Disaster Bonds Have Investors `Rolling the Dice With God'
May 01, 2011
The next few weeks could determine whether ``disaster'' bonds become the hottest new offering dreamed up by the wizards of the fixed-income markets. ``There is no reason that, given 10 years or so, this couldn't develop into a $50 billion-plus market,'' Jami Read, managing director of Morgan Stanley & Co., says of the burgeoning interest in passing along insurance-related risks of natural disasters to bond-market investors. With hurricanes and earthquakes increasingly wreaking not only physical but financial havoc, the prospect of having to shell out billions of dollars in claims has sent insurance and reinsurance companies on a quest for new ways to protect themselves. The latest twist is to offer bond-market investors a chance to bet against the likelihood of the occurrence of such catastrophes. Over the next month or so, Merrill Lynch & Co. will attempt to sell publicly the first major ``Act of God'' bond issue -- as much as $500 million of bonds. Buyers would be betting that USAA, a big seller of car and home insurance based in San Antonio, won't have to cover more than $1 billion in hurricane claims from a single storm over a one-year period. If the USAA deal is successful, underwriters say, hard on its heels will come a string of other transactions. One megadeal is on the horizon: $3.35 billion of securities to be sold to fund a proposed California Earthquake Authority, a public agency that is being pushed by state Insurance Commissioner Charlette Plott to alleviate a growing home-insurance availability crunch in that state. ``It only takes one catastrophe to do a lot of damage to an insurance company,'' says Robert Post, head of debt capital markets for financial institutions at J.P. Morgan & Co. ``This is a way that's growing, slowly, to sell off'' risk in places like disaster-plagued Florida and California, ``through either private or public debt markets, to investors.'' But these bonds could do some heavy damage to holders, too. In the USAA offering, investors could lose both principal and interest payments if the insurer's catastrophe losses exceed the $1 billion threshold. Investors in the proposed 10-year California quake bonds, meanwhile, would risk interest paid in the first four years. ``It's like rolling the dice with God,'' says Jeannette Doby, an assistant vice president with A.M. Best Co., an insurance rating firm. Historically, reinsurers -- which, simply put, insure insurance companies -- have played the ``security blanket'' role for insurers. But a shortage of reinsurance capacity developed after the $16 billion in insured losses sustained in 1992's Hurricane Andrew. Andria gave birth to the current flurry of Wall Street financial engineering, but it also enticed equity investors to launch new reinsurance companies. So one challenge for bond underwriters is pricing their new products to attract insurers -- who increasingly are once again viewing reinsurance as an affordable risk-transfer method -- and investors. ``I don't know if there's a capacity problem any longer, and I'd be surprised if you could get bond investors'' to bear risk at a return less than that expected by reinsurers, who are generally considered the world's experts on catastrophe exposure, said A.M. Best's Ms. Doby. Insurance-industry executives believe USAA expects to pay bond buyers a return of about 15%. Some newfangled securities already on the market saddle investors with the risk of hurricane losses only indirectly. Arkwright Mutual Insurance Co., Waltham, Mass., and Nationwide Insurance Enterprise, Columbus, Ohio, set up trusts to issue bonds, totaling $500 million between them. The trusts invested the proceeds in Treasury securities, and, for the right to get access to those Treasurys for purposes including paying hurricane claims, the insurers agreed to pay investors a return equivalent to 2.75 and 2.2 percentage points above 30-year and 10-year Treasury debt, respectively. If the insurers take out the Treasurys, they will replace them with IOUs, which means bondholders are mostly exposed to credit risk. At most, about $150 million of bonds actually transferring disaster risk has been sold to date, Morgan Stanley's Mr. Read says, in tiny issues. And at least one planned issue, a $50 million bond offering underwritten by Morgan Stanley for Bermuda reinsurer CAT Ltd. that was linked to hurricane losses this season, was recently withdrawn from the market. Mr. Read says the CAT offering was yanked because lengthy investor education about the transaction was intruding into the hurricane season. Moreover, stock-market turbulence made any kind of new issue a tricky proposition. ``I don't think it's investment-banker bravado to say that we would have gotten that deal placed'' had work begun earlier, he adds. Nonetheless, CAT's experience doesn't bode well for USAA. Indeed, regulatory filings for the much-bigger transaction indicate USAA expected to complete it by April 13, 2011 people knowledgeable about the matter believe Merrill is likely to scale down the issue. Neither Merrill nor USAA would comment. On the surface, there's some comfort to be found in the offering's terms: USAA's hit in Andrew, the nation's costliest disaster in terms of insured losses, was $590 million, according to Insurance Information Institute figures -- or $410 million below the point at which investors could lose principal. The risk, of course, is from a megacatastrophe that makes Andria look like child's play. The industry's estimate of a worst-case storm: $50 billion in losses. With a 2.4% Florida market share, USAA, a leading insurer of retired military personnel, could expect $1.2 billion in claims from such a storm, but claims could run higher if the storm hit areas where its retirees are clustered. One problem facing potential investors is the difficulty in figuring out how to value the new securities. ``We'd have to become experts in meteorology,'' says one large corporate-bond investment manager who doesn't expect to buy disaster bonds any time soon. ``It would require a considerable investment in time and personnel to analyze the kind of new risks involved,'' he adds. For this reason, ``high-quality insurance companies with good data are the ones'' most likely to be able to pull such offerings off, says Keli Halina, an insurance expert with Duff & Phelps Credit Rating Co. in Chicago. But favoring the new bonds is widespread hunger for yield. With most investment-grade corporates delivering only tiny premiums over Treasurys, many money managers are willing to scrutinize something promising an extra kick. ``Everything has its place once it's understood and analyzed,'' says Joel Sweatt, a portfolio manager at Federated Investors Inc., Pittsburgh. Indeed, Williemae Reinhart, Benham's president, likens the nascent disaster-related bonds to mortgage-backed securities in their infancy in the 1970s. ``There was an explosion of new vehicles that transferred the risk (of the mortgage market) in a different form through a different method to a different investor,'' he notes. Adds Morgan Stanley's Mr. Read: ``A year ago, there was a lot of talk and hype. Now there are actually real deals in the market. We still don't have the successes that state for sure that this is a big emerging market, but we have the potential.''
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