ANALYSIS-Private cat bonds quench investor appetite
* Sponsors look for cheapest reinsurance cover* Investors buy private reinsurance deals as traditional cat bond market stagnates
* Private cat bonds currently $300-$400 mln outstanding
By Sarah Mortimer and Myles Neligan
LONDON, Sept 19 (Reuters) - A slowdown in new sales of catastrophe bonds this year has prompted an increase in private bond placements as frustrated investors arrange bespoke transactions with insurers seeking cheap protection from disaster losses.
The growth in private deals, regarded as carrying higher risk for the investor, comes as institutional players commit more money than ever to the sector, seen as insulated from turmoil in mainstream financial markets.
Insurers and reinsurers use publicly rated catastrophe bonds to transfer major risks on their books, such as for storms and earthquakes, to capital markets investors.
Pension funds and other large institutions have shown increasing interest in the market, although they tend to invest via specialist insurance-linked securities funds.
But issuance of traditional cat bonds has slowed since risk modelling firm RMS, whose disaster loss projections are a key element of pricing for many bonds, adjusted its model in February to incorporate a higher probability of hurricane damage in inland areas of the United States.
The change increased loss estimates on some bonds by as much as 90 percent, prompting credit rating reviews for some issues, and led insurers and other issuers to defer planned deals.
TAILOR MADE DEALS
Frustrated cat bond investors have since sought to stimulate deal flow by encouraging smaller insurers who would otherwise have bought conventional reinsurance to issue bonds privately.
That has helped increase the volume of outstanding private cat bonds to about $400 million, compared with a total market size of $11 billion.
Private, or 'club' deals, where a bond is placed directly with a handful of selected investors, allow primary insurance issuers to avoid the costly legal, catastrophe-modelling, and rating agency hoops associated with a public sale.
In July, broker Towers Watson placed $11.95 million of private cat bond notes with a syndicate of capital markets investors to protect a small Florida-based insurance company from U.S. hurricane claims.
Some experts worry, however, that growth in opaque private deals could concentrate power in the hands of a few buyers, deterring new investors from entering the market and constraining its ability to efficiently share the insurance industry's risk burden.
"My concern is that the market could go much more private than public," said Peter Nakada, managing director at RMS.
"The evolution of this market is that there are a handful of very large specialist investors that seem to be getting larger. I feel like having more managers of this stuff out there would allow you to access the market more quickly."
Market participants say some issuers have also taken the private route to prevent their bonds being bought by reinsurers -- major holders of cat bonds because their coupon payments often make them more profitable than traditional reinsurance contracts.
Their worry is that this increases reinsurers' vulnerability to disasters, potentially impairing their ability to pay claims after major catastrophes, and defeating the market's fundamental objective of transferring risk away from the insurance industry.
Private placements can also be used to sell an unusual risk that may not be palatable to the wider market. Such deals often carry a higher probability of loss and offer investors more generous coupons to compensate.
"The traditional cat bond market has a lot of capacity for plain vanilla first-event transactions with a 1-2 percent expected loss," said John DeCaro, founding principal of cat bond investor Elementum Advisors.
"But anything with a unique structure, such as a higher risk layer -- there are only a finite number of investors who will buy those notes."
This year saw a larger-than-usual private bond placed with six investors to cover Tokio Marine against $160 million of Japanese typhoon risk.
The deal was a strategic move by the Japanese insurer to ensure the bond found buyers at a time when an unprecedented series of natural disasters had reduced reinsurers' appetite for new business, said people familiar with the deal.
Christian Bruns, vice president of insurance-linked investments at Swiss private bank Clariden Leu, a major investor in the sector, reckons the recent spate of private deals is unlikely to become a long-term trend, especially for larger transactions.
But he acknowledged that the rise in private placements had caused some ill feeling among bond investors who have not been invited to take part.
"What is a bit unfortunate is that it has stirred up a lot of emotions, especially among the smaller investors, who have the perception they are being cut out," he said.
Experts say they expect the supply of traditional cat bonds to pick up again late this year or in early 2012 as the market digests the new RMS model.
Munich Re sees new issuance this year of traditional cat bonds at about $4 billion, down from $5 billion last year and well short of the record $7 billion issued in 2007.
The world's biggest reinsurer said it saw new issuance volumes of $10 billion in the medium term, while Nakada at RMS said the volume of outstanding cat bonds could be up to $50 billion in five years compared with $11 billion now .
Reinsurance broker Guy Carpenter said the bulk of deals planned for the fourth quarter and the first quarter of 2012 were still in the traditional cat bond format.
"The investor base should not be concerned that risk will go solely via the private placement route," said Cory Anger, global head of ILS structuring for GC Securities, the capital markets arm of Guy Carpenter.
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