Perils Draw Stable Money

Contacted recently for his views on the growing catastrophe (cat) bond market, Jeff Sica, founder and chief investment officer of Sica Wealth Management, professed his lack of knowledge about these ABS. In effect, they insure state and private entities against risks stemming from hurricanes and other natural disasters. A few days later, however, after researching cat bonds' risk characteristics and performance, Sica was a fan.

"As long as the underwriting stays the way it is, and the current risk/reward is still there, I will almost certainly put cat bonds in my portfolios," Sica said. "They definitely look like investments that create a level of non-correlation, diversification and potential return that we're just not getting anywhere else."

That's music to the ears of long-term players in the cat bond market, which saw its first deal in 1997 and its annual volume numbers ebb and flow ever since. The volume of new issues in 2011 was $4.5 billion, down from $5.2 billion the year before. Already exceeding last year's volume as of early September, 2012 is expected to top $6.5 billion and may even surpass 2007's record $7 billion in issuance from 27 offerings.

If so, it will be in large part because the State of Florida issued in April the largest cat bond ever from a state-related entity. The deal may prompt issuance by several new government agencies, not only because it was unabashedly successful but also because it illustrated how the market is adapting to issuers' needs.

In addition, the sector has attracted stable institutional investors that have become more comfortable with the asset class and crave its relatively high returns and lack of correlation to the economy and other financial markets.

"We lost the bond market - we're out of anything providing yield because of the downside risk - and the stock market is topsy-turvy. There's just not that much else to do," Sica said.

Market participants mostly predicted a similar volume number next year, although they quickly hedged by noting variables, including the performance of competing markets such as reinsurance and collateralized reinsurance, that could change the outcome. In fact, even new issuers, whose deals received warm welcomes earlier this year, discussed the cat bond market's benefits while noting no commitment to it.

"We're going to maintain the same [$450 million] level of coverage for hurricanes, but in the future it's really a pricing and design issue in terms of what we think will work best," said Steve Cottrell, chief financial officer of the Louisiana Citizens Property Insurance Corp., a government-established insurer of last resort.

The non-profit organization's $125 million, three-year Pelican Re offering was originally slated at $100 million. Louisiana Citizens' coverage needs, however, are relatively small compared to those of Florida's Citizens Property Insurance Corp., which appears to be a bellwether transaction in the cat bond market.

The deal was originally slated to raise $200 million, an amount that was increased to $250 million when the deal went to market. Demand was so strong, however, that the Everglades Re trust ultimately sold $750 million in bonds that complemented another $750 million in reinsurance that was placed at the same time.

Florida Citizens was mostly self-insured previously. John Seo, co-founder and managing principal of Fermat Capital Management, probably the largest fund devoted to cat bonds, said that catastrophe-protection seekers typically must buy re-insurance before issuing cat bonds."If you can't get people on board with the reinsurance, then it's assumed you can't do the cat bonds," Seo said. He added that the Florida Citizens deal was "sort of like watching folks leapfrog the automobile and go straight to jet airplanes."

Because Florida is surrounded by ocean and private insurers have been unwilling cover all the risk, Florida Citizens is among the top 15 providers of property insurance in the country - directly taking on the risk of the homeowners and businesses it insures. In addition, its reliance on reinsurance has been sporadic. So when Florida Citizens' board gave the green light for the then-forthcoming cat bond deal last December, it came as a pleasant surprise to the market. Given Florida's prominence in the North American wind region, Seo said that "even if it had come to market with a $150 million bond offering, it would have been very significant."

Sources said Fermat was an investor in the Everglades Re deal. Seo declined to comment.

Sharon Binnun, chief financial officer of Florida Citizens, said the relative lack of significant storms in recent years has allowed the agency to build up a surplus, but that could quickly be exhausted with a series of storms in a single season or one large storm. In addition, the agency doesn't charge "actuarially sound" rates because of a legislative mandate to ensure affordability; this means the agency's premiums do not sufficiently cover the risk it insures, and it has little funding to purchase reinsurance.