Contacted recently for his views on the growing catastrophe (cat) bond market, Jeff Sica, founder and chief investment officer of Sica Wealth Management, professed his lack of knowledge about these ABS. In effect, they insure state and private entities against risks stemming from hurricanes and other natural disasters. A few days later, however, after researching cat bonds' risk characteristics and performance, Sica was a fan.

"As long as the underwriting stays the way it is, and the current risk/reward is still there, I will almost certainly put cat bonds in my portfolios," Sica said. "They definitely look like investments that create a level of non-correlation, diversification and potential return that we're just not getting anywhere else."

That's music to the ears of long-term players in the cat bond market, which saw its first deal in 1997 and its annual volume numbers ebb and flow ever since. The volume of new issues in 2011 was $4.5 billion, down from $5.2 billion the year before. Already exceeding last year's volume as of early September, 2012 is expected to top $6.5 billion and may even surpass 2007's record $7 billion in issuance from 27 offerings.

If so, it will be in large part because the State of Florida issued in April the largest cat bond ever from a state-related entity. The deal may prompt issuance by several new government agencies, not only because it was unabashedly successful but also because it illustrated how the market is adapting to issuers' needs.

In addition, the sector has attracted stable institutional investors that have become more comfortable with the asset class and crave its relatively high returns and lack of correlation to the economy and other financial markets.

"We lost the bond market - we're out of anything providing yield because of the downside risk - and the stock market is topsy-turvy. There's just not that much else to do," Sica said.

Market participants mostly predicted a similar volume number next year, although they quickly hedged by noting variables, including the performance of competing markets such as reinsurance and collateralized reinsurance, that could change the outcome. In fact, even new issuers, whose deals received warm welcomes earlier this year, discussed the cat bond market's benefits while noting no commitment to it.

"We're going to maintain the same [$450 million] level of coverage for hurricanes, but in the future it's really a pricing and design issue in terms of what we think will work best," said Steve Cottrell, chief financial officer of the Louisiana Citizens Property Insurance Corp., a government-established insurer of last resort.

The non-profit organization's $125 million, three-year Pelican Re offering was originally slated at $100 million. Louisiana Citizens' coverage needs, however, are relatively small compared to those of Florida's Citizens Property Insurance Corp., which appears to be a bellwether transaction in the cat bond market.

The deal was originally slated to raise $200 million, an amount that was increased to $250 million when the deal went to market. Demand was so strong, however, that the Everglades Re trust ultimately sold $750 million in bonds that complemented another $750 million in reinsurance that was placed at the same time.

Florida Citizens was mostly self-insured previously. John Seo, co-founder and managing principal of Fermat Capital Management, probably the largest fund devoted to cat bonds, said that catastrophe-protection seekers typically must buy re-insurance before issuing cat bonds."If you can't get people on board with the reinsurance, then it's assumed you can't do the cat bonds," Seo said. He added that the Florida Citizens deal was "sort of like watching folks leapfrog the automobile and go straight to jet airplanes."

Because Florida is surrounded by ocean and private insurers have been unwilling cover all the risk, Florida Citizens is among the top 15 providers of property insurance in the country - directly taking on the risk of the homeowners and businesses it insures. In addition, its reliance on reinsurance has been sporadic. So when Florida Citizens' board gave the green light for the then-forthcoming cat bond deal last December, it came as a pleasant surprise to the market. Given Florida's prominence in the North American wind region, Seo said that "even if it had come to market with a $150 million bond offering, it would have been very significant."

Sources said Fermat was an investor in the Everglades Re deal. Seo declined to comment.

Sharon Binnun, chief financial officer of Florida Citizens, said the relative lack of significant storms in recent years has allowed the agency to build up a surplus, but that could quickly be exhausted with a series of storms in a single season or one large storm. In addition, the agency doesn't charge "actuarially sound" rates because of a legislative mandate to ensure affordability; this means the agency's premiums do not sufficiently cover the risk it insures, and it has little funding to purchase reinsurance.

"That made it difficult for many years for management or the board to support the huge spend on private reinsurance to cover the low likelihood of a catastrophic event," Binnun said. Reinsurance purchased in 2005 did cover damages from Hurricane Wilma, but there was no significant weather event following reinsurance bought in 2008. No reinsurance was purchased in 2009 and 2010, and fortunately there were no significant storms. Without reinsurance or some other way to transfer risk regularly, however, a major storm could leave Florida Citizens with massive insurance payouts and require it to raise assessments significantly.

Binnun realized it was essential to transfer at least some of that risk and, just as importantly, establish Florida Citizens as a reliable and regular source of catastrophic risk exposure for investors. Binnun had been analyzing the cat bond market for some time, she said, and in 2012 the stars aligned. The surplus provided sufficient capital, and the cat bond market had evolved enough to compete effectively with the reinsurance market on price.

After receiving board support, she incorporated plans to transfer the risk via an Everglades Re bond issuance in the 2012 budget prepared last December, alerting investors to Florida Citizens' plans and enabling them to allocate capital. Binnun attributed the ability to increase the deal massively to that early warning and noted that 30 of the 35 investors invested in cat bonds but not reinsurance.

"I view that as 30 new sources of risk transfer for Citizens. That was huge for us," Binnun said, noting that about half the investors were money-management funds that traditionally have invested in cat bonds, about a third were hedge funds, and the rest were a mix of traditional reinsurers, pension funds, and other money managers.

One of the main benefits to the deal was pricing, not only on the cat bonds but for nearly simultaneous and complementary risk transfers. Binnun said the rate to investors on the cat bond is 17.75%, and after including underwriting fees, closing costs and other expenses, the net to Florida Citizens is 19.089%, or a cost of $143 million for $750 million in risk transfer. By comparison, Florida Citizens paid a rate of 21.5% the year before for $575 million of traditional reinsurance in 2011.

The cost savings the insurer achieved for this year's risk transfers alongside the cat bond are even more impressive. Florida Citizens also bought $500 million in reinsurance above the cat bond layer and privately placed $250 million in the form of collateralized reinsurance alongside the cat bond with two reinsurers - redboth two years in length. The rates on those transactions are 17.095% and $18.75%. "The cost in pure dollars to transfer that risk came down significantly for us, to $40 million" and change, Binnun said.

The Pelican Re deal also resulted in savings for Louisiana Citizens, which has been a long-term purchaser of reinsurance. Cottrell said that the Japanese tsunami and Risk Management Solutions' hurricane model change (see sidebar on p. 16), which both took place in 2011, pushed up prices and prompted the insurer to look at alternatives. By selling $125 million in cat bonds, Louisiana Citizens reduced its reinsurance needs to $325 million from $450, leaving the same number of reinsurers to go after a smaller piece of the pie."We were able to buy in 2012 coverage that was comparable to what we bought in 2011 for about 5% less - good savings, especially when we're spending $60 million to $70 million a year on reinsurance," Cottrell said. "We figure we saved about $3 million to $4 million on our reinsurance buy."

Increasing the competition among reinsurers to bring down costs works only if cat bond investors are distinct from reinsurance providers. Cottrell estimated that overlap to be 20%, so the remaining 80% - the top five of which were investment managers - represented a new source of insurance capacity for Louisiana Citizens (see table).


Investor Appetite

Demand for cat bonds comes from dedicated insurance-linked securities funds, from hedge funds and increasingly from pension funds, sovereign wealth funds, high-net-worth individuals and endowments, of which a relatively small number buy the bonds directly and most invest through investment funds.

In fact, said Cory Anger, global head of insurance-linked securities structuring for GC Securities, the investment banking arm of reinsurance broker Guy Carpenter, the shift to more long-term, "stable" money and away from more opportunistic hedge fund capital may be the most significant recent development. "It's not new, but the pace with which it's been coming into this space has dramatically increased over the last year," she said. London-based Leadenhall Capital Partners' chief executive officer Luca Albertini said his four-year-old fund - a joint venture with insurance and reinsurance underwriter Amlin Group - got its first pension-fund investors last year, and now 83% of its $770 million in capital comes from mostly European pension funds. "We're going from an investor base made of hedge funds looking for quick returns, often using leverage pension funds with stickier, long-term views," Albertini said.

The Royal Bank of Scotland Group pension fund, for example, reportedly reduced its portfolio of equity futures and shifted some of those funds to alternative investments, including reinsurance. The Ontario Teachers' Pension Plan, a long-time investor in cat bonds and cat-bond funds, went a step further earlier this year and invested directly in Dutch reinsurer ANV Holdings. Nephila Capital, the largest fund investing in peril risk, has seen the Oregon Public Employees' Retirement Fund, the Pennsylvania Public School Employees' Retirement System and other pension systems commit to its funds in the last year or so.

Another cat bond shift that could serve to draw more state-entity issuers is the move toward indemnity-based triggers. Early on, cat bonds were mostly structured with parametric triggers that activated when storms reached pre-established intensity levels, allowing issuers to keep principal. Such bonds provide the advantage of paying quickly after being triggered, and because they're based on the likelihood of specified types of events occurring, they are relatively simple to put together and analyze and tend to be less costly for issuers. However, a hurricane could result in significant damage without quite reaching enough intensity to trigger a payout, resulting in significant basis risk for issuers.

Indemnity-based triggers, on the other hand, pay out when losses reach a pre-determined amount. Florida Citizens' so-called "attachment point" is $6.3 billion. "When I first started looking at cat bonds in 2008, I saw very few indemnity-based triggers and more were parametric," Binnun said. "With indemnity, we can plan better because we can better gauge how we're going to be able to pay for different loss scenarios."

The increased use of indemnity triggers in part reflects more cat bond issuance by state insurance entities. They have all used indemnity triggers going back to the first issuance by a state entity when Parkton Re, sponsored by the North Carolina Joint Underwriting Association and North Carolina Insurance Underwriting Association, issued $200 million in bonds in 2009.

Some U.S. private-company issuers have also switched to indemnity triggers, including Liberty Mutual and Travelers in their most recent cat-bond deals. Barney Schauble, a principal at Nephila Advisors, the U.S. affiliate of Nephila Capital, noted that the increasing use of indemnity triggers is drawing the reinsurance market and cat bond market closer together.

"It means the cat bond market is looking more like the reinsurance market, and the risk is just being placed with different investors," Schauble said.

Indemnity deals require investors to look under the hood at a sponsor's claims, underwriting and other processes. And for that reason, indemnity triggers are most appropriate for pools of individual policies rather than large and complex commercial ones, since policies for individuals are simpler to analyze and in large pools they diversify risk.

"For investors, there's generally more comfort around the modeling for pools of individual-policy risk. It's a more homogenous portfolio, and there's not as much risk concentration," said Paul Schultz, chief executive officer of Aon Benfield Securities. In addition, most state-entity sponsors outside the U.S. cannot yet capture data of sufficient quality to use in models. As a result, none that have tapped the cat bond market, such as Mexico's FONDEN, have adopted indemnity triggers.

"What would be a major shift would be if one of the large European sponsors start doing indemnity deals" in Europe, said William Dubinsky, head of insurance-linked securities at Willis Capital Markets & Advisory, a unit of major insurance and reinsurance broker Willis Group. In the U.S., the states whose government entities are seen as candidates to enter the cat bond market include New York, South Carolina and Texas.


Secondary Market Pricing

Whoever takes the leap in the near term can expect to find plenty of demand. Craig Bonder, head of insurance-linked securities trading at Rochdale Securities, noted that cat-bond prices in the secondary market typically fall toward the start of hurricane season, and move up closer to par in September. Another indication of institutional investors' increasing demand for exposure to peril risk is what appears to be significant growth in the collateralized reinsurance market. The contracts are similar to reinsurance, but investors in them - typically the same type that invest in cat bonds - don't meet the security guidelines that sponsors mandate of their reinsurance providers. So sponsors require them to collateralize the deals fully by putting cash or Treasury bonds into a trust that becomes available to issuers when a deal is triggered. When reinsurers meet issuers' security guidelines, they are trusted to fork over the full amount after a trigger event. With collateralized reinsurance, because providers place collateral in a trust that's equal to 100% of the policy, issuers can be sure that capital is available should the transaction be triggered.

Anger said the recent development of the collateralized reinsurance marketplace can provide investors, ranging from hedge funds to pension funds to money managers, with exposure to small and midsize insurers that do not have the capacity needs to access the cat bond market."It's a way to diversify the risk they're assuming as well as what clients they're assuming risk from," Anger said, adding that key renewal dates for year-long reinsurance contracts are the first days of January, April, June and July, a hindrance for some investors that collateralized reinsurance addresses.

"These investors have to deploy capital throughout the year and not just around renewal dates," Anger said.

The collateralized reinsurance market also reflects those investors' demand for peril exposure that is not being met by the reinsurance and cat bond markets. Dubinsky noted that outstanding collateralized reinsurance transactions may, in fact, "slightly exceed the outstanding cat bond notional for 2013." Much of that will likely come from cat bond issuers, such as Florida Citizens and its $250 million in collateralized reinsurance. The California Earthquake Authority (CEA) recently completed a $300 million reinsurance contract with Embarcadero Re, which turned around and sold $300 million in cat bonds under complementary terms. Tim Richison, the CEA's chief financial officer, said the organization's increased purchases of collateralized reinsurance have been driven mostly by investors seeking exposure to earthquake risk through brokers who set up the anonymous transactions. "In one program with a placement coming up in January that will be a little over $700 million, about $80 million to $90 million of that will be collateralized," Richison said.



Issuers Shun RMS While Investors Use Firm's Models

Since Risk Management Solutions (RMS) changed its hurricane model in March 2011, no issuers seeking coverage for wind storms have chosen the firm's model to use in their cat bond offering materials, but that doesn't mean investors haven't taken notice. RMS, a top risk-probability modeler alongside AIR Worldwide, routinely captured more than half that market prior to the model change, which increased the "one in 100 year" U.S. hurricane industry loss - the biggest component of the cat bond market - to $180 billion from $120 billion.

Such hurricanes are obviously rare, but should one occur, it could put investors on the hook for significantly higher payouts and prompt them to require issuers to pay much higher spreads. Issuers could potentially use RMS's baseline model, which employs a historical average of how many hurricanes have made landfall and assumes that the future will be like the past. That model changes little, and that stability aids investors evaluating and trading cat bonds. Issuers fear, however, that tapping RMS for the offering materials would draw rating agency scrutiny and require acknowledgement of the firm's new medium-term-rate model, introduced in March 2011. That model blends historical data with forecasted rates of hurricane activity that the risk firm sees rising due to warmer sea surface temperatures, which have been scientifically linked to a higher likelihood of hurricanes."The biggest driver of the increase in the industry loss hurricane risk was the change in medium-term rates," said Peter Nakada, managing director of risk management solutions at RMS. "We're the only modeling firm that uses this approach." Nakada said issuers are also concerned that tapping RMS would prompt investors to pay greater heed to the medium-term-rate model, except that concern is all but moot considering 25 of the largest investors already license RMS' cat bond portfolio-management platform, which includes the medium-term-rate model.

Luca Albertini, chief executive officer of London's Leadenhall Capital Partners, noted that either RMS got its hurricane modeling "phenomenally wrong" or some heed must be paid to it, and that even using the best models the market has to offer, there isn't one answer for the probability of hurricane risk. "The models are pieces of information, and it's healthy to show two different views on the world. They key is you need to underwrite these deals," Albertini said. Whether issuers eventually adopt aspects of RMS' medium-term-rate model in their offering materials remains to be seen. For its part, RMS has publicly acknowledged that there's merit to capital-markets participants selecting the baseline view, since stability over transactions' two- or three-year life spans is important. - John Hintze

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