A popular punt

Experts remain bullish about the flow of new money into catastrophe cover. But an influx of hedge funds backed increasingly by institutional capital has led to worries of a “domino effect”. By Maria Kielmas

The aftermath of the Caribbean and south eastern US hurricane season this year left a large number of investors very happy. Despite preliminary estimates of insured losses from the storms ranging between $2 billion and $10 billion, the hurricanes are not expected to trigger any losses in the catastrophe bond market, according to initial estimates by Fitch Ratings. If the insured losses from these storms exceed a pre-determined threshold, then the investors could lose their entire principal as well as interest. But since the catastrophe bond market’s inception nearly a decade ago, no such loss has happened.

Investor confidence has been boosted to such an extent that catastrophe bonds are now competitive in price with traditional reinsurance, noted a recent study on this market by Guy Carpenter, a division of New York-based insurance broker Marsh & McLennan. Hedge funds, which have become major investors in the catastrophe bond market, are now moving into the catastrophe reinsurance market. Regulators on either side of the Atlantic have been worrying publicly about the necessity for greater regulation of hedge funds, which themselves are attracting interest from institutional investors such as pension funds hungry for greater returns while the equity markets remain depressed. Could a natural disaster trigger a serious domino effect on the capital markets?

No, says Thomas Russell, professor of economics at the Leavey Business School, Santa Clara University in California. The event that would trigger payment on the bond is too unlikely. In addition, this market has developed securities based on multiple-event triggers such as a windstorm in Florida and an earthquake in Japan. “The likelihood of triggering both events is very unlikely, so this seems like a good deal for investors,” Russell says. The principle underlying a catastrophe bond is that once an event (the trigger) occurs, the proceeds of the issue are used to meet the loss suffered.

Opportunity for utilities
Although issuers of catastrophe bonds are predominantly reinsurance companies, especially the Zurich-based Swiss Reinsurance Company, corporate issuers have entered the market, with Electricité de France (EDF) the first energy company to do so (see box). The December 1999 windstorms Lothar and Martin caused serious financial losses for EDF, as well as severe embarrassment in its inability to deal quickly with the subsequent power cuts. Other utilities could follow EDF’s example for some of their catastrophe cover, thinks Jeremy Weinstein, a California-based corporate lawyer and president of Venture Asset Management Inc.

With reports from meteorological stations that the El Niño Southern Oscillation climatic effect is forming in the equatorial Pacific, next year’s south eastern US hurricane season may not be as damaging as this year’s. The El Niño effect is likely to reduce both hurricane frequency and intensity in this region. But the flip side is that severe ice storms in North America have also been attributed to El Niño. These have damaged utilities’ transmission and distribution systems, causing blackouts during the North American winter. So catastrophe bonds could make sense for many utilities.

“For a power company to protect itself from the consequences of catastrophic blackouts or catastrophic damage to its transmission system, this could be better than going through the insurance market,” Weinstein thinks.

Christopher McGhee, managing director of New York-based MMC Securities, concurs. “(EDF’s cat bond) is an indication that the insurance markets could not provide the amount of capacity that EDF expects,” he says. But McGhee thinks that this an option for the larger utilities only. The minimum size of any catastrophe bond would be about $100 million, as the set-up costs tend to be fixed, he says.

It’s also not an option for many US utilities whose credit-worthiness has been damaged by energy market failures in recent years. “You need a good reservoir of credit,” says Weinstein.

According to the Guy Carpenter study, the total catastrophe bond issuance in 2003 was $1.73 billion – a 42 % increase on 2002. But this remains a minute proportion of the total world reinsurance market of some $300 billion. If more investors such as hedge funds pile into catastrophe bonds, this can only be a good thing, experts say. “I don’t see any downside,” says Leavey Business School’s Russell. “The entry of hedge funds will lower spreads and everyone will benefit. The market is going to be liquid,” he says.

MMC’s McGhee thinks that concern in the international media about hedge fund activity in the catastrophe market is overplayed. There continues to be a steady influx of money into this market, especially from dedicated investment funds – cat funds – with a specific focus on the catastrophe bond market and a long-term perspective. The Guy Carpenter study estimates that funds under management dedicated to catastrophe investment will soon exceed $3 billion. But there is no breakdown of how many hedge funds are investing in the bonds and how many act as high-risk reinsurers.

Concern
However, Russell can foresee one doomsday scenario. Over the past five years hedge funds have been creating their own reinsurance entities and providing cover for some reinsurers at the very top end of their modelled potential catastrophe losses. Though not quantified, some market reports have suggested that the hedge funds now account for up to half of such extreme event cover on the reinsurance market. If the maximum expected loss from a Californian earthquake is, say, $50 billion, a reinsurer could sell a layer of $45 billion to $50 billion of its catastrophe cover to a hedge fund. Insured damages from Californian earthquakes have not exceeded $25 billion, says Russell. But if the extreme event were to happen, and the hedge fund had insufficient assets to cover the event, the subsequent loss could travel through the entire investment chain.

In October, William Donaldson, chairman of the US Securities and Exchange Commission (SEC) warned of a “gold rush mentality” as relatively unregulated hedge funds betting on high-risk markets attract ever more money from pension funds and institutional investors. The same month, Stephen Drayson, manager for wholesale investment banks at the UK’s Financial Services Authority (FSA) told a London conference that the regulator is examining the potential risks from hedge funds as capital flows into them.

Dominoes
And in an October research note, Moody’s Investors Service warned of a “domino effect” as an increasing number of unregulated investor groups take on the same market bets. According to Moody’s, the hedge fund industry ballooned to more than $1 trillion in 2004. “There is a risk of a domino effect resulting from multiple failures of hedge funds engaged in the same directional bets,” the agency says. The funds generated an estimated $7.5 billion in equity-related fees alone in 2004. All of the experts consulted stressed that catastrophe bonds are not “a widows and orphans’ play”. But with institutional investors increasingly placing capital in the hedge funds, and hedge funds targeting the catastrophe market, the correlation is there.

The EDF cat bond and European windstorm risk

In January 2004 Electricité de France (EDF) became the first utility worldwide – and the first European corporate – to issue a catastrophe bond, through its special-purpose vehicle Pylon Ltd. This was also the first such catastrophe bond to be issued in euros. The purpose of the securitisation is to protect EDF from the financial consequences of a severe windstorm similar to the Lothar and Martin storms which hit France and other western European countries in December 1999. The bond covers the risk of damage to EDF's transmission and distribution network. It uses a parametric trigger. This means that the bond’s payout will not match EDF’s losses or exposure exactly. Instead, it is triggered when wind speeds across France exceed certain levels set by an index (see below). The index is weighted most heavily towards south west France and is based on data provided by the French meteorological service, Méteo-France. The five-year bond comes in two tranches. The first, E120 million, will pay out the first time the index is triggered. Investors will lose capital according to a sliding scale depending on the severity of the storms. This tranche is rated Ba1 by Moody’s, BB+ by Standard & Poor’s and has an expected loss of 54 basis points. A second, E70 million euro tranche will only pay out if the first tranche already has been triggered, its capital exhausted and a second event occurs during the five years the bonds are outstanding. This tranche is rated A2 by Moody’s, BBB+ by Standard & Poor’s and has an expected loss of two basis points. Paris-based CDC-Ixis Capital Markets arranged the transaction. The parametric index for the Pylon Ltd transaction was set by Newark, California-based Risk Management Solutions (RMS). It is based on recorded wind speeds and is weighted to match the regional variations in vulnerability to wind-related damage to the network. A multi-year risk analysis to quantify the loss probabilities was performed using RMS’s proprietary stochastic database in its European windstorm model. The Lothar and Martin storms caused total economic losses throughout France of E11 billion. This included damage to transport, communications, buildings, monuments and vegetation, as well as power infrastructure. Wind speeds in excess of 150 kph (93 mph) were measured over much of the country, reaching 180 kph in some places. The electricity sector suffered some 10% of the total economic loss, according to EDF. Over 80% of the damage to the distribution network (lines of capacity less than or equal to 20 kV) and over 50% of the damage to the high-voltage network (63kV and 90kV) was caused by trees falling onto the power lines. In addition, high winds caused direct damage to structures when wind pressures exceeded design specifications.