Hurricane Katrina was one of the worst natural disasters in U.S. history. Deadly as it was, though, investors in catastrophe bonds were sitting pretty. The bonds are issued by insurers to cover huge losses from bad weather or earthquakes. Investors are effectively acting just like insurers; if the worst happens, investors forfeit some or all of their capital. But Katrina wasn't powerful enough, or cause enough damage, for that to happen.
Why would anyone buy such risky bonds? For major pension funds and the like, their high yields -- around 7% now -- are a big attraction. What's more, the bonds may be less risky than they look. Since insurers started issuing them in 1992 after sustaining huge losses on Hurricane Andrew, they've never collected on any of the bonds. In Katrina's case, wind speeds weren't high enough or barometric pressure low enough at the eye to trigger some of the $2 billion in bonds issued to cover Atlantic storms. Insured losses along Katrina's path apparently aren't big enough to trigger others.
That's not to say catastrophe bonds won't ever be wiped out. Several famous past disasters would have done the trick. Swiss reinsurer Converium Holding (), which issued $100 million in such bonds last year, ran 21 of the worst disasters through its computer model. Seven would have triggered the bonds, but only four would have caused serious losses for bondholders. The earthquake that leveled San Francisco in 1906 would have wiped out the entire $100 million, while the unnamed hurricane that killed 600 in New York and New England in 1938 would have taken $61 million. Converium's bonds also can be triggered by a serious earthquake in Japan or windstorm in Europe, but only if the disaster is the second during the bonds' five-year term.
Although the bonds are in high demand, insurers haven't been eager to issue them and share the premiums they get with investors. New issues totaled $1.14 billion last year, down from a record $1.73 billion in 2003, according to Marsh & McLennan Cos. () affiliate MMC Securities Corp. Since Andrew and the Northridge (Calif.) earthquake in 1994, insurers and reinsurers have amassed more capital by boosting their reserves and increasing premiums. "We've been disappointed [that] the market hasn't grown as much as their chief sponsors said it would," says Keith Ashton, director of pension fund TIAA-CREF's asset-backed securities department. But after insurers finish stumping up their Katrina losses, now estimated at around $40 billion, they may start issuing more cat bonds.
By Aaron Pressman in Boston and Chester Dawson in New York