‘Hole-in-One’ Cat Bonds Rank as Top Asset Eluding Japan Disaster's Grasp

Catastrophe bonds may escape Japan’s worst earthquake mostly unscathed, outperforming stocks, commodities, junk-rated debt and the reinsurers they’re meant to protect.
Insurers and reinsurers typically sell cat bonds to help cover their most extreme risks such as an earthquake rocking Tokyo or a hurricane with the force of Katrina hitting the center of Miami. This month’s earthquake in Japan struck about 240 miles (380 kilometers) northeast of the capital, meaning investors may pay insurers less than 10 percent of the $1.7 billion of debt sold to help cover losses, said Niklaus Hilti, head of insurance-linked strategy at Credit Suisse Group AG. (CSGN)
“It’s almost like hole-in-one insurance,” said Nelson Seo, co-founder of Westport, Connecticut-based Fermat Capital Management, which oversees about $2 billion, including cat bonds. “It’s been very good returns, and most of the investors in this space have been very happy with it.”
Cat bonds, whose owners risk losing their entire investment if a disaster occurs exactly as defined under the security’s terms, have returned 64 percent over the past five years through March 18, with annual gains even following Hurricane Katrina in 2005 and the collapse of Lehman Brothers Holdings Inc. in 2008, according to the Swiss Re Cat Bond Total Return Index. Only two bonds among the more than 300 tranches issued have ever suffered notable losses as a result of disasters, according to Moody’s Investors Service.

Relative Returns

The returns on cat bonds compare with global gains of 54 percent since March 2006 for Bank of America Corp.’s Global High-Yield Index and the UBS Bloomberg Constant Maturity Commodity Index. Stocks on the MSCI World (MXWO) Index returned 10 percent in the same period, while the Bloomberg Europe 500 Insurance Index, which includes four of the world’s six biggest reinsurers as well as companies forming the Lloyd’s of London insurance market, lost 21 percent.
“The triggers are very specifically defined,” said Tom Keatinge, managing director in JPMorgan Chase & Co. (JPM)’s insurance capital management team in London. “Typically for a cat bond to trigger you need a bull’s eye to be hit instead of a general shot in the right direction.”
The 9.0-magnitude earthquake that struck off the coast of Japan near Sendai on March 11 unleashed a tsunami that engulfed towns, triggering the worst nuclear catastrophe since Chernobyl.

Insurers’ Losses

While the actual economic toll may be $200 billion to $300 billion, according to risk modeler Risk Management Solutions Inc., the disaster may cost insurers and reinsurers $12 billion to $25 billion, according to a March 16 estimate by catastrophe- modeling firm Eqecat. Rival modeler AIR Worldwide put insured losses at 1.2 trillion yen ($15 billion) to 2.8 trillion yen, excluding the tsunami.
“I would not expect to hear that cat bonds have been triggered by events in Japan,” Keatinge said. “The losses don’t seem that considerable.”
The Guardians of New Zealand Superannuation, which oversees a NZ$16 billion ($11.7 billion) fund to help pay for future pensions, doesn’t expect losses on its cat bonds because the triggers of its investments don’t relate to that particular location or event, spokesman Paul Gregory said. New Zealand Superannuation began investing in cat bonds in February 2010 with $125 million, increasing that to a $300 million commitment in May, including exposure to earthquakes in Japan, according to the Auckland-based fund.

Significant Risks

Munich Re and Swiss Reinsurance Co., the biggest reinsurers, are among issuers of cat bonds with Japanese earthquake coverage. Both companies declined to comment.
Cat bonds still carry significant risks and would get crushed if a hurricane directly struck Miami, Seo said. The Swiss Re index, calculated weekly, fell 0.31 percent in the five-day period ended March 11, the Friday the quake struck, on concern some securities may suffer losses. It tumbled 1.6 percent last week, the biggest drop since October 2008, as the loss estimates came in. The declines ended 11 weeks of gains.
Cat bonds typically pay a floating interest rate that ranges from the London interbank offered rate to as high as 49 percentage points more than the benchmark. Spreads on cat bonds issued this year have averaged 786 basis points, or 7.86 percentage points, over Libor, narrowing from 824 basis points in 2010 and 949 in 2009, according to data compiled by Bloomberg. The premiums were 606 basis points in 2005, before losses from Hurricane Katrina widened spreads, the data show.
‘Turning Point’
The Japan earthquake may actually boost cat-bond returns by driving up spreads on the securities for the first time since 2009 because the premiums reinsurers charge are set to rise.
“In the affected regions, I’m sure spreads will rise in line with what is expected to happen in traditional reinsurance,” said Henning Ludolphs, head of insurance-linked securities at Hannover Re, the world’s third-biggest reinsurer. “It remains to be seen how strong they will rise.”
Investors may also benefit as more risks from insurers in Japan, Australia and New Zealand, seeking additional catastrophe cover, could come to the market, Ludolphs said. That would help buyers of cat bonds diversify from U.S. hurricanes, which make up about half of the risks covered by the securities.

‘Turning Point’

“The Japan earthquake could mark a turning point,” said Christophe Fritsch, head of insurance-linked securities at Axa Investment Managers, the asset-management unit of Paris-based Axa SA. (CS) “Reinsurers will probably increase the price of reinsurance to recover the losses they incurred, which should lead to cat bond spreads increasing.”
Ten bonds with $1.66 billion outstanding have triggers tied to an earthquake in Japan, data compiled by Bloomberg show. Four of them, including $200 million of debt due in August and sold by Platinum Re’s Topiary Capital Ltd., require multiple disasters to trigger payments. The $260 million Midori Ltd. cat bond issued by Munich Re only covers earthquakes within 70 kilometers of Tokyo.
Standard & Poor’s on March 18 put the Topiary notes on credit watch with negative implications after the issuer asked Risk Management Solutions to determine whether the Japanese earthquake is an initial trigger. If the Newark, California- based modeler determines it is, the holders are at risk of losing principal and interest for subsequent covered events that occur through July 31, according to the statement. S&P said it doesn’t expect to lower the rating.

Bond Triggers

Four other cat bonds pay out to insurers if certain conditions are met regarding the specific strength and location of the earthquake. Details necessary to determine whether those bonds will be triggered haven’t been made available because of the ongoing catastrophe, yet none of them will cover losses linked to the subsequent tsunami.
One of the cat bonds tied to Japan earthquakes, Valais Re Ltd., pays out if a certain loss amount is reached, as well as covering tsunamis.
Cat bonds were developed after Hurricane Andrew hit near Miami in August 1992 and help reinsurers maintain their credit ratings by diversifying their exposure to the most extreme and costliest disasters. There were $12.5 billion in cat bonds outstanding at the end of last year, according to Aon Benfield, the reinsurance broker of Chicago-based Aon Corp. (AON)
Demand from pension funds will drive sales of cat bonds to $6 billion to $7 billion this year, according to Axa Investment Managers. Sales were $4.9 billion in 2010, Aon Benfield said.

‘Small Fraction’

Cat bonds’ tendency to avoid taking losses may make insurers think twice about issuing them in the future, said Hilti, who helps manage about $3.5 billion of insurance-linked debt at Credit Suisse.
“My sense is that the recent events will not increase the appetite of cat bond issuers in Japan, because ultimately, the structure almost failed to pay,” he said. “If there is any payout, I think it is going to be a small fraction of the $1.7 billion, absolutely.”
Katrina was the first time that a natural disaster caused meaningful losses for cat bond investors, when buyers of Zurich Financial Services AG (ZURN)’s Kamp Re 2005 Ltd. security suffered principal losses of $144 million of the $190 million in the issue, according to Moody’s.
Glacier Reinsurance AG has also indicated that one class of its Nelson Re Ltd. cat bond will likely experience losses from Hurricane Ike, which slammed into Texas in 2008 and cost the insurance industry $18.5 billion. The bankruptcy of Lehman Brothers led to losses on debt issued by the Newton Re, Ajax Re, Carillon Re and Willow Re cat bonds, according to Moody’s. Those bonds led to losses for their buyers as they failed to fully pay back investors when the collateral proved more risky than initially thought.
“It’s certainly not without risk, and you can get zapped for a large amount on a big event overnight,” Seo said. “This can happen anytime, even tomorrow, and that’s why a lot of people have a hard time stomaching it.”