LONDON (Reuters) - Investors who have put their money into specialist financial bonds which cover insurance companies from huge natural disasters are unlikely to be hit with big losses from monster storm Sandy even though it is one of the biggest ever to hit the United States.
So-called catastrophe bonds represent an obscure part of the insurance industry in which insurance and reinsurance companies transfer extreme risks, such as those for earthquakes and hurricanes, to financial market investors who receive a handsome yield in return for agreeing to cover damages they consider unlikely.
You would have thought a storm so big it's being called 'Frankenstorm' would cause cat bonds investors to worry about losing their money, but not so. Cat bonds are designed to cover natural catastrophes that are so big they only happen once every 250 years. Also, they need to hit specific locations at a specific intensity to trigger a payout.
Disaster modelling company Eqecat said Sandy is likely to cause insured losses of $5 billion to $10 billion - big numbers, but not big enough to significantly impact the cat bond sector.
"The current estimates of insured losses are not enough to trigger full payouts from any exposed bonds," said Antonio Guevara-Mazariego of cat bond broker Tullett Prebon.
Not even Hurricane Katrina caused huge losses for cat bond investors. It only partially triggered one of the nine cat bonds covering the Gulf region despite the 2005 hurricane being the insurance industry's most costly natural disaster, causing $40 billion in claims.
HURRICANE HOT SPOTS
Sandy is in the right part of the world though - cat bond transactions tend to cover U.S. hurricane hot spots such as Florida, North Carolina and the Northeast - and other potentially big and expensive disasters, such as Japanese earthquakes and storms in Europe. But it would need a disaster many times worse than Sandy to trigger a payout.
The publicly traded catastrophe bond market, with a capitalization of about $16 billion, is still tiny - but the percentage of cat bonds with exposure to U.S. hurricane risk stands at 67 percent, according to GC Securities, part of broker Guy Carpenter.
There are around 14 bonds totalling $3.6 billion that are exposed to Hurricane Sandy's track along theEast Coast of the United States, which cover reinsurers such as Swiss Re , Munich Re and SCOR, and big American insurance companies including Chubb, American Insurers Travelers Co Inc and USAA.
The chances of a bond triggering are low - around 1-2 percent in any year. Most of the transactions that are exposed to Sandy use an industry loss index to calculate any losses.
In this instance, U.S.-based data aggregator Property Claims Services (PCS) will provide a catastrophe loss estimate, which is used to define whether an event qualifies under the terms of the deal or not.
The brunt of the storm's financial impact is more likely to end up falling on the National Flood Insurance Program, which is responsible for almost all flood coverage in the country.
Investors are attracted to the high returns on cat bonds, which are rated below investment grade
From 2007 to 2012, investors have seen an average annual return of 8.32 percent from cat bonds, compared to 5.84 percent from 3-5 year U.S. treasury notes and -1.15 percent from the S&P 500, according to the capital markets team at reinsurance broker Aon Benfield.
Only eight bonds have ever paid out to the issuing insurer because of a natural catastrophe from a total of 232 bonds issued since the market's inception back in the early 1990s. But regulations governing the market require that insurers must cover themselves against the sort of huge disaster that a cat bond would protect them from.
Cat bonds have not avoided losses altogether though. Some transactions are structured so that a number of natural disasters need to happen in order to create a payout. This happened when a cat bond called Mariah Re was eventually triggered after a string of devastating tornadoes struck theUnited States in April and May 2011.
American Family Mutual Insurance, who sold the bond, claimed $100 million from investors after the insured losses from each tornado reached a point that triggered a payout.
Sandy is likely to qualify as an 'event' which could lead to an overall loss when the bond matures if there are other linked disaster under the terms of the bond.
Last year's Japanese earthquake triggered a cat bond issued by Munich Re that forced investors to pay $300 million to the reinsurer.
When huge natural disasters do happen, it boosts the demand for cat bonds from insurers looking for alternative reinsurance protection, by selling catastrophe-linked notes to capital market investors.
"The market has seen catastrophe events of equal or greater economic impact (than Sandy), and investors have remained committed to the cat bond sector," said Guevara-Mazariego.
The market is likely to keep growing as investors look to avoid exposure to faltering economic growth in the United States and Europe.
Catastrophe bond issuance is likely to grow by 25 percent in 2012, reaching up to $7 billion by the end of the year, according to brokers and investors.
Conservative investors, such as pension funds, are fuelling booming demand for these specialized bonds, including PGGM, the Dutch pension fund manager with $154 billion in assets under management.
Sandy is another test of a relatively young market, but one British-based cat bond investor said not to underestimate Mother Nature just yet.
"I don't see any significant cat bond losses at the moment, but the storm is still going and will be until the end of the week," said Luca Albertini, chief executive officer at Leadenhall Capital Partners.