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Investor Interest in Catastrophe Bonds Keeps Growing

Mounting natural disasters and healthy returns help swell the cat bond market.

When the Metropolitan Transportation Authority issued its first catastrophe bond this summer, New York joined the ranks of disaster-prone global hot spots like Florida, California, China and Indonesia. The MTA was responding to last October’s Hurricane Sandy, which left lower Manhattan in the dark and flooded several of the authority’s subway tunnels.

With infrastructure damage assessed at $4.8 billion, the MTA wanted to mitigate the cost of future devastation. A new category, storm surge protection, was created for the $200 million bond offering, which insures the city agency through August 2016. Goldman, Sachs & Co. and GC Securities, a subsidiary of New York–based professional services firm Marsh & McLennan Cos., underwrote the issue. Rated BB– by Standard & Poor’s, the MTA bonds pay 4.5 percent over Treasury money market funds. But investors lose their money if a storm surge exceeds predetermined levels — deemed highly unlikely by a risk modeling firm — in key areas of New York.

Cat bonds offer protection against so-called peak perils, such as typhoons, earthquakes and hurricanes. They tap the capital markets to cover unlikely but extreme events and transfer risk when traditional insurance capacity runs dry. As of mid-July there was $19 billion in outstanding cat bonds, according to Zurich-based Swiss Reinsurance Co.

Cat bond demand slowed after the financial crisis, but the market is growing again thanks to the increasing frequency and severity of natural disasters, along with rising real estate prices and business values in areas at risk from such events, explains Thomas Holzheu, U.S. chief economist with Swiss Re in Armonk, New York.

Warren Buffett helped pioneer cat bonds in mid-1996 by striking a deal with Northbrook, Illinois–based Allstate Insurance Co. to cover Florida hurricanes. Later that year the billionaire drew up a policy for the California Earthquake Authority that saw his Omaha, Nebraska–based Berkshire Hathaway assume all the risk until March 2001. In his 1996 chairman’s letter to investors, Buffett argued that the potential gains far outweighed the odds of a major catastrophe.

Goldman Sachs, Swiss Re and other firms began issuing cat bonds in the late 1990s. Nearly all are sponsored by insurers and reinsurers seeking to hedge their key risks. Including the cat bonds on its balance sheet, Swiss Re owns almost half of the market. Goldman is the top underwriter that doesn’t carry the bonds on its balance sheet.

The financial crisis thrust cat bonds into the spotlight when they proved to be uncorrelated with other asset classes, says Judith Klugman, head of insurance-linked securities sales and distribution at Swiss Re Capital Markets in New York. As investors battle low interest rates, decent returns have helped too. The Swiss Re Cat Bond Performance Indices’ noninvestable global index gained 8.32 percent a year, on average, from 2002 through 2012.

More than half of the capital in catastrophe-linked assets comes from pension funds, endowments and sovereign wealth funds, with the bulk of that amount invested in specialty funds, according to Michael Millette, New York–based head of structured finance at Goldman Sachs. Hedge funds, private equity funds, asset managers and life insurers own a further 25 percent, while reinsurers and high-net-worth investors each account for 10 percent.

The slim chance of paying out a claim is what drew John Seo, co-founder of cat bond specialist Fermat Capital Management, to the space in 1998. “It’s a stunning type of risk-reward,” he says, citing Buffett’s $400 million profit on a $1 billion trade with the California Earthquake Authority. Seo launched Westport, Connecticut–based Fermat, 80 percent of whose clients are pension funds, in 2001 after helping Lehman Brothers Holdings build a cat bond business. The firm’s returns have closely tracked the Swiss Re global index, he says.

Aashh Parekh, a director with the global public markets division of New York–based retirement fund giant TIAA-CREF, sees cat bonds as a compelling addition to any portfolio. “We view it as an asset class with attractive returns relative to the amount of risk embedded in the sector,” he says. But even though $523 billion TIAA-CREF boosted its cat bond allocation in 2012 after a postcrisis slowdown, he warns that such investments require much risk modeling research.

Like previous nascent bond markets — high-yield bonds in the 1980s and mortgage-backed securities in the 1970s — cat bonds will become a feature of institutional portfolios worldwide, Fermat’s Seo predicts. • •

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