Insurers look to cat bonds

According to Swiss Re, natural catastrophes cost the insurance industry around $31bn, while man-made disasters caused claims of $5bn.

In the first 11 months of this year, eight events caused insured losses of more than $1bn. The costliest event for insurers was the earthquake which struck Chile in February. Estimated insured loss: $8 bn.

Another disaster in the Mexican Gulf region concerning the BP Deepwater Horizon oil rig explosion in April this year, is expected to result in insured losses of $1bn. According to Swiss Re, there is still uncertainty about the eventual loss, because the complexity of the claims.

For instance, Swiss Re has not included liability claims in its loss figures. Although the Haiti earthquake in January caused the largest death toll of 222,570 lives, insured losses were minimal.

Despite significant higher than average earthquake losses, overall claims this year were in line with the 20-year average due to unusually modest hurricane losses in the United States. However, the Swiss Reinsurer stated that the total cost of natural catastrophes this year may increase further because of the ongoing European winter storm season.

Regarding catastrophes as mentioned above, a step to catastrophe bonds, or cat bonds, is made easily. These are risk-linked securities which transfer a specified set of risks from a sponsor to investors. These are often structured as floating rate bonds, in which principal is lost if specified trigger conditions are met. If the cat bond is triggered, the principal is paid to the sponsor by the buyers of these bonds. Triggers are typically linked to major natural catastrophes like hurricanes, earth quakes and other disasters.

Sponsors (issuers) of cat bonds can choose how the principal impairment is triggered, varying from indemnity (actual losses) to parametric (indexed). A parametric based cat bond is, for instance, triggered by wind speed in case of a hurricane bond. Earthquake bonds could be triggered if a certain ground acceleration takes place.

Cat bonds are typically used by insurers as an alternative to diversify/transfer its risk to other parties. Categories of investors participating in this market include for hedge funds, specialized catastrophe-oriented funds, and asset managers. Also life insurers, reinsurers, banks, pension funds, and other investors (with deep pockets) have can participate in offerings. Participants are able to diversify its portfolio to be less dependent of for instance the stock, bond and commodity markets.

To give an impression of the cat bond market: in 2007 approximately $5bn of cat bonds has been issued. In 2008 the total amount of catastrophe bonds was almost $3bn, last year 2009 approximately $1.4bn. In the three quarters of this year, more than $2.5bn of cat bonds has been issued. The 'ledger' of the last quarter of 2010 is still counting, heading towards the level of issuances in the year 2008.