With newfound interest from market participants and a significant increase in issuance, the insurance sector of asset-backed securities is expected to prosper in the year 2000, sources say.
"It's finally showing some normal life," said James Doona, a director in the capital markets sector of insurance ratings at Standard & Poor's Ratings Service. "It's been a long time coming. There's been about six billion dollars worth of issuance in the last three years but a chunk of that has been in the last year or so."
This evolving asset class, which debuted in 1996, includes, to name a few, catastrophe (cat) bonds, weather bonds, viatical settlements and elder settlements. Once considered a risky sector, it is now being described by some as the "wave of the future."
Doona explained that both the issuer and investor can benefit from insurance bond transactions. "Cat and weather bonds present investors with a source of return whose risks are uncorrelated to either interest-rate risk or credit risk," he said. "Normally, this opportunity has been limited to insurers, who are both registered and subject to stringent oversight. Since this class is an emerging sector right now, investors get an even higher payout compared to securities with similar default risks."
But why would an asset class with so many benefits continue to keep market participants at bay?
"The main issue that is confronting the insurance industry right now is that the vast majority of insured property is in relatively small places, such as the Atlantic coast of the United States or it's in western Europe or Japan or California," Doona said.
This among other things, creates a lack of opportunity to diversify.
"The problem is the re-insurers who serve as hedging counter-parties, they are basically exposed to the same risks as the people are seeking re-insurance," he said. "So the problem is, was and will be for awhile, how to diversify your capital needs away from these narrow risks."
Advantages of the Capital Markets
Because they are trying to develop a source of alternative re-insurance capacity, Doona explained that many of the active issuers in the insurance sector opt to use the capital markets even though they can complete their transactions cheaper in the re-insurance market.
Additionally, access to the capital markets helps to curb the default-risk factor as opposed to straight re-insurance transactions, Doona said.
"You know how if all the depositors of the bank need their money at the same time, you have a problem?," Doona said. "The problem with the insurance sector is that you know that when the big hurricane hits Miami, it can wipe out $60 billion to $75 billion of our insurance capital. Twenty percent to 25% of the re-insurance would evaporate overnight and that would probably trigger a domino effect."
On the other hand, he said, Wall Street is capitalized at over $12 trillion, so a disaster that could potentially wipe out a huge portion of the re-insurance capital would only slightly mar the New York Stock Exchange.
"What's $60 billion on $12 trillion? - that's less than half of a percent," he said. How frequently does the NYSE trade off half a percent a day? The issue is, that is not a lot of money for the capital markets and a huge amount of money for the insurance market to absorb."
There is also a significant amount of pressure on this market not to grow, in spite of all of the compelling reasons for it to grow.
"This is a pretty broad class," Doona said. "Right now there is this whole set of stuff out there that has not been very well securitized. There is a lot of stuff that could potentially be done."