Cat bond sponsors tempt investors with diversified perils and geographies

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A new wave of more diversified insurance-linked securities (ILS) is expected in the wake of the world's first cat bond to covering exclusively storm surge risk.

ILS investment managers and dealers predict that targeted cat bonds providing cover for specific perils and geographic regions will become increasingly popular as investors look to diversify their portfolios.

This comes after the MetroCat Re cat bond, placed on July 31, secured $200 million of protection from storm surge risk in New York City for First Mutual Transportation Assurance Company (FMTAC), a captive insurer attached to the city's Metropolitan Transportation Authority.

It is the first bond of its kind to protect solely against storm surge risk.

MetroCat Re will trigger a pay-out to FMTAC in the event storm surge exceeds a predetermined height within the New York City metropolitan region, during the event period of a named storm.

ILS specialists say the narrow geographical focus of the bond and coverage for a non-wind related peril are features that will grow in popularity over the next few years.

Michael Stahel, partner at LGT Insurance-Linked Strategies, the insurance-linked investments division at asset manager LGT Capital Management, says these features will allow cedants to secure catastrophe protection at a lower cost as investors are willing to take a price cut in exchange for diversification benefit.

"It was an interesting move by FMTAC to sell this as a storm surge-only transaction to give it the twist as a diversifier. Ultimately, the transaction was placed at a very attractive price for them," Stahel says.

MetroCat Re will yield a 4.5% coupon for investors, plus US Treasury money market earnings. This compares favourably with bonds covering US hurricane risk, which can exceed 8%.

Cory Anger, global head of ILS structuring at GC Securities in New York, says interest in storm surge cat bonds is taking off. "Since the completion of MetroCat Re, a number of parties are considering the application of storm surge cat bonds both in the New York City area as well as more broadly in the United States," she says.

Cat bonds targeting specific geographic areas are also growing in popularity with cedants and ILS investors.

In April this year, two US state insurance pools (North Carolina Joint Underwriters Association and the North Carolina Insurance Underwriters Association) co-sponsored a $500 million hurricane bond that triggers only if a storm incurs losses within North Carolina.

Louisiana Citizens Property Insurance Corporation launched a similar proposition covering Louisiana hurricane risk to the tune of $125 million in 2012.

Stahel says cat bonds targeting specific areas will provide diversification to ILS investors. "With transactions like those in North Carolina and New York, there is no other chance the bond will pay out besides a direct hit with a hurricane event in the specified geographic area. This means investors can build diversified portfolios, [for example] incorporating North Carolina wind risk, metropolitan New York storm surge risk, Florida risk and Louisiana risk".

He adds: "As it is shown by our stress test analysis this further enhances the diversification of our portfolios and ultimately adds to our risk capacity."

The MetroCat Re issue used a new catastrophe model developed by Risk Management Solutions (RMS) specifically designed to analyse storm surge risk. The RMS North Atlantic hurricane model version 13.0 is the first to quantify risk from hurricane-driven storm surge throughout the full life-cycle of a storm.

The untested nature of RMS v13 has led some to caution that the risk covered by the MetroCat Re bond may be understated.

"With certain risks like storm surge, they have not been modelled for decades like hurricane risk," says Hans Peter Boller, Zurich-based managing partner at Swiss ILS specialist Secquaero Advisors. "So there might be more model risk in these storm surge models, which means as an investor you have to be more careful and do more analysis."

RMS insists these concerns are overblown. Peter Nekada, New York-based managing director of capital markets at RMS, says surge modelling is in many ways less uncertain than traditional loss modelling.

"Many of the uncertainties associated with loss modelling do not apply when estimating the likelihood of reaching certain levels of water – for example, extrapolation of historical loss experience to current building codes and practices, insurance policy terms and adjusting methods, and uncertainties associated with data quality and valuation," says Nekada.

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