums from the sponsor and funds from investors, which are then invested through a trust. If there is a triggering event, a major specified catastrophe, for example, the investment principal is used to provide insurance to the sponsor. If there is no such event during the life of the bond, the investors get their principal back.
The first CAT bond was issued in 1994. Annual issuance gradually built up to $1 billion in 1999 and remained at that level until 2001 because of a soft reinsurance market, says Mike Millette, managing director at Goldman Sachs & Co. After Sept. 11, 2001, reinsurance prices went up and CAT bond issuance followed.
While insurers and reinsurers have shrunk to 7 percent of the investor base, hedge funds, funds dedicated only to insurance-linked securities and money managers have grown from 40 percent to 89 percent of the investor base, according to Swiss Re, the global reinsurer in Zurich, Switzerland.
Swiss Re runs a close second to Goldman Sachs in the value of insurance-linked-securities deals it lead-managed ($4.4 billion versus $4.6 billion) between 2002 and the present, according to Swiss Re. Lehman Brothers, the New York investment banking firm, is third with $2.3 billion in the period.
In 2002 through 2004, there were about $1.5 billion annually in new issues. As of July 1 of this year, there had already been $1.4 billion in new issuance, and Millette expects there will be $2 billion worth by the end of the year.
As of July, there were $5.8 billion in CAT bonds outstanding, according to Goldman Sachs.
September 1, 2005
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