Cat bonds have soared in issue size in just two years—from around layers. “When buying a cat bond, most insurance companies have
$2 billion in 2005 to almost $7 billion at the end of 2007. The area purchased protection out in the tail. This is a more natural place for
of greatest demand for cat bond capacity is in Bermuda’s traditional such products to exist, because investors in cat bonds often want a
areas of expertise, the peak areas of the traditional reinsurance very low frequency of loss.
sector: US hurricane, US earthquake, European windstorm, and
“In the traditional reinsurance market, reinsurers are driven to
terrorism.
minimum rates on line for cat capacity due to the level of capital
As this growth first began to take off this decade, concerns required by the rating agencies for such exposure. Therefore,
mounted among senior figures in the traditional reinsurance sector cat bonds would typically attach above companies’ traditional
that it might threaten the security of their own market. With this reinsurance programmes.”
year’s renewal season out of the way, now is a good time to ask
He stresses: “There’s a place for both cat bonds and the traditional
whether these concerns were justified.
reinsurance market. In Bermuda, for example, several reinsurers
Colm Homan, partner in the commercial insurance group, PWC have purchased cat bonds as an efficient mechanism to manage their
Bermuda, says that it is becoming more difficult for cat bonds to get own risks and peak exposures.”
investment grade ratings, and he predicts that, as a result, the ability
There’s no doubt the cat bond market has grown in issuance size,
to sell them at a lower rating or a lower investment grade rating
but is it a zero sum gain or has the actual capacity bought risen?
will become more of a challenge. “They will have to give a higher
The answer is a combination of both, according to Christopher
return to support that rating, and a higher return means getting
McGhee, managing director at Marsh & McLennan’s broker-dealer
higher rates. Going into a softening market, that combination
unit, MMC Securities. “Cat bonds have taken away some of the
doesn’t seem to work too well,” he says.
capacity that would have been placed in the reinsurance market.
This is where Bermuda comes into its own, he suggests. One of But it has also expanded what is being bought. There are some
the hallmarks of the Bermuda market has been its adaptability deals that might not have been done at all that are being done in
to evolving market conditions. “I wouldn’t be surprised to see cat bonds,” he says.
some variations on structures coming out that would address or
There’s absolute crossover between risk transfer protection and
compartmentalise some of these issues and make it an effective
reinsurance, with both marketplaces looking at all their options
investment tool for some of those institutional investors.
and price being the principle driver. If the reinsurance market were
“In fact, I’d be surprised to see significant innovation that wouldn’t to become dramatically softer, bringing prices very low, then it
have its origins in Bermuda,” he adds. follows there would be a diminution in the deals done in the capital
markets.
One reason why reinsurers have been significant users of capital
market instruments such as cat bonds has been the relative demise But it is also clear that the very largest clients, which need the largest
of the retrocession market, which has meant there weren’t that amount of risk transfer capacity, are increasingly demonstrating
many conventional alternatives to traditional reinsurance. that they want to have a foot in both camps, with capacity both
from reinsurance and from the capital markets to hedge their bets
Reinsurers were in fact the leaders in sponsoring cat bonds. It
if one market or the other experiences some kind of shock.
is only over the last few years that the bulk of cat bonds have
been sponsored by primary companies as opposed to reinsurers. At a little over 10 years old, the cat bond market is not a
It follows that reinsurers are set to continue to grow as users of particularly young market and, in order of magnitude, at $14 billion
capital markets. of outstandings, it is probably one-tenth the size of the reinsurance
market.
Cat bonds are both a complement and a supplement to the
conventional market. “It is fair to say that if you think of reinsurance Cat bonds provide capacity in the core areas of Bermuda reinsurance
pricing as being governed to a large degree by supply and demand expertise, but Bermuda is showing no sign that its market share may
dynamics, then the presence of an alternative market for some of be becoming diluted. “I don’t think anyone can predict a wholesale
the provision of that kind of coverage must at least dampen supply loss by the Bermudian reinsurers. The capital markets do not pose a
and demand, imbalance-led pricing gyrations,” says Mark Hvidsten, particular threat to their market,” McGhee says.
chief executive officer, Willis Capital Markets.
There is no doubt that there is a permanent need for risk transfer
But it is very hard, if not impossible, to quantify the ebb and flow capacity. For as long as there are functioning markets on both sides,
from reinsurance to cat bonds and vice versa. Some sponsors of cat people will continue to buy from both sides. If not, people will
bonds, particularly direct companies, may be doing that to spread find an alternative. “The important point is that the capital market
their credit risk between the conventional reinsurance market has evolved to become a legitimate, reasonable and cost-effective
and the alternative market. Furthermore, a switch to the use of complement to the traditional reinsurance market,” he concludes.
cat bonds is not just a pricing consideration but also a credit risk
Jamie Veghte, executive vice president and chief executive of
management issue, which Hvidsten says is another reason why it is
reinsurance operations, XL Re, says cat bonds and reinsurance
hard to quantify.
operate side by side. In 2007, there was a 50 percent increase in
John Doucette, president and chief underwriting officer of cat bond investment over the year before and, at the end of 2007,
property and casualty reinsurance, Max Bermuda, says cat bonds are there was about $14 billion of principle outstanding in the cat bond
having some effect on the reinsurance market, but more at the top market, he says. “We estimate that would still represent less than
Bermuda Re/insurance . February 2008 19
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