Spreading, the risk: the capital markets have acquired a healthy appetite for insurance-linked securities as a supplement to traditional reinsurance. Proponents say tightening spreads will elicit further interest in these products. Others are less sanguine

Risk & Insurance, Sept 1, 2005 by Linda Corman

When insurance-linked securities emerged a decade ago, buyers were largely reinsurance companies that took advantage of the opportunity the bonds afforded sponsors to insure themselves against major, natural catastrophes. Reinsurers, and some insurers, also represented the vast majority of the investors in the bonds.

Over the last 10 years, the sponsor base has expanded to include insurers and a smattering of large corporations. At the same time, the range of events covered has broadened from natural catastrophes--largely hurricanes and earthquakes--to the risk of cancellation of the World Cup, industrial casualty and mass death. A whole separate category of the bonds, linked to life insurance policies and primarily designed to offset insurers' costs of holding reserves, has also emerged.

On the investor side, the reinsurance and insurance companies that accounted for 55 percent of investments in 1999 have been supplanted by hedge funds and funds dedicated solely to investing in insurance-linked securities.

"The market has evolved a lot," says Christopher Lewis, director of alternative risk management at the Hartford Financial Services Group, the diversified insurance company of Hartford, Conn., which sponsored its first insurance-linked security, a $247.5 million CAT bond, in November of last year to cover hurricane and earthquake risk. "It's now a very good supplement to traditional reinsurance. Five to seven years ago, it wasn't."

While growth has been steady, it has not been exponential. Early on, this was probably because of insufficient investor interest, says Nelson Seo, a managing partner of Fermat Capital Management of Westport, Conn., investment managers who specialize in insurance-linked securities. But over time, investors have grown more comfortable with the securities, and they have diversified and proliferated, says Ken Bock, managing director of Munich America Capital Markets of New York. Munich America's parent company, Munich Re, has both underwritten and sponsored insurance-linked securities.

Funds specializing in CAT bonds emerged in about 1998, says Mike Millette, managing director of the New York investment bank Goldman Sachs & Co. Currently, there are about six such funds managing about $4 billion. Hedge funds began investing heavily in the market in 1997 to 1998. Hedge-fund participation fell following the market disruption of 1998.

But in the last year and a haft, these funds have re-emerged, especially attracted by the relatively high yields insurance-linked securities offer as spreads overall have tightened.

From an investor's standpoint, the insurance-linked securities have lived up to their promise. There have been no losses, returns have been good, the market has become reasonably liquid, and they have provided their vaunted diversification.

"If anything, they've turned out to be a better portfolio diversifier than expected," says Millette. "They performed very well in the bad economic patch around 2001."

Moody's Investors Service, the New York ratings agency, has rated 75 percent of the CAT bonds that have been issued, and none of them has triggered a loss, says Rodrigo Araya, vice president and senior credit officer at Moody's. There has been just one downgrade, he says.

Even though spreads have tightened recently, investor interest remains strong, and some issues have been oversubscribed, says Araya.

At the same time that spreads have narrowed, expected loss is up. Trading multiples have fallen, says one major institutional investor. But that has not discouraged him or other investors. Demand for the securities is so strong that this investor says that if he wanted to, he could sell his entire portfolio immediately.

Satisfied as investors are with the bonds, they admit they have limited appetites for below investment-grade bonds (as most CAT bonds are).

Despite this constraint, analysts now say the market is being held in check by a limited number of sponsors. The modest sponsor interest has been attributed to a variety of causes. Early on, reinsurers were the predominant sponsors because they best understood the risks being transferred, analysts say.

For many years, for example, USAA was the only primary insurance company to sponsor an insurance-linked security. "The primary insurers were hesitant to try something new," says one investor of insurance-linked securities.

A VOTE OF CONFIDENCE

But in the past year, there have been signs that this may be changing. Hartford's sponsorship in November may well be a turning point heralding a wider use of the bonds by primary insurers, this investor says.

In June of this year, Oil Casualty Insurance Ltd. of Bermuda, a primary oil-industry insurer, sponsored its first CAT bond, as did FM Global, a property/casualty insurer based in Johnston, R.I. A French primary insurer has also sponsored its first CAT bond in a private placement in the past year, said the ILS investor.

Because the Hartford is widely viewed as cautious, its move into the market may encourage other insurers to follow its lead, says this investor.