The Ca Ts Are Out Of The Bag
Back in November, 1996, Morgan Stanley & Co. expected to make some history on Wall Street. The New York investment bank was about to underwrite the first public issue of insurance-related securities--catastrophe bonds, or CAT bonds for short.
The client was the California Earthquake Authority (CEA), created by the state to insure California homeowners forsaken by insurance companies after the Northridge earthquake. The plan was to market bonds to big institutional investors with a novel feature: Bondholders would earn a huge 10%, but if any earthquake were to cause more than $7 billion in losses to the CEA, bondholders could lose their principal.
Thanks to Warren Buffett, however, the deal never happened. At the eleventh hour, National Indemnity Co., Berkshire Hathaway Inc.'s insurance division, stepped in and insured the risk. It was just another deal, says Ajit Jain, president of Berkshire Hathaway's reinsurance division. But several industry insiders think Berkshire was intent on thwarting the nascent market for insurance securities.
BIG HIT. It worked, for the moment. But the cat, so to speak, is out of the bag. Some $900 million worth of CAT bonds have been sold in the last 13 months. And some analysts predict similar securities will eventually insure such risks as airline crashes, satellite launches, and even more predictable hazards such as automobile accidents. Although reinsurers are putting a brave face on it, few industry executives deny that CAT bonds will radically change their business. "Anybody who ignores them does so at his own peril," warns Charles F. Hays, chief financial officer of Bermuda-based reinsurer Mid Ocean Ltd.
CAT bonds are designed to protect insurance companies from events like Hurricane Andrew in 1992, which happen rarely but cause enormous damage. The bonds pay interest and return principal the way other debt securities do--as long as the issuer doesn't get whacked by a catastrophe that causes losses above an agreed-upon limit. For USAA, a San Antonio-based insurer that floated the largest CAT bond issue ($477 million) to date last June, the loss threshold is $1 billion. As long as a hurricane doesn't hit USAA for more than that, investors can enjoy their junk-like yields of about 11%, and also get their principal back.
The one-year bonds have been a big hit with investors. Jie Dong of lead underwriter Merrill Lynch & Co. says that the issue was oversubscribed and that more than half of the 62 investors were mutual funds and money managers. Courtesy of--you guessed it--El Nino, the Atlantic hurricane season was unusually tame last fall, and the chances of a hurricane before the bonds mature in June are virtually nil.
NIGHTMARE. The USAA deal and the handful of other small CAT issues trading in the secondary market are only a tiny drop in the bucket of worldwide catastrophic risk that needs insuring. Indeed, the amount of CAT bonds outstanding is less than many analysts expected by this point. But that's not surprising, says Morton Lane, CEO of Sedgwick Lane, a subsidiary of Sedgwick Reinsurance Inc. New securities markets take time to develop. "Look at the mortgage-backed securities market," suggests Lane. "It didn't become commercially viable for several years."
Driving the CAT bond wavelet are the reinsurance industry's boom-and-bust cycles, which make managing catastrophic risk a nightmare for primary insurers. In periods of few disasters, coverage is cheap enough. But after a string of losses, such as over the five years culminating in Hurricane Andrew, prices for policy renewals can skyrocket. "We couldn't get enough coverage," says USAA spokesman Tom Honeycutt.
As the CAT market develops, "it will moderate reinsurance prices," says Peter Burns, director of a program called Managing Catastrophic Risk at the University of Pennsylvania's Wharton School. Many believe it will do much more than that. After the next wave of disasters once again depletes the reinsurance industry's capital and companies attempt to jack up prices, Wall Street will be ready. "The next time around, the capital markets will be in place and will take a large chunk of business," predicts Lane.
If that happens, says Mid Ocean's Hays, "we would want to be a packager of risks like a mortgage banker. We'd live off fees." The Bermuda reinsurers, as well as a number of domestic players, are already positioning themselves as catastrophic-risk consultants.
Bullish analysts expect about $2 billion to $5 billion in new catastrophe bond issues this year, but their projections may be overly optimistic. Three relatively disaster-free years have allowed reinsurers, including Lloyd's, to replenish their capital bases and resume their traditional price wars. All the major investment houses are working on deals, but they will have a tough time matching reinsurance bids this spring. "We want to do part of it in the capital markets," says CEA Director Greg Butler. "But the bottom line is, the price has to be right."
Ironically, a serious disaster or two may be just the thing to tighten the market and make CAT bond issues, which currently are more expensive, a viable alternative to traditional reinsurance. Whatever the case, CATs are probably forever, and the insurance industry will never be the same.