Last year, a record $1.2 billion of "catastrophe bonds" were issued, transferring risk from property owners or insurers to investors in the capital markets.
In addition, this risk-transfer strategy gained a stronger foothold in the United States last year, when Vivendi issued bonds to protect against earthquake damage to its Universal Studios properties in Southern California. The bonds are attractive to entities seeking to manage "high severity, low frequency" risks to reduce credit concern on the financing of real estate.
Because of the high severity associated with major storms and disasters, investors financing properties with this type of risk are increasingly concerned about "counterparty" risk associated with their reinsurers. The capital markets provide an alternative source of risk transfer.
So far, East Coast hurricanes in the United States, California earthquakes, European winter storms and Japanese earthquakes are the perils most frequently securitized, according to a study by the investment banking firm Marsh & McLennan.
Essentially, catastrophe bonds transfer insurance risk from corporations, property owners, reinsurers and insurers to investors. Since 1997, when the market began in earnest, 46 catastrophe bonds have been issued, with total risk limits of more than $6 billion. And $3 billion remained outstanding at the end of last year.
Catastrophe bonds have "dampened the rise in prices" of catastrophe reinsurance programs, according to Marsh & McLennan.
Christopher McGhee, managing director at Marsh & McLennan Securities Corp., said that the catastrophe bond market complements the capacity available from the reinsurance industry.
"Catastrophe bonds work best as a source of capacity for companies with large risk transfer needs, which are typically the largest insurance and reinsurance companies."
The insurers, rather than property owners or investors, are the most likely entities to sell catastrophe bonds because single commercial entities generally would find it too expensive to securitize their own risk, according to Marsh & McLennan. The investment bankers liken this to the mortgage market, where mortgage originators generally do not securitize their own loans but rather obtain financing from intermediaries that in turn bundle the loans and sell them in the secondary market.
Insurers and reinsurers can accumulate large pools of risk through the issuance of policies, warehousing the policies until they are large enough to be packaged into transactions that can achieve economies of scale. Insurers and reinsurers also can retain risks that are not attractive to capital market investors.
Mr. McGhee said Catastrophe bonds have evolved significantly over the past five years.
"In the past five years, bond structures have become more standardized and the investor base broader and more sophisticated. Further developments are certain as new issuers and investors enter the marketplace and refinements in bond structures are introduced," Mr. McGhee said.
Increasingly, the bonds are being issued with three-year risk terms.
In 2002, the trend toward larger catastrophe bonds also continued, with the average size hitting a high of $174 million, up from $138 million the year before. Larger deal sizes are important because they foster greater liquidity in the market for catastrophe bonds.
And with Swiss Re's creation of a $2 billion shelf for issuance of catastrophe bonds, the market is poised to respond more quickly to demand than in the past. Copyright 2003 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com, http://www.mortgageservicingnews.com