Cat bonds and the ‘perfect storm’

Every natural catastrophe metaphor around seems to have been pulled out to describe the collapse of Lehman Brothers a year ago (a la “perfect storm”), as the FT’s Paul J Davies noted last week.

But no one expected that the US investment bank’s downfall would have an impact on the markets for natural catastrophe risks. These markets are only now beginning to recover from a collapse of confidence after Lehman’s role in holding the collateral for a handful of catastrophe bonds caused huge losses (magnified by a series of hurricanes)  for investors.

Issuance of cat bonds, which reinsurers issue in the capital markets to effectively buy protection against extreme losses, collapsed in the six months following Lehman’s demise.

One year after the investment bank’s failure, though, the weather is relatively mild and they are enjoying a near-record run.

Bloomberg reports on Monday that cat bonds advanced for a record 10th straight week on fewer storms in the US and improved capital markets.

The Swiss Re Cat Bond Price Return Index rose 1.4 per cent to 93.03 on September 11, the biggest increase since September 2004 and marking the longest string of weekly gains since 2002, when Swiss Re began tracking the data.

Much to the relief of cat bond investors, the US has escaped major onshore storms this year after hurricanes Ike and Gustav contributed to $25.2bn in catastrophe losses in 2008, Bloomberg notes.

This despite the current hurricane season in the US, when prices could be expected to go the other way amid concerns about weather-related losses.

But lower bond prices, a higher yield and a separation from other financial markets have driven a revival in investor interest this year, David Priebe, of reinsurance broker Guy Carpenter & Co told Bloomberg.

As the FT notes, only two cat bonds were sold in the second half of 2008, comprising a total issuance of just $320m, and nothing was done in the market between September and February this year, according to reinsurance broker Aon Benfield.

Total annual issuance tumbled from a record $7bn for the 12-month period ending June 30 2007 and $5.8bn in 2007-08 to just $1.7bn in 2008-09.

But improved capital markets have helped boost cat bond prices, and investors may earn as much as 17 percentage points above benchmark rates, Bloomberg calculates. Already, notes Aon Benfield, cat bond issuance has climbed to $2bn so far this year and could increase to as much as $4bn by year-end.

In addition, recent cat-bond deals have limited the kind of collateral that can be used to cash, government securities, and government-guaranteed bank debt, or have done away with a swap counterparty completely. The problem with the deals related to Lehman Brothers, according to Aon Benfield, was that “no one anticipated that a swap counterparty backing a cat bond could collapse and the collateral also become impaired at the same time. The collapse of Lehmans showed that it could”.

But investors eyeing cat bonds should move soon. The bonds face competition from derivatives that can be used to transfer catastrophe risk – both OTC and exchange traded. And, as the FT notes, the OTC market is based on bilateral swaps called Industry Loss Warrants, which pay out if total industry losses from an event breach certain levels.

Related links:
Ajax, the suicidal bonds – FT Alphaville
Cat bonds an alternative in correlated markets - I&PA