I was reading something about this and I thought I'd share with you in a form of a question. I'll post the article (hints: from WSJ) later.
Catastrophe Bonds Are Selling Briskly
As Insurers Seek Ways to Spread Risk
By IAN MCDONALD and LIAM PLEVEN
December 21, 2006; Page C1
Money managers are increasingly smitten with an unusual new asset class: hurricanes.
Hedge funds, pension funds and other money managers have invested more than $9.2 billion this year in disaster-related investments, including catastrophe bonds and "sidecars," which allow them to rake in millions of dollars if catastrophe losses are low, but can also risk the loss of their whole investment if hurricanes or earthquakes trigger massive claims.
This year's inflow to these securities more than doubles the $4.4 billion invested last year, according to preliminary figures from Goldman Sachs Group Inc. Trading volumes on so-called industry-loss warranties also are soaring.
Each of these quirky securities allows deep-pocketed investors to make bets on whether natural disasters will strike and cause large insurance claims.
Catastrophe bonds, usually issued by insurers or their reinsurers, pay investors above-average interest in return for the right to tap the cash behind the bonds if the disaster is severe or claims are high, according to preset yardsticks. Investors in sidecars backstop specific insurance policies -- agreeing to pay claims if needed -- in return for pocketing some of the premiums. A loss warranty is a contract that allows the seller to pocket a fee and in exchange pledges to make big payments to the buyer, usually an insurer, if claims industrywide exceed a certain level.
Wall Street's interest in these types of investments reflects, in part, demand among insurers for ways to spread their risks in the wake of the costly hurricanes of 2004 and 2005.
Reinsurers, who back the risks of insurance companies, found themselves needing capital to back big-ticket catastrophe policies this year, intensifying efforts to tap financial markets as another source of cash. For investors, catastrophes represent a shot at big returns that aren't closely correlated with other investments in areas like bonds and stocks.
"The rate of growth in the sector following Hurricane Katrina exceeded everyone's expectation," says Michael Millette, head of financial-institutions structured finance at Goldman Sachs in New York.
Sidecars, for instance, started up and quickly amassed billions of dollars.
And "wind risk" looks like an asset class that is set to grow. Recently, WL Ross & Co., run by billionaire investor Wilbur Ross, led the creation of a $360 million sidecar called Panther Re Bermuda Ltd. that will back a portion of policies written by an underwriting firm at the Lloyd's insurance market in London. It was Mr. Ross's second investment in a sidecar and the first ever approved by Lloyd's.
Although investments in the catastrophe-risk market have grown right through the recently ended, and tame, hurricane season, some forecasters say the coming season could be above average.
Of course, early forecasts can be off the mark -- there were similar fears about this year. And it's not clear that even steep losses would curtail interest in cat bonds, as they are known in the industry, and sidecars.
The cat-bond market dates to at least the mid-1990s. It has gone through several growth spurts, as other massive disasters spurred innovation and drew capital.
Cat-bond issuance wasn't slowed at all by record claims from Hurricane Katrina, which triggered losses on at least one cat-bond issued just a few months before the storm. In fact, cat-bond issuance over the following year set a record.
Insurers and reinsurers are looking for even more capital to back up policies. The steep price increases for catastrophe coverage that followed Katrina and other storms last year have made the chances of huge returns especially enticing for many investors.
While results vary, people in the insurance industry estimate some sidecar investors earned returns of more than 20% in the past year. Cat bonds now typically pay investors several percentage points above a benchmark interest rate known as the London interbank offered rate, or Libor. That rate is currently at 5.36%, with many investors earning yields up to -- and into -- the double digits.
With such high returns this year and hopes for high returns going forward, one concern is that funds might flock to the market and take on too much risk.
"Is there discipline among these investors? That's the question that we need to ask, and the one that will be answered," says Grahame Chilton, chief executive of British reinsurance brokerage firm Benfield, which has structured cat bonds for clients this year.
Indeed, executives at Lloyd's and elsewhere are quick to note that neither the losses in 2005 nor the lack of them this year is typical. "The guys who gambled this year have done well," says Rolf Tolle, who monitors the business plans and risks of underwriters at Lloyd's as the market's franchise-performance director. "But the first hurricane forecasts for 2007 have said they expect a higher-than-average storm season. So, we may not see the same returns on these securities."
Still, many investors are likely drawn by the cat securities' diversification benefits, as well as their potential returns. Cat bonds are "generally uncorrelated" with the financial markets, says John Brynjolfsson of Allianz AG's Pacific Investment Management Co., known as Pimco, a bond-investment firm that invests in cat bonds. By spreading their money across assets that don't move in lock step, investors can help insulate themselves from particularly steep losses in any single year.
Mr. Millette of Goldman Sachs says more and different types of cat securities may be on the way. His team is working on new structures for such securities, and others in the investment-banking and insurance worlds are doing the same.
Write to Ian Mcdonald at email@example.com and Liam Pleven at firstname.lastname@example.org