Cat Bond Man To The Rescue?

It's not all bad news on the insurance front in the mass media. For one, I was pleasantly surprised to see an intelligent story about catastrophe futures gracing the cover of “The New York Times” magazine on Aug. 26, headlined: “In Nature's Casino.” The piece focused on the efforts of one individual to figure out a way for the financial markets to profitably take on some of the risk of natural disasters. Can cat bonds make a big difference in today's disaster-shy insurance market?

(To read the “Times” story, click here.)

To the credit of the author, Michael Lewis, the story is a fascinating read and often very dramatic–not the norm for anything having to do with insurance reporting. (“The more John Seo looked into the insurance industry, the more it seemed to be teetering at the edge of ruin,” one paragraph breathlessly began, halfway through the lengthy piece. “Then CAT BOND MAN came to the rescue…” All right, I made up that second sentence, but you get the idea.)

Mr. Seo opened a hedge fund to trade in cat bonds, but the problem remains that relatively speaking, there doesn't seem to be a lot of cat bonds to trade. It's still a niche market–even though, as the article points out a number of times, the capital markets have far more funds at their disposal to risk on insurance than do insurance companies themselves.

It hasn't exactly been smooth sailing for Mr. Seo, the article notes. Four years after opening his hedge fund, the “Times” reported, he “still faced two problems. The smaller one was that investors were occasionally slow to see the appeal of an investment whose first name was catastrophe…His bigger problem was that insurance companies still didnt fully understand their predicament: they had $500 billion in exposure to catastrophe but had sold only about $5 billion of cat bonds–a fifth of them to him.”

Mr. Seo, according to the “Times,” contends that “insurance companies are charging customers too much–or avoiding their customers altogether” in catastrophe-prone areas, “instead of sharing their risk with others, like himself, who would be glad to take it.”

The insurance companies are basically running away from society, he is quoted as saying. What they need to do is take the risk and kick it up to us.

One of the big concerns about cat bonds is that the investment community will scatter like frightened rabbits if another major event hits. But Mr. Seo scoffs at that assumption.

Indeed, the “Times” reports that Mr. Seo believes “investors will endure losses as long as they come in the context of a game they perceive as basically fair, which is why they dont abandon the stock market after a crash.”

Thats all I need to know, he is quoted as saying. Thats all my clients need to know. In fact, he added, investors should take a hit if another major disaster strikes. I would be embarrassed if we had a big event and our loss wasnt commensurate with it,” he said. “It would mean that we didnt serve society. We failed society. How often have insurers made a humble admission like that about its mission?

We ran a piece in NU shortly before the “Times” story broke, in our Aug. 20 edition, headlined: “Is There A Future In Trading Of Catastrophe Futures?” Frank Ellenbuerger, a partner and global head of the insurance practice for KPMG LLP in New York, talked about how with hedge funds seeking high returns, futures linked to catastrophe exposures may now succeed. (That may not be a good thing, I think, since the same desperate drive for higher returns caused the crisis in the subprime mortgage market, did it not?)

(For our complete story on cat bonds, click here.)

He cites some of the history of this alternative market, noting that the concept is far from new, going back to 1973, and including interest from some heavyweights such as the Chicago Board of Trade with its insurance futures.

“Which begs the question,” he noted. “Why would an investor participate in a market characterized by massive and unpredictable losses?” Good question, indeed!

Do any of you have an answer? Are cat bonds a significant solution for those writing disaster coverage? Can the concept make a dent in the massive exposure facing the industry? Could it help bring down prices for consumers along the vulnerable coastlines by better spreading the risk? Or is this a pipedream among a few fat cats looking for a new financial game to play?

I tend to think that while cat bonds could provide some badly needed reinsurance support for those carriers that still want to write catastrophe coverage–as well as those who self-insure their property risks–it will never be a truly significant form of capacity in the grand scheme of things.

However, these days, with companies pulling back from cat-prone areas, every little bit helps.

What do you folks think?