Cat bond market could be boosted by Japanese crisis

3rd April 2011, Comments 0 comments

The market for bonds designed to cover natural catastrophes has taken a hit since the disasters in Japan last month, but could profit in the end from such dramatic events, specialists say.

"Cat bonds" are a way for reinsurance companies to transfer part of the risks they cover to financial markets.

While providing a layer of protection for issuers, they are also a lucrative investment opportunity, with an average rate of return in 2010 of 11 percent.

Investors accept the risk of losing some or all of their money in the rare event that the specific catastrophe defined in the bond's issuance occurs before it matures, which is typically after a relatively short period.

"Very often it's about covering a 100-year event. So it's pretty safe for investors," said Steve Evans, director of the Internet group that specialises in risk transfers.

The earthquake and tsunami that struck Japan on March 11 closely resemble the kind of events that cat bonds are meant to cover however.

Dirk Schmelzer of the Swiss investment group Plenum Investments said: "It remains to be seen if cat bonds were hit" by the disasters. "It is not improbable."

Schmelzer estimated that a total of 11 cat bonds worth $1.7 billion were potentially exposed to losses from the events in Japan.

The market is of course very worried about that possibility, and bond values have fallen sharply since March 11.

"It is a short term reaction given the current uncertainty," Schmelzer said.

He was upbeat however about the longer term viability of a niche global market with an estimated value of 13 billion dollars.

One reason is because from an investor's point of view, potential losses in Japan from cat bonds are small compared with the overall losses, which risk assessment company AIR Worldwide has put at $20-30 billion.

Another is that future regulations on insurance shareholder funds known in the European Union as Solvability 2 could incite insurers to transfer more of their risks to financial markets.

Finally, higher insurance premiums likely to be charged following a string of disasters this year in Australia, Japan and New Zealand could boost the rate of return on cat bonds issued by insurers, Schmelzer said.

And the huge costs of natural catastrophes, which caused $218 billion in damage last year, more than three times the 2009 level according to the reinsurance group Swiss Re, has also sparked interest among some governments.

Israel, South Korea and Taiwan are among those looking at the possibility of bond issues, Evans noted.

Such bonds nonetheless remain a kind of luxury financial product for insurance groups, given high rates of interest they have to offer and strict clauses that make benefitting from the no-payment aspect very rare.

Of the more than 300 cat bonds issued worldwide, issuers have only been able to defer payment on two since 2005 according to information provided by Moody's investors services.

"It's good to be a cat bond investor. But that means it's bad to be on the other side of the trade," said Daniel Indiviglio, and editorialist at the US magazine The Atlantic who questions their ultimate worth.

© 2011 AFP

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