Cat bonds worldwide and worthwhile

A truly uncorrelated asset class yielding stable returns.
The turbulence on the financial markets this summer and the effects of the US subprime mortgage crisis have sent many investors seeking improved stability for their investment portfolio. As one of the truly uncorrelated asset classes yielding stable returns over the past years, insurance-linked securities (ILS) have gained broad interest from the investor community. The following article explains the basics of ILS investments, provides an overview of the ILS market and highlights the unique features of this asset class.

Insurance-linked securities
Insurance-linked securities (ILS) are fixed-income securities (bonds) with a pre-defined maturity through which the insurance industry passes on pure insurance risk to the financial markets. The bonds are issued by insurance and reinsurance companies as protection in the event of extreme insurance losses, for instance following severe natural catastrophes or a potential pandemic disease outbreak. In some cases, large industrial corporations may issue an ILS as a substitute for traditional insurance coverage (e.g., a power company issues an ILS as protection against losses to its landlines from an extreme windstorm).

The risk assumed by investors is related to a specific insurance loss (e.g., earthquake, mortality, airplane crash, etc.). For natural catastrophe ILS, the term ôCat Bondö is typically used. ILS transactions have their roots in asset backed securities (ABS) and typically pay an interest rate comprising two components:
ò Libor (usually three-month US dollar Libor)
ò Spread that reflects a premium in relation to the underlying insured risk

The risk premium is linked to the default probability of a bond, with higher default probabilities typically yielding higher premiums. While the Libor is adjusted periodically, the risk premium remains constant for the entire duration of the bond. The total performance of a bond is thus dependent on the reference money market rate over a given period. In addition, some Cat bonds are subject to seasonal price fluctuations in the form of mark-to-market price adjustments. This is due to the seasonality of covered events (for instance, US hurricanes only occur between July and November).

Prior to maturity of a Cat bond, two scenarios may develop: as long as no major natural catastrophes have occurred, Cat bonds are redeemed at 100% on the maturity date. Alternatively, if a catastrophic event of a pre-defined peril and within a specified region does occur, the bonds may default, and part or all of the capital is immediately transferred to the issuer of the bond. The issuer then uses this capital to pay its claims to policyholders.

Motivation of Insurers
The insurance industry is a highly competitive and yet strongly regulated environment. The market is greatly driven by premium income, as paid by the insured customer, with each company trying to write an everincreasing number of insurance policies. Since each policy written represents a financial liability on the balance sheet of an insurance company, this behavior puts more and more pressure on the capital base of a company. However, in order to protect private customers, the insurance industry is subject to regulatory authority.

Regulators annually review each individual insurer to assess whether the available capital reserved by the company is sufficient to live up to the ôpromiseö to pay out a specific sum in case an unexpected event occurs. In certain peak scenarios, such as a magnitude 8.0 earthquake in California or a category 5 hurricane in Florida, the available capital base of the insurance and reinsurance industry may no longer be deemed sufficient to cover the losses from extreme catastrophic events. Traditionally, the insurance industry has had three ways of mitigating the financial impact of extreme events:

ò Limiting the size of assumed business (i.e., write fewer or ôsmallerö insurance policies)
ò Increasing the capital base (by issuing additional equity or debt to the capital market)
ò Passing on part of the risk to another party by means of reinsuranceILS Market: Brief History & Review
In the aftermath of Hurricane Andrew (1992), for most (re)insurers increasing their capital base was financially unattractive and the catastrophe reinsurance market was offering very limited insurance capacity. As an alternative to the traditional process of buying reinsurance, a few players in the insurance industry pioneered a method to pass on part of their risk to the financial markets and the first catastrophe securitisations were initiated. More than 10 years later, Cat bonds remain an attractive alternative to traditional reinsurance offering a multi-year term with a fixed price, greater security (as the Cat bond structure virtually eliminates any counterparty credit risk), and the guarantee of systematic claims recovery.

Following the two extremely active Atlantic hurricane seasons of 2004 and 2005, and the corresponding record high insurance industry losses, the Cat bond market gained significant momentum. This revived interest became most evident in 2006 with a wave of new catastrophe securitisation issuances totalling $4.7 billion, more than doubling 2005Æs prior record of almost $2 billion. The number of transactions also doubled to 20 in 2006 from 10 in 2005, leaving the total risk capital outstanding at year end at around $8.5 billion. This trend has continued into 2007 with Cat bond issuances in the first half year already surpassing the 2006 whole-year volume at $5.7 billion in new non-life transactions, hence, a 17% growth over 2006 just in the first 7 months.

Benefits for Investors
The turbulence on the financial markets this summer and the effects of the US subprime mortgage crisis have sent many investors seeking alternative and less volatile asset classes. Cat bonds offer the following advantages for investors:

ò Uncorrelated with Other Asset Classes
Natural catastrophe events are not related to or triggered by other economic risk factors, thus Cat bond investments are uncorrelated to the financial markets and returns from other asset classes.

ò Stable and Attractive Returns
Following Hurricane Katrina in 2005, insurance prices increased substantially due to severely reduced reinsurance capacity. Risk / return rates for reinsurance have remained very attractive throughout 2006 and during the first-half 2007, making these instruments appealing to capital market investors. Due to their structure as ôLibor + Spreadö products, Cat bonds offer sustainable returns above the three-month reference rate.

ò Liquidity
A healthy secondary market exists for the trading of Cat bonds. This allows positions to be bought and sold on a regular basis and permits the active management of a portfolio of bonds.

ò No Interest Rate Lock up
Cat bonds are designed as floating rate notes, thus, there is no long-term interest rate lock up.

As Cat bonds are only available to professional, qualified investors, catastrophe securitisations are accessible to private investors via funds investing in Cat bonds or funds of mixed ILS investments. In these dedicated Cat Bond funds, a balanced and well-diversified portfolio is achieved by investing small shares in multiple bonds insuring different natural catastrophe risks stemming from various sponsors and covering a wide geographic distribution.

In a well-diversified portfolio, the impact of a single Cat bond position, where a total loss of the invested capital is possible, is greatly reduced. Due to the low correlation with traditional financial products and the attractive risk/return ratio, Cat Bond funds are suitable as a partial substitute for either fixed-income or alternative asset classes. Cat Bond funds in a given portfolio of a private investor add a new dimension of diversification and contribute solid and stable returns thus improving portfolio efficiency.

Michael Stahel is head of insurance-linked investments at Clariden Leu, while Hilary Paul is a natural catastrophe risk modeling expert, and Christian Bruns is a portfolio manager at the same firm.

This story first appeared in the Private Capital supplement that was distributed with FinanceAsia's November issue.
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