Catastrophic Risk: Cat Bonds and Beyond

Description

The increasing incidence of disaster -- from Hurricanes Katrina and Rita to tsunamis and earthquakes -- has highlighted the need for catastrophe protection and insurance for individuals, communities and companies.

In response, the Milken Institute hosted a "Financial Innovations Lab for Catastrophic Risk: Cat Bonds and Beyond" on October 25, 2007, at the Metropolitan Club in New York City. The Lab focused on identifying and analyzing capital market solutions for financing catastrophic risk management.

Participants included insurance professionals, investment bankers, academics, lawyers, rating agencies and risk-modeling experts, as well as other experts from the insurance and capital markets. The goal of the Lab was to identify obstacles to the expansion of the market for catastrophe (cat) bonds and risk-linked securities, and to develop strategies to tackle those barriers.

The agenda identified four primary barriers that translated into four sessions featuring presentations, case studies and the lively participation of the 48 participants. At the start of the day, Markus Schmutz from Swiss Re provided an industry overview of risk-linked securities. Schmutz noted that the market for catastrophe bonds has grown substantially, from around US $700 million in 1997 to approximately US $13.5 billion outstanding at the moment. He also outlined the benefits of cat bonds -- such as full collateralization and multi-year pricing of contracts -- as attractive alternative sources of capital.

The first identified barrier dealt with limits in the secondary market and concerns about liquidity. Gerald Ouderkirk of Goldman Sachs and Albert Selius of Swiss Re, who both head trading desks for cat bonds, described the market for the bonds as liquid and pointed to the lack of issuances as one of the barriers of expansion. Selius provided an overview of exchange-traded instruments and recent developments on derivative exchanges, which are currently active in catastrophic risk trading. Ouderkirk noted that hedge funds were the primary participants in the secondary market space over the past 12 months.

One session was dedicated to the role and perspective of investors in the cat bond market. Eric Silvergold of Guggenheim Partners explained that despite the attractiveness of these bonds (including low correlation with other asset classes), fixed-income investors typically do not have the economics to invest in them. There is a need, he said, to democratize access to risk-assessing tools.

Rating agencies play a crucial role in the issuance of risk-linked securities, Rodrigo Araya of Moody's noted that they can help develop the market lies by educating investors and offering sponsors a clear and reasonable rating approach.

Another session dealt with transaction costs. Jeff Cooper of Allstate Insurance Company highlighted the many hesitations insurers have in becoming buyers of cat bond coverage. Cooper estimated that currently the transaction costs for cat bonds run at approximately 20 percent higher than for typical reinsurance contracts. However, Michael Millette from Goldman Sachs pointed out that the higher transaction costs result from the novelty of capital market insurance solutions and said he expects them to decline substantially.

The final session of the day addressed the importance of public-private partnerships in tackling the challenges of providing risk coverage to communities and nations. Stuart Miller of AIR Worldwide gave a presentation on an innovative issuance by the Government of Mexico, which placed the first sovereign cat bond in history to provide funding for emergency losses in the aftermath of an earthquake in Mexico City.

Click here for a detailed report of the Lab's findings.