`Extremely Active' Hurricane Season to Test Catastrophe Bonds

As the U.S. enters this year’s hurricane season, the market for catastrophe bonds may face its biggest test since the collapse of Lehman Brothers Holdings Inc. in 2008 brought sales to a six-month standstill.

Insurers and reinsurers sell cat bonds to investors such as hedge funds to help cushion potential claims from the most costly disasters, including earthquakes and U.S. hurricanes. Buyers demand yields above benchmark interest rates because they may lose their entire investment if a pre-defined disaster hits.

The U.S. National Oceanic and Atmospheric Administration predicts 14 to 23 named storms during this year’s Atlantic hurricane season. The June-through-November period may be “comparable to a number of extremely active seasons since 1995,” and even reach a record, NOAA said.

“A devastating U.S. hurricane season could be a real crash test for the cat bond market,” said Niklaus Hilti, who helps manage about $2.4 billion of debt as head of insurance-linked strategy at Credit Suisse Group AG. “Cat bonds with their collateralized structure could prove to be a much safer risk transfer for insurers.”

American International Group Inc.’s Chartis property- insurance unit, Swiss Reinsurance Co. and Allianz SE were among sellers of the 10 cat bonds sold so far this year. New sales of cat bonds stood at $2.4 billion, up 70 percent from the year- earlier period. That brings the volume of the investments outstanding to about $14 billion, according to Swiss Re.

Chartis Cat Bond

Chartis issued a $425 million cat bond last month through Lodestone Re, a special-purpose entity, to help protect it from U.S. hurricanes and earthquakes in its first purchase of reinsurance via capital markets. The bond’s $250 million slice will pay 8.25 percentage points more than three-month Treasury bills. The second slice yields 6.25 points above the benchmark.

“An extraordinarily large event may impair traditional reinsurers’ ability to pay, but that’s not a concern with a cat bond,” said Dave Fields, chief reinsurance officer of New York- based Chartis.

Proceeds from cat bond sales are invested in collateral such as government bonds that is used to pay interest to investors and payouts to the bond’s seller if a pre-defined disaster occurs. Buyers of Zurich Financial Services AG’s Kamp Re 2005 Ltd. cat bond were the first investors in these securities to lose money after Hurricane Katrina, the costliest storm in history, hit the U.S. Gulf Coast.

Lehman Collapse

One slice of the Avalon Re Ltd. cat bond, which covers energy-industry owned insurer Oil Casualty Insurance and matured on June 7, paid out parts of its principal to the insurer after losses, Standard and Poor’s said yesterday.

The September 2008 collapse of Lehman brought new sales of cat bonds to a halt until February 2009 as it left the U.S. investment bank unable to meet commitments to guarantee minimum returns on assets held by some bonds, undermining investor confidence. Sellers of cat bonds have since agreed to invest the collateral’s funds in higher-rated assets.

Munich Re and Swiss Re, the world’s biggest reinsurers, have both estimated that cat bond sales may climb 43 percent to $5 billion this year as maturing notes are replaced and new investors enter the market.

Munich Re is sticking to that forecast because it expects bond sales tied to other disasters such as European windstorms during the second half of the year, said risk trading head Rupert Flatscher, even as Swiss Re is damping expectations.

‘Costly Disasters’

“While we are optimistic that the market will beat last year’s $3.5 billion, it remains to be seen whether it will reach $5 billion,” said Martin Bisping, head of non-life risk transformation at Swiss Re.

This year already saw two major disasters in February, the earthquake in Chile and European storm Xynthia.

“Despite the first quarter’s costly disasters, 2010 hasn’t yet become a costly year for insurers and reinsurers in general,” said Karsten Bromann, chief risk officer at Solidum Partners AG, a Zurich-based hedge fund that specializes in insurance-linked securities. That may change should the U.S. be hit by a major hurricane, so “cat bonds have been selling like hot cakes until a month ago,” he said.

This year’s outlook for an Atlantic storm season with as many as 23 named storms compares with a total of nine last year. A record 28 named storms formed in 2005, including Katrina.

Researchers at the Colorado State University boosted their forecast for the 2010 season last week, predicting 18 named storms, 10 of them becoming hurricanes.

“While this year’s hurricane season could be a test to the market, it won’t be the first one,” said Michael Halsband, who helps develop and market cat bonds at Goldman Sachs Group Inc. “Cat bonds already passed the test of the 2005 record hurricane season as well as the test from the credit market side with the collapse of the broader credit markets and failure of Lehman.”

To contact the reporter on this story: Oliver Suess in Munich at osuess@bloomberg.net

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