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When insurance-linked securities emerged a decade ago, buyers were largely reinsurance companies that took advantage of the opportunity the bonds afforded sponsors to insure themselves against major, natural catastrophes. Reinsurers, and some insurers, also represented the vast majority of the investors in the bonds.

Over the last 10 years, the sponsor base has expanded to include insurers and a smattering of large corporations. At the same time, the range of events covered has broadened from natural catastrophes--largely hurricanes and earthquakes--to the risk of cancellation of the World Cup, industrial casualty and mass death. A whole separate category of the bonds, linked to life insurance policies and primarily designed to offset insurers' costs of holding reserves, has also emerged.

"The market has evolved a lot," says Christopher Lewis, director of alternative risk management at the Hartford Financial Services Group, the diversified insurance company of Hartford, Conn., which sponsored its first insurance-linked security, a $247.5 million CAT bond, in November of last year to cover hurricane and earthquake risk. "It's now a very good supplement to traditional reinsurance. Five to seven years ago, it wasn't."

While growth has been steady, it has not been exponential. Early on, this was probably because of insufficient investor interest, says Nelson Seo, a managing partner of Fermat Capital Management of Westport, Conn., investment managers who specialize in insurance-linked securities. But over time, investors have grown more comfortable with the securities, and they have diversified and proliferated, says Ken Bock, managing director of Munich America Capital Markets of New York. Munich America's parent company, Munich Re, has both underwritten and sponsored insurance-linked securities.

Funds specializing in CAT bonds emerged in about 1998, says Mike Millette, managing director of the New York investment bank Goldman Sachs & Co. Currently, there are about six such funds managing about $4 billion. Hedge funds began investing heavily in the market in 1997 to1998. Hedge-fund participation fell following the market disruption of 1998.

But in the last year and a half, these funds have re-emerged, especially attracted by the relatively high yields insurance-linked securities offer as spreads overall have tightened.

From an investor's standpoint, the insurance-linked securities have lived up to their promise. There have been no losses, returns have been good, the market has become reasonably liquid, and they have provided their vaunted diversification.

"If anything, they've turned out to be a better portfolio diversifier than expected," says Millette. "They performed very well in the bad economic patch around 2001."

Moody's Investors Service, the New York ratings agency, has rated 75 percent of the CAT bonds that have been issued, and none of them has triggered a loss, says Rodrigo Araya, vice president and senior credit officer at Moody's. There has been just one downgrade, he says.

Even though spreads have tightened recently, investor interest remains strong, and some issues have been oversubscribed, says Araya.

At the same time that spreads have narrowed, expected loss is up. Trading multiples have fallen, says one major institutional investor. But that has not discouraged him or other investors. Demand for the securities is so strong that this investor says that if he wanted to, he could sell his entire portfolio immediately.

Satisfied as investors are with the bonds, they admit they have limited appetites for below investment-grade bonds (as most CAT bonds are).

Despite this constraint, analysts now say the market is being held in check by a limited number of sponsors. The modest sponsor interest has been attributed to a variety of causes. Early on, reinsurers were the predominant sponsors because they best understood the risks being transferred, analysts say.

For many years, for example, USAA was the only primary insurance company to sponsor an insurance-linked security. "The primary insurers were hesitant to try something new," says one investor of insurance-linked securities.

A VOTE OF CONFIDENCE

But in the past year, there have been signs that this may be changing. Hartford's sponsorship in November may well be a turning point heralding a wider use of the bonds by primary insurers, this investor says.

In June of this year, Oil Casualty Insurance Ltd. of Bermuda, a primary oil-industry insurer, sponsored its first CAT bond, as did FM Global, a property/casualty insurer based in Johnston, R.I. A French primary insurer has also sponsored its first CAT bond in a private placement in the past year, said the ILS investor.

Because the Hartford is widely viewed as cautious, its move into the market may encourage other insurers to follow its lead, says this investor.

The Hartford bought its first ILS largely because there has been a "large convergence in the cost of execution between RLS (risk-linked securities) and traditional reinsurance," says Lewis. Also, new technology has become available that assists sponsors in assessing risk themselves, he says. Time to market has also fallen considerably.

A growing concern about the credit quality and capacity of reinsurers may also encourage other insurers to emulate the Hartford, says the major institutional investor. That was largely what motivated FM Global to sponsor its $300 million bond, according to Jeff Burchill, FM Global's chief financial officer. The company decided to sponsor a CAT bond after it learned of new research that indicated that the chance of a catastrophic earthquake in the northwest United States and Canada was higher than it had thought, says Burchill. Its alternatives were second- and third-tier reinsurers that "gave us credit-risk issues," says Burchill. Even though the CAT bond was slightly more expensive, the credit-risk trade-off made the CAT bond the better deal for the company, says Burchill.

While insurers show signs of becoming a larger presence among the sponsors, there have been only a handful of companies outside the insurance and reinsurance sectors that have sponsored insurance-linked securities. This is in part because corporations prefer to focus on their businesses and to delegate risk transfer to insurance brokers, says Mark Rouck, an analyst for Fitch, the ratings agency of New York and London.

Another impediment is that very few companies face the magnitude of concentrated risk that lends itself to CAT bonds, and many companies do not have the know-how to undertake securitization, says Rouck.

The few corporate deals that have been done include one by Vivendi Universal, the media company based in Paris, which sponsored a $175 million bond in 2002 to cover earthquake risk to 100 studio buildings in Los Angeles. Oriental Land, a Japanese theme-park operator, sponsored a $200 million bond in 1999 to protect against earthquake risk for its two parks in and around Tokyo. In 2003, Electricité de France, an energy company in Paris, sponsored a $147 million bond to cover the risk of windstorms blowing down its power lines, according to the Organization for Economic Cooperation and Development.

As spreads tighten further, other companies will be drawn into the market, says Judith Klugman, managing director for ABS/ILS distribution for Swiss Re. But others, like Millette, think that participation by noninsurers is likely to be more limited.

While sponsors find much to like in insurance-linked securities, there are disadvantages. Depending on how it is determined when an insurance payment is due, the sponsor can be exposed to considerable risk.

A so-called "parametric" trigger is increasingly being used, in part because it is popular with investors. Such triggers dictate an insurance payment when a predetermined level of catastrophe occurs. For example, an insurance payment may be required if there is an earthquake of 7.5 or more on the Richter scale. But if the earthquake measures 7.4, there is no payment, leaving the sponsor with considerable exposure, says Burchill. In addition, insurance-linked securities are still more expensive than reinsurance and can take longer to issue than buying reinsurance.

Kinks notwithstanding, insurance-linked securities have evolved into a strong complement to reinsurance, sponsors, analysts and issuers agree. While earthquake- and hurricane-linked securities still dominate the issues, sellers and sponsors are also innovating.

Swiss Re and Credit Suisse First Boston, the investment banking arm of Credit Suisse Group, the financial services company of Zurich, Switzerland, have underwritten a $260 million CAT bond for the sponsors of the 2006 World Cup should that event be cancelled.

Swiss Re has also issued a $362 million so-called Vita bond to cover the possibility of massive deaths as well. Goldman Sachs meanwhile underwrote the first industrial casualty bond for Bermuda's Oil Casualty Insurance Ltd. "There's nothing sacrosanct" about insurance-linked securities, Klugman also says. "We look to transfer a wide spectrum of risk."

LINDA CORMAN, a former editor, is a New York-based writer covering the financial services industry.

September 1, 2005

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