The problem with the obligations of disaster

A highway collapsed the 1994 Northridge quake Tim Clary/AFP/Getty Images

By Bryan Keogh, Oliver Suess and Jesse Westbrook

It is not easy to cover against Armageddon. Take the case of catastrophe bonds designed to provide capital to insurance companies when extreme disasters, large scale. Mid-March earthquake, tsunami and the crisis in the Japan nuclear reactor would seem to qualify. The economic balance of these disasters may run between 200 and 300 billion to $ and could cost global industry anywhere $ 21 billion to $ 34 billion, according to an estimate on 12 April by the research risk-modelling risk management Solutions firm.

Yet, it turns out that the market cat bond is not so much to cover losses related to the Japan. These obligations often have covenants that strictly limit the type and location of a disaster, that they will cover. Most of the cat bond losses quake covered only in Tokyo. The temblor actually occurred about 240 miles (380 kilometers) northeast of the capital. "Triggers are very precisely defined," said Tom Keatinge, managing director of JPMorgan Chase (JPM) the management of the capital of insurance by team in London. "In General, for a bond of cat trigger, you need a sight to be hit at a general shot in the right direction.".

Early 1990s, Hurricane Andrew, which devastated parts of Florida and the Northridge quake in California, insurers began to issue bonds of cat to spread the risks for financial investors. Business of reinsurance as Munich Re and Swiss Re were also active in this market. (Reinsurance traditionally have provided other insurers against big disasters.) At the end of 2010, there were $ 12.5 billion in bonds outstanding cat, according to Aon Benfield, the based Aon Reinsurance broker in Chicago.

The market works this way: an insurance company issues bonds to financial investors, such as hedge funds and pension, who are willing to place a bet on the probability of a disaster occurring in a particular place and during a specific period. For the duration of the bond, the insurer pays investors a coupon interest rate. If nothing happens, the insurer returns the money when the bond reaches maturity. If the fates are cruel, cat bond investors Kiss to offshore all or part of the capital.

In the case of the Japan, a large part of the 1.7 billion cat bonds based on the Japan have been designed for earthquakes in the Tokyo metropolitan area, hub of market economic and financial in the country representing approximately 40% of the country's economy. The location of the earthquake to the rural Japan will limit the losses investors will face probably said Niklaus Hilti, Chief Strategy Officer of the Switzerland Group (CS) Credit insurance. Bond that a cat, issued by Munich Re and approximately $ 300 million, is supposed to be paid, said Hilti. "The Japan was very similar to Hurricane Katrina." It was of great events, but cat bonds are designed narrowly. ?

Catastrophe bonds have done a job much better protect investors that they must provide financial coverage insurers. The titles are returned 60% over the past five years through April 8, according to Swiss Re Cat Total return bond index. "It's almost like the hole-in-one insurance," says Nelson Seo, co-founder of Fermat Capital Management in Westport, Conn., who oversees approximately 2 billion dollars, including the obligations of cat. "It was very good yields, and most of the investors in this space have been very pleased with it."

Insurance companies show no sign of the abandonment of cat bonds, even if the market did not deliver a payment for the disaster of the Japan big. Reinsurers are required to issue new securities to cover future losses to the Japan. Insurers, certain to face higher premiums of their reinsurers, can do the same. Swiss Re, second largest reinsurer in the world, sold bonds coupon $ 95 million disaster March 30 through its unit of sector Re V containing loss triggers which include another earthquake in the Japan. It is also a demand from pension funds, which can grow up to cat bond issue, 6 billion dollars or $ 7 billion this year against 5 billion in 2010, according to Axa Investment Managers.

The cat bond market's long-term future is less certain, Hilti of Credit Switzerland. End of account, taking a traditional reinsurance contract could be a deal better that to use the chat as a bulwark bond market against major disasters. Hilti, explains: "the point of view of insurers and reinsurers, traditional reinsurance is clearly the hedge better."

The bottom line: The catastrophe bond market will provide only $ 300 million to up to 34 billion dollars in losses of earthquake Japanese.

Keogh, Suess, and Westbrook are reporters for Bloomberg News.

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