Catastrophe Derivatives Demand Surges as Storm Season Nears

Demand for disaster derivatives is surging as insurers seek alternatives to scarce reinsurance and expensive catastrophe bonds, with the forthcoming North Atlantic hurricane season likely to give a further boost.

Prices are at record levels for Industry Loss Warranties (ILWs) and derivatives such as catastrophe futures, used by insurers to cover their potential losses from natural disasters.

“People are trying to purchase as much cover as they can, be they insurance companies in Florida or reinsurers in Bermuda, and obviously pricing has been driven up considerably,” said Stephen Breen, Executive Vice President at Tradition Re, which brokers traditional reinsurance and catastrophe derivatives.

ILWs are reinsurance contracts that pay out according to the total loss to the insurance industry of an earthquake or hurricane, rather than the buyer’s losses alone. Similar derivatives can be traded on an exchange or over-the-counter.

Charles Withers-Clarke, executive vice-president at reinsurance broker Willis Re said his firm had placed 40 percent more by limit in ILWs than at the same point in 2008. “The ILW market is a private market, so we can only estimate global ILS (insurance linked securities) capacity based on … our own portfolio, but we are seeing increased volumes and are ahead of last year,” he said.

An ILW paying out on 2009 insured losses in the United States of more than $50 billion is currently quoted at a premium of 17.5 percent. An equivalent contract would have cost about 11 percent a year ago, and hit only 15.75 percent after 2006’s Hurricane Katrina, the most costly U.S. natural catastrophe.

REINSURANCE SHORTAGE
Prices are also up at IFEX, which offers Event-Linked Futures (ELFs) via the Chicago Climate Futures Exchange, and which reported its busiest ever trading day on April 23.

An ELF paying out on a 2009 U.S. windstorm loss exceeding $50 billion currently carries a premium of about 12.55 percent, nearly double the price of an equivalent contract a year ago (http://communities.thomsonreuters.com/ILSExchangePrices).

Insuring against a loss of more than $10 billion costs 45 percent — up from 37 percent one year ago, for the 2008 contract, which was triggered by September’s Hurricane Ike.

Further rises may be seen if a shortage of reinsurance — particularly retrocession, the passing on of reinsurance risks to other reinsurers — prompts a scramble for storm cover ahead of the U.S. hurricane season, which starts on June 1. Reinsurers’ capital bases have been eroded by 2008 disasters such as Ike and heavy losses on investments.

But high prices have prompted a standoff between protection sellers and buyers, some of which may opt instead to retain more risk or reduce their exposures ahead of the hurricane season.

“There’s no doubt that it’s going to be a late season for retrocession but I think there is considerable capacity sitting on the sidelines,” said Breen, noting that derivatives are often used to fill gaps in a book of traditional reinsurance. “We saw a flurry (in ILW sales) in the first quarter and I expect a similar flurry late in the second quarter.”

Withers-Clarke and his colleague Henry Kingham at Willis Re said reduced volumes in the catastrophe bond market were forcing insurers to look for alternative sources of contingent capital.

Nearly $1 billion of new catastrophe bonds, used by insurers since the 1990s to transfer peak risks to investors, have been sold this year — about a third of 2009’s expected total. But heavy selling late last year by hedge funds — which once accounted for about a third of the market — has pushed up costs for potential issuers.

“The ILW market is cheaper than the catastrophe bond market, although ILWs are difficult to place at efficient pricing once you get above $100 million of limit,” said Kingham. The contracts are typically placed in multiples of $10 million.

FOREX BOOST
He said large ILW transactions completed late last year, some to replace maturing catastrophe bonds at a time when that market was effectively closed, had given impetus to prices.

The yen’s 30 percent rise against sterling in the year from April 2008 drove an increase in demand for ILWs on Japanese perils, primarily earthquakes, notably from Lloyds of London members which report in sterling.

Many bought three-month cover to protect themselves until they could reduce their exposures at the April 1 Japanese reinsurance renewals, Willis Re’s Withers-Clarke said.

“People of that sort are beginning to take (derivatives) as a new method of managing reinsurance exposures and insurance buying,” said IFEX director, Robert Miller, noting that costs tend to be lower than for traditional reinsurance. Transacting via an exchange also eliminates counterparty risk. “It’s a useful and cheap way of doing things, and allows you to do things you can’t do in the conventional market, such as sell forward contracts,” Miller added.

Rupert Flatscher, head of Munich Re’s risk trading unit, said his firm regards insurance linked securities and cat swaps as “additional tools in the box” when finding solutions for clients or managing its own balance sheet.

The world’s biggest reinsurer last month closed a private catastrophe swap transferring some of its peak European windstorm exposures to Japan’s Tokio Marine Nisshin Fire. “We have done transactions for peak scenarios Munich Re has on the balance sheet and that has helped us manage our budget and risk situation,” Flatscher said.

(Editing by David Cowell)