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Possible regrets on the part of Florida lawmakers for their expansion of the state's catastrophe fund could increase demand for catastrophe bonds and other alternatives to traditional reinsurance.

While the capital market alternatives played an important role in maintaining and expanding reinsurance capacity following the 2004-05 season of record hurricane losses, the current soft market trend has raised questions about whether demand for such products will remain.

"For what it's worth, I have seen an uptick in inquiries from bankers since the beginning of the year," he says. "Whether that will translate into any increase in deals is anybody's guess."

J. Eric Brosius, senior vice president and manager, reinsurance, for Boston-based Liberty Mutual Insurance Company says diversification remains an important component of any program of protection against catastrophic risk.

"You are safer in buying from two sources rather than one. So what I see in the capital markets is an alternative source of protection," he says.

Moreover, Brosius recalls that "when I met with some cat bond investors, it was hard to tell whether they were cat bond investors or reinsurance underwriters."

"That is important because they were taking the same sort of risks," says Brosius, who is also responsible for reinsuring Liberty Mutual's risk portfolios.

The numbers pretty much tell the story that catastrophe bonds--once derided as "the perfect solution in search of a problem"--are not going anywhere. Even in a softening market, which 2008 is expected to be barring any severe catastrophic events, the instruments will offer good returns free from what the experts call "uncorrelated risk."

That becomes increasingly attractive in a year like 2008 when the bonds' risk are related specifically to certain defined acts of nature and not the general uncertainty afflicting the credit market.

Edward Torres, senior vice president for Benfield Group Ltd, says that issuance last year rose to $6.9 billion from $4.9 billion in 2006, despite the market that grew softer following the relatively benign catastrophe season that year.

"The investor type has broadened from the specialized hedge funds to the mass market, including the traditional pension fund and mutual fund asset manager," he says.

The use of sidecars, or those special short-term equity instruments used to target specific areas of capacity shortage, will remain a phenomenon of an event-driven capacity shortage.

While Benfield estimates about $1.2 billion of coverage was raised last year, that figure fell from the $4 billion raised the previous year following the 2005 record losses.

Sidecars usually involve an equity participation on the part of the investor and a quota share arrangement of payouts. "In an environment of oversupply of capacity and falling rates, such a proposition has proved less attractive," Torres says.

Contrast that with catastrophe bonds that Thorpe notes of "significant spread pick-up" which he describes as "banker talk for higher interest rates."

In addition, coverage can be locked in for three to five years instead of annual renewals. "Depending on the structure, the buyer can get almost an instant cash payout with virtually no dispute risk after an event," he says.

April 1, 2008

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