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Take an interest in catastrophe

The next earthquake to hit California could send shock waves through the portfolios of bond investors, if a new kind of investment known as catastrophe bonds catches on.

Some of the world's biggest insurers and investment banks are devising ways to share insurance risk with investors, designing bonds that pay lower returns in the event of a natural disaster.

Insurance companies are engineering ways to access new capital sources, expanding their scope to do new insurance business and ensuring they can still offset risk if a big insurance claim drains the cash available in the traditional reinsurance market or if the cost of reinsurance gets too high.

"You need the financial markets - it's a way of getting rid of some of the risk," said Kaj Ahlmann, chairman and chief executive of Employers Reinsurance, a unit of General Electric of the US and one of the world's biggest reinsurers.

Europe's biggest insurer, Axa, said last week it was forming a joint venture with Banque Paribas to engineer products combining financial instruments and insurance policies to offer corporate clients any kind of protection they might want.

"We are just at the beginning of the learning curve on getting investor interest in this type of product," said Marc Romano, chief executive officer of the joint venture. "We believe there is huge potential because investors need to diversify the risk profiles in their portfolios."

The products will include catastrophe bonds, in which investors get less interest, or lose all or part of their capital, or both, if some specified natural disaster happens, such as an earthquake. They will also include multiple-risk products, in which the insurer blends different kinds of insurance risk into a single security. An industrial company could hedge against currency shifts eroding profits and taking out insurance against a supplier being unable to provide materials.

Investors have already bought a couple of bonds linked to insurance risks. In January, Winterthur Insurance sold Sfr300m (pounds 130m) in three-year bonds paying interest of 2.25 per cent, which the company said was about a third more than it would typically pay. But the interest payment is cancelled if Winterthur receives 6,000 or more claims in a year for weather damage to cars, which the insurer said has happened twice in the past 10 years. Hailstone bonds, if you like.

Insurers want to guard against a big insurance claim, such as the $16bn paid out in 1992 after Hurricane Andrew hit Florida, or the $12.5bn damages caused by the Northridge earthquake in California, driving the cost of reinsurance through the roof. They want to educate investors in advance, persuading them to buy securities which take on some form of insurance risk, before that happens.

"The capital markets are big, whereas the reinsurance market has more a finite appetite for risk," said Kristin Brooks, a director at rating company Standard & Poor's in New York. She reckons the market is "analogous to the mortgage-backed securities market 10 years ago."

Other insurers who've said they plan to expand into this new business include Swiss Re, with its banking partner Credit Suisse Group, American International Group of the US, and Zurich Insurance. Allianz said it plans to join the fray later this year. Allianz Chairman Henning Schulte-Noelle said that while the use of financial products in insurance has until now been limited, the market is of "rising importance".

In May last year Lane Financial, which specialises in ways to transfer insurance risk, and Sedgwick Re Insurance Strategy formed a joint venture, Sedgwick Lane Financial, to explore new capital market products for the insurance and reinsurance business.

"It's going to take time and education, but it's increasingly accepted as a concept and if there's a hard market, it'll be increasingly accepted as a reality," said Morton Lane, president of Sedgwick Lane Financial.

In April the company sold its first bond, an 18-month security linked to catastrophe, marine, aviation and satellite risk for the first year of its life. Investors sacrifice part of their principal in the event of specified insurance claims. Mr Lane expects "to come out with two or three insurance-linked notes of some sort before the end of the year".

The new securities are a unique diversification tool. The performance of stocks, bonds or property is tied to the economy, but natural disasters are random, so have a different risk profile. There's no reason why a decline in stocks or bonds should coincide with a loss on an insurance- linked product.

Investor Warren Buffett thinks betting on earthquakes can be a good way to make money. Last year the California Earthquake Authority began marketing a $1.5bn bond designed to help meet claims in the event of a Californian quake.

The state-sponsored insurer of earthquake risks cancelled the bond plan, however, when Buffett's Berkshire Hathaway Group opted to take on the whole risk. Buffett said such huge risks, known as super-cat risks, prove highly profitable over several years, though they can suffer big one-time losses.

"What you must understand is that a truly terrible year in the super- cat business is not a possibility - it's a certainty," Mr Buffett said. "The only question is when it will come." Copyright: IOS & Bloomberg