High yields are driving Wall Street into 'catastrophe' bonds

February 6, 2007, George Stein, Bloomberg© via International Herald Tribune©

NEW YORK – John Brynjolfsson at Pacific Investment Management Co. is one of the biggest buyers of catastrophe bonds, securities whose returns are linked to insurance claims from calamities like hurricanes, earthquakes and disease.

Brynjolfsson enjoys watching documentaries about cataclysmic events and violent storms on television, but the bonds are more than a personal interest. They pay as much as 10 percentage points more than benchmark interest rates, making them some of the highest- yielding investments in fixed income.

Fund managers like Brynjolfsson are increasingly turning insurance into the next frontier for securitization, the technique Wall Street perfected to package everything from credit card bills to mortgages and car loans into tradable bonds. They want high-yielding securities that are not tied to stock or bond markets, and the insurers themselves, still reeling from Hurricane Katrina and under pressure from regulators to conserve capital, are searching for ways to off-load risk.

Swiss Reinsurance, the world's largest reinsurer, estimates that the market for insurance-linked securities, which includes things like "bird flu bonds," will grow to $350 billion in a decade after more than quadrupling to $27 billion in the past five years. With as much as $2 billion in underwriting fees up for grabs, almost every investment bank, from Lehman Brothers Holdings to Deutsche Bank, is building teams to sell and trade insurance.

"You can't match these yields," Brynjolfsson, who holds $1 billion of catastrophe bonds at Pimco, said during an interview last week. "They fully compensate the investor for the risks that are being underwritten and provide an additional premium. I'm making a real strong push with issuers and Wall Street to bring out more of these securities for my investors."

Roger Ferguson, who became Swiss Re's head of financial services last year after quitting as vice chairman of the U.S. Federal Reserve, said in December that insurance-linked securities might offer the growth potential of mortgage bonds, a market that has grown to more than $6 trillion from almost nothing in the late 1970s. Fees in the capital market for insurance also are more lucrative.

Underwriting commissions on catastrophe bonds range from 1 percent to 1.5 percent, according to Dan Ozizmir, head trader of insurance-linked securities at Swiss Re. For "sidecars," vehicles that let investors bet on specific reinsurance risk, arrangers can make 2 percent. That compares with the 0.12 percent average fee bankers earn selling bonds for Fannie Mae or Freddie Mac, the biggest providers of funds for U.S. home loans.

Most insurance bonds function like reinsurance, except that instead of being underwritten by a single company, like Berkshire Hathaway, the risk is borne by multiple investors. Insurers sell catastrophe bonds to cover damage claims from disasters like Hurricane Katrina, which cost the industry more than $40 billion.

"When you put all that together, you have an attractive market with legs," said Nelson Seo, who holds insurance- linked securities at Fermat Capital Management, a hedge fund in Westport, Connecticut.

Buyers of AAA-rated mortgage bonds get yields of 1 percent more than benchmark interest rates for assuming the risk that homeowners will default. The stakes — and potential payoff — on catastrophe bonds are higher.

A disaster like a typhoon or pandemic flu can trigger claims that consume a bond's principal. Four months after Swiss Re sold $190 million of "Kamp Re" bonds in July 2005, the company said investors probably would not get their money back because of Katrina's devastation.

Standard & Poor's lowered its credit rating on the bonds to "CC," two steps from a default, in October 2005. Pimco valued its $5 million of Kamp Re bonds at $3,000 in a filing two months ago, down from $2.47 million a year earlier. The bonds mature this year on Dec. 14.

On Lehman's New York trading floor, Brett Houghton watches screens displaying radar readings from the U.S. National Weather Service and seismic data from the U.S. Geological Survey. He trades in catastrophic risk.

"If someone asks us for a quote on a type of bond, we're going to look at hurricanes or earthquakes that happened in the area before we actually set a price," Houghton said.

Lehman has 20 bankers and traders specializing in insurance-linked securities. To bet on the likelihood of a global or regional pandemic, Houghton can buy and sell bird flu bonds. For earthquakes there are catastrophe bonds.

Niraj Patel, a money manager at Genworth Financial, an insurer based in Richmond, Virginia, uses the returns from catastrophe bonds to finance payments that Genworth makes on life insurance claims. "People never thought of insurance as a trading instrument, but that's changing," Patel said.