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It's not easy hedging against Armageddon. Consider the case of catastrophe bonds designed to provide capital to insurance companies when extreme, big-scale disasters occur. Japan's mid-March earthquake, tsunami, and ongoing nuclear reactor crisis would seem to qualify. The economic toll from these catastrophes may run between $200 billion and $300 billion and could cost the global insurance industry anywhere from $21 billion to $34 billion, according to an Apr. 12 estimate by risk-modeling research firm Risk Management Solutions.
Yet it turns out the cat bond market won't be of much help in covering Japan-related insurance losses. Such bonds often have covenants that strictly limit the type and location of a disaster they will cover. Most cat bonds covered quake losses only in Tokyo. The temblor actually occurred about 240 miles (380 kilometers) northeast of the capital. "The triggers are very specifically defined," says Tom Keatinge, managing director in JPMorgan Chase's (JPM) 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."
Back in the early 1990s, in the aftermath of Hurricane Andrew, which devastated parts of Florida, and the Northridge quake in California, insurers started to issue cat bonds to spread risk to financial investors. Reinsurance companies such as Munich Re and Swiss Re were also active in this market. (Reinsurers traditionally have insured other insurers against big disasters.) At the end of 2010, there were $12.5 billion in cat bonds outstanding, according to Aon Benfield, the reinsurance broker of Chicago-based Aon.
The market works this way: An insurance company issues bonds to financial investors, such as hedge and pension funds, that are willing to place a bet on the probability of a disaster occurring at a particular location and during a specific time frame. During the life of the bond, the insurer pays investors a coupon interest rate. If nothing happens, the insurer returns the money when the bond matures. If the fates are cruel, cat bond investors kiss off all or part of the principal.
In Japan's case, much of the $1.7 billion worth of cat bonds focused on Japan were designed for quakes only in the Tokyo metropolitan area, the country's economic and financial market hub that accounts for about 40 percent of the nation's economy. The location of the earthquake in rural Japan will limit the losses investors will likely face, says Niklaus Hilti, head of insurance strategy at Credit Suisse Group (CS). Only one cat bond, issued by Munich Re and worth about $300 million, is expected to be paid out, says Hilti. "Japan was very similar to Katrina. These were big events, but the cat bonds are designed in such a narrow way."
Catastrophe bonds have done a far better job protecting investors than they have providing a financial hedge to insurers. The securities have returned 60 percent over the past five years through Apr. 8, according to the Swiss Re Cat Bond Total Return Index. "It's almost like hole-in-one insurance," says Nelson Seo, co-founder of Fermat Capital Management in Westport, Conn., 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."
Insurance companies show no signs of abandoning the cat bonds, even though the market failed to deliver a big payout for the Japan disaster. Reinsurers may need to issue new securities to cover future losses in Japan. Insurers, sure to face higher premiums from their reinsurers, may do the same. Swiss Re, the world's second-biggest reinsurer, sold $95 million of zero-coupon catastrophe bonds on Mar. 30 through its Sector Re V unit containing loss triggers that include another earthquake in Japan. There is also strong demand from pension funds, which may push up issuance of cat bonds to $6 billion or $7 billion this year, vs. $5 billion in 2010, according to Axa Investment Managers.
The longer-term future of the cat bond market is less certain, says Credit Suisse's Hilti. In the end, taking out a traditional reinsurance contract might be a better deal than using the cat bond market as a hedge against big disasters. Says Hilti: "From the perspective of insurers and reinsurers, traditional reinsurance is clearly the better hedge."
The bottom line: The catastrophe bond market will provide only $300 million toward up to $34 billion in insurance losses from the Japanese quake.