As the fear of interest rate rises threatens virtually every market in the world from sovereign bonds to high-tech stocks to emerging market securities investors may no doubt be wondering where they can seek refuge.
Such an anxious environment may be the best thing to happen to catastrophe bonds, aka cat bonds. These structured financings, which transfer some of the catastrophic risk of property-casualty insurers to investors, have been struggling to get off the ground for the past several years. Investment bankers are trying to convince investors that, although cat bonds may be risky, such risks have nothing to do with interest rates and are thus not correlated with other financial assets. Bankers hope eventually the market will be akin to mortgage-backed or other asset-backed securities.
While most of the work on cat bonds has been done in the US, it was in Zürich last month that the largest, and first, public cat transaction was offered. Credit Suisse First Boston (CSFB) arranged the three-year Sfr400 million ($281.7 million) subordinated convertible bond for Winterthur Insurance, which was based on the risk of hailstorm damage to automobiles. The deal was sold to retail investors and trades on the Zürich Stock Exchange. Investors will get a 2.25% annual coupon, which will be knocked out if any single hail or other storm damages more than 6,000 motor vehicles insured during the year with Winterthur in Switzerland. The principal is guaranteed and after three years the bonds are convertible into Winterthur shares. The 2.25% coupon is higher than the 1.49% a traditional convertible would offer in Switzerland.
Bankers say that if deals are structured right, investors are clamouring to buy in. "We have a shortage of good deals, not a shortage of people who want to put money in them," says John Kelly, a managing director at Citicorp Securities, which has been one of the leading banks in the nascent market. He says Citicorp has structured several $100 million cat private placements in recent years. Its latest, a $100 million November deal for Hanover Re, was oversubscribed. Kelly says the deal, a multi-year transaction in which investors were allocated a notional amount of risk in a diversified portfolio of risks originated by Hanover, was successful because it was leveraged, offered investors diversification with a company with a track record, and and could provide yields "north of the other deals in the market". Citicorp has about 20 institutional investors interested in the deals, says Kelly. While principal protection appears to be the key to getting some deals off the ground, Kelly says these investors don't mind sharing risk with the reinsurer as long as they are compensated similarly.
Last month, Goldman Sachs issued the first 144A private-placement cat bond in the US, a 10-year $68.5 million securitized reinsurance transaction for St Paul Re, the reinsurance arm of the St Paul Companies, a US based insurer. However, the deal ended up much smaller than the $200 million offering originally planned and had to be separated into two tranches notes whose principal is guaranteed and preference shares whose principal is at risk.
Merrill Lynch is restructuring a public $500 million one-year (renewable for three) hurricane-risk cat bond for the US-based United Services Automobile Association (USAA) which recently was pulled for lack of investor interest. Individuals close to the deal say the revised transaction should close in the first quarter. In addition to the Winterthur deal, CSFB is also expected to close by April a $100 million public two-year deal for a European reinsurance company that will cover Californian earthquake risk.
Many investors who are more knowledgeable about interest rate risk than that of natural disasters are still wary of the new deals. "It appears pretty clear that the capital markets are not receptive to a complete risk transfer," says Jonathan Plutzik, an insurance analyst at CSFB, a position contrary to Kelly's assessment. "Investors are not going to buy securities with a risk of losing all their interest and principal." Bankers are "wrestling with how to strike the balance between risk and reward," he says.
As a comparison, investors look to the returns of reinsurance companies, which have been high in the past two years because of a decline in natural disasters since 1994, the year of the Los Angeles earthquake. Indeed, some of the Bermuda reinsurers set up to deal with huge catastrophe losses suffered between 1989 and 1994 have had returns in the 30% range. Some private deals have sought to offer such high returns, but with a higher risk profile. For example, last year's private placement by American International Group offered a maximum 25% return, but also had a 25% risk of principal loss, according to CSFB.
Citicorp's Kelly says reinsurers can earn better returns because of their leverage an element that is often missing in the public cat bond deals. "These public deals operate on a leverage of one to one," says Kelly. "For every $100 of liability, the investor puts up $100 in capital against it. It creates a sub-par return." Reinsurers would have a leverage of five or six to one, he says.
In general, cat bonds offer investors a coupon on a securitization that is created from what's left from the premium the insurers charge and the investments of the debt issuance after the bankers subtract their fees. Although typically these securities are structured to offer a set coupon, the overall return would be lowered if catastrophic losses were to rise above a set point, called an attachment point. Then the insurer taps the pool of money to cover his losses and the notional amount in the vehicle is decreased.
For example, in the original USAA deal, which was shelved, investors could theoretically have lost all their money for a return that was based on a coupon only 600-700 basis points above US treasuries. The deal also covered only a single risk, instead of a diversified pool. USAA, which insures the home and property of the US military among others, was hard hit by Hurricane Andrew, which swept across Florida in 1992 and caused catastrophic losses of close to $20 billion. As a result, USAA wanted to create a vehicle specifically to cover future hurricane losses. With its own capital of $4 billion, USAA set the attachment point at $2 billion, which meant that losses above that amount could be drawn from the bond proceeds.