While the catastrophe bond market is still in it's early stages, the asset class continues to gain credibility as a formidable sector that may soon involve the securitization of diverse disaster risks such as automobile accidents, airline crashes and satellite launches.

"There's been a lot done in hurricane and windstorm and earthquake risk securitizations but now we're starting to see people broadening their horizons a little bit," said James Doona, director at Standard & Poor's Ratings Service.

"A lot of people asking questions about things like private-passenger auto liability and even other types of risk. It's sort of similar to the packaging and bundling of exposures in the asset or mortgage-backed market," he added.

To be sure, it's an expanding market that is picking up steam. This year, approximately $657 million of catastrophe (cat) bonds have hit the market on pace with 1999, and far eclipsing issuance in years prior.

While market players are looking towards the future for new types of disaster risk, the latest deals are catching the eye of many market watchers.

In the average cat bond transaction, an offshore trust is set up in Bermuda or the Cayman Islands, from which bonds are sold. Funds garnered from the bond sale are then used to pay out any losses to the insurer in the case of a disaster, according to the specifications of the reinsurance contract.

The premium paid by the insurer pays the trust to make up the interest.

Alpha Wind Transaction

In Alpha Wind 2000-A Ltd., sponsored by Goldman Sachs' Bermuda-based subsidiary, Arrow Re, State Farm Insurance Co. purchased a reinsurance contract from Arrow Re which kept 10% of the risk and issued $90 million of notes. It was issued to protect against a hurricane loss in Florida.

The notes have a one-year maturity. One $52.5 million tranche of notes rated double-B-plus priced at 4.56 percentage points over the three-month Libor, roughly a 11.38% yield. A second tranche of $37.5 million of preference shares priced at seven points over Libor, 13.82% yield, were rated double-B by Standard & Poor's.

Insurance companies, mutual fund managers, banks and hedge funds bought the bulk of the notes. Goldman Sachs kept $10 million.

However, should a single hurricane hit and cause loss of over $2.43 billion to homes insured by State Farm over the next year, investors stand to lose both principal and interest. A hurricane of that nature only occurs once every 150 years.

Insurers Keeping Options Open

For issuers, the capital markets represent an alternative to traditional reinsurance markets. "It's something new for those people not familiar with issuing ... securitizing their exposures ... this is non-standard," said S&P's Doona. "But what were going through now is doing a few more [transactions] getting people more accustomed to this type of financing as more of a possibility."

Issuing a cat bond is more expensive in terms of time and money, yet there are incentives which may not be immediately realized. For one, it's a way to diversify capital coverage. Should the reinsurance market be met with a huge disaster costing $100 billion, for example, that one peril could wipe out capital. The key is alternative coverage.

Initially it will be larger companies to test the waters. "Issuers like State Farm are basically willing to try coming to the market," said Doona. "If this becomes a viable market and they'll be able to use it more down the road. They want to make sure they have all the options open."

Still, the market should be relevant to all players in the insurance market, he said. "Its really a natural thing for insurance markets to access the capital markets, in some sense it's a very natural progress," said Doona.

A Long Way, Baby

In addition, analysts say the capital markets will continue to soak up more business as the reinsurance market becomes more expensive. This process is sped by waves of disasters, such as was experienced in 1999's spate of storms, quakes and hurricanes, which deplete the reinsurance industry's capital.

In fact, the Alpha Wind transaction comes at a time when there is practically no difference in pricing between traditional reinsurance market and capital markets alternatives.

"We've been tracking the market for several years and it hasn't been cost-effective until now," said Jim Ament, vice president of State Farm in Illinois, in a recent statement.

To be sure, since 1997, when the first cat bond was rated by S&P, strides have been made in the sector, which is slowly gaining credence among market players. But as one source said, "Look at the mortgage-backed securities market. It didn't become commercially viable for several years."

"People are starting to get used to catastrophe bonds," he says. "They are really becoming accepted by some investors as a way to diversify their risk profile."

Although insurance risk is very new to the public, it can be analyzed, purchased and managed much like any other securitized product. "It just happens to be some thing that's new and buyers tend to be conservative," said Doona, regarding initial investor skittishness towards the asset class.

Proceed With Caution

Cat bonds are privately placed in the Rule 144A market, often referred to as a testing ground for new types of securities, and will likely stay in the market for some time. Regardless, investors involved in the transactions can expect rich returns from the relatively new and risky asset class.

"You're getting something like 4, 5 points plus Libor, so you're getting paid very well for the risk taken," said Doona. "Nobody buying these things can think there's no likehood of a catastrophic outcome."

Which is part of why the securities have stuck to the Rule 144A market, he says. "Those who can buy these things have to be sophisticated, consider a complete wipeout and recognize they are getting paid for that risk."

Most Cat bond ratings fall in the double-B to low triple-B range except those with principal protected, through some kind of defeasance clause whereby a certain amount of money is set aside to protect the principal.

"Partly because it's a new asset and there's significant uncertainty in the length of payoff or what scenarios are," added Doona, referring to the dearth of A-range credits.

"We consider it a credit cliff - the notion that a catastrophic event will cause that note to default makes it unlikely for significant time enough for downgrades," he said. Credit would drop off instantly, rather than steadily declining. "It's good, and then it's all of a sudden not good [when a disaster hits]."

While the market may not be ready to eclipse the traditional reinsurance market or be ripe for every investor right now, most signs point to a bright future for these types of transactions.

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