Investors Embrace Catastrophe Bonds

Insurers Capitalize on Surge of Interest in Bonds Linked to Natural Disasters

Insurance companies are taking advantage of the appetite for high-yielding debt by selling bonds that can force investors to help pay for the cost of natural disasters.

With the U.S. hurricane season about a month away, insurers are issuing "catastrophe bonds" at the fastest clip since before the financial crisis. Insurers sell the bonds to help cover potential claims from hurricanes, tornadoes, earthquakes and other major insured risks. While losses on so-called cat bonds have been rare over the years, investors can forfeit both interest payments and their principal if disaster costs exceed designated levels, which gives insurers the right to tap the funds. The bonds have floating interest rates and are usually paid off upon maturity in three or four years.

Cat-bond issuance in the first quarter more than doubled from the year-earlier period, to $1.2 billion, and second-quarter issuance is expected to hit an all-time high above $3.5 billion, according to Willis Capital Markets & Advisory. More than $2 billion of deals have closed or been announced this quarter, Willis said.

Citizens Property Insurance Corp., the state-run insurer in Florida, this week boosted its latest cat-bond offering to at least $1.25 billion from $400 million, according to investors. It would be the largest single cat-bond transaction ever, according to Artemis, an insurance-linked data provider.

Yields on cat bonds, meanwhile, have sunk to their lowest level in nine years. The average quarterly yield dipped to 5.22% recently, from 9.61% in 2012.

Cat bonds historically have appealed to large pension funds but now are attracting a wider array of buyers, yield-hungry investors who otherwise might purchase corporate junk bonds, according to brokers, bankers and investors.

"Institutions of smaller and smaller size are becoming interested in the market," said Brett Houghton, a managing principal at Connecticut-based Fermat Capital Management LLC, a long-standing specialist in catastrophe bonds, with $4.4 billion under management.

Many insurers that sell coverage for homes and businesses seek to spread the cost of potential claims by buying "reinsurance" from other companies. Insurers have used cat bonds since the mid-1990s to augment their reinsurance arrangements, and many now are boosting their use of the market as costs of issuing debt have fallen.

 

Cat-bond issuance jumped to $7.1 billion last year, just shy of the record $7.2 billion in 2007, according to Willis, an investment-banking unit of insurance broker Willis Group Holdings WSH -2.90% PLC. About $20.3 billion of the bonds were outstanding at the end of 2013, the most ever, according to Swiss Re Capital Markets. About $300 billion of catastrophe-reinsurance coverage is in place world-wide, including cat bonds, according to Aon Benfield, the reinsurance broker of Aon PLC.

The Swiss Re Global Cat Bond Total Return Index, which tracks the price change and interest payments of all property natural-catastrophe bonds outstanding, returned 8.51% on an annual basis between 2002 and last week. By comparison, Barclays's U.S. Corporate High Yield and U.S. Aggregate Bond indexes have increased, respectively, 9.35% and 5.04% annually.

The drop in bond yields has forced many reinsurers to lower their prices. But one big loss could rattle the cat-bond market, giving reinsurers the ability to raise rates again, said Tony Ursano, chief executive at Willis Capital Markets.

Losses, though rare, can be significant. Buyers of one bond that provided payouts for claims tied to the giant earthquake off the coast of Japan in 2011 lost all their money. Cat bonds are linked to specific types of disasters and are issued on the condition proceeds won't be used by the insurer for claims payments until the insurer's claim costs top a set level. Natural disasters have saddled cat bonds with $682 million in losses since 1996, or 1.3% of the $51 billion issued, according to Lane Financial LLC, an insurance consulting firm.

Superstorm Sandy damaged homes on the New Jersey coast in 2012. Buyers of catastrophe bonds can lose principal if costly disasters strike. Associated Press

Yields on cat bonds typically rise after natural disasters, reflecting lower bond prices and higher coupons on newer issues seeking to attract buyers. After Hurricane Katrina, which caused $47.4 billion in insured losses in 2012 dollars, yields rose 147% through the next four quarters, according to Lane Financial.

Cat bonds have become especially popular as an alternative to reinsurance policies in hurricane-prone Florida. With no hurricane landing there since 2005, interest payments on the debt have been uninterrupted, and principal on bonds that haven't matured has gone untouched.

Trevor Hillier, vice president of finance and accounting at American Strategic Insurance Corp., based in St. Petersburg, Fla., said the current low rates led the insurer to use cat bonds to cover named U.S. storms and severe thunderstorms, after rejecting the idea twice in previous years. In March, an ASI affiliate called Gator Re issued $200 million in cat bonds to provide reinsurance to ASI, boosting the size from $125 million and lowering yields from an expected 7%-7.75% to 6.5%.

In California, where earthquakes shook Orange County last month, the growth of the cat-bond market has been "really game-changing," said Glenn Pomeroy, chief executive of the California Earthquake Authority, a publicly managed, privately funded quake insurer that has sponsored three cat-bond offerings since 2011. The "tremendous amount" of new money flowing into cat bonds has increased price competition with reinsurers, he said.

Everglades Re, the affiliate used by Citizens Property, likely will sell its issue at a yield close to 7.5%, a yield reflecting both the particular risks faced by the bond buyers and the deal's unusually large size, a person close to the deal said. It is being managed by Citigroup Inc. and Bank of America Merrill Lynch. A Citizens spokesman declined to comment.

Some say the increased demand for cat bonds reflects dangerous complacency on the part of investors who have driven the bonds' prices to unreasonable heights.

"The absence of a catastrophic event over a long period of time" has helped feed demand for the securities, said Al Selius, a portfolio manager at Pine River Capital Management LP, which has about $125 million in insurance-linked securities. "It doesn't seem to be the right time" to expand Pine River's position, even as the bonds remain attractive relative to other debt, he said.

Write to Al Yoon at albert.yoon@wsj.com and Leslie Scism at leslie.scism@wsj.com
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