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Investors turn to ‘catastrophe bonds’ as hedge against uncertain market

So-called "catastrophe bonds," a backup plan designed to protect insurers from the costs of Mother Nature's worst visitations, are getting new attention from investors following the recent wave of earthquakes, floods, tropical storms and other natural disasters.

Investors, turned off by the turmoil in the financial markets, are instead taking their chances and betting against natural disasters like earthquakes and hurricanes. Most of the time, they get good returns on their money. If a catastrophe strikes, though, they can lose everything.

Ironically, catastrophe bonds, or "cat bonds," are considered a relatively safe gamble compared to the volatile financial markets of late. For investors seeking shelter from the wild swings on Wall Street, the U.S. debt downgrade and the euro crisis savaging Europe, catastrophe bonds represent a move to diversify into a market facing completely unrelated risks.

"The financial markets tanking don't increase the possibility that there's going to be an earthquake," said Judy Klugman, managing director and head of insurance-linked securities distribution at Swiss Re, a reinsurance company that issues catastrophe bonds for its client insurers. "Investors are just generally nervous about everything that's going on in the financial world. Right now, they think this is a safe haven. They don't know where else to put their money."

The $11.5 billion cat bond market is still small compared to the global corporate bond market of $7.5 trillion, according to John Forney, managing director of public finance at Raymond James & Associates Inc.

But demand is growing, and the catastrophe bond market has jumped 2.8 percent since Hurricane Irene made landfall in late August.

Swiss Re is trying to increase of the size of the market so it can pay interest rates for the bonds it sells. "As you create more and more demand," Ms. Klugman said, "the spread will go down."

The task is becoming easier for Swiss Re because demand is up, as, it appears, is the supply of disasters to pay for.

The tab in New Orleans from Hurricane Katrina was enormous. More recently, Japan was ravaged by an earthquake, a tsunami and a nuclear meltdown, while deadly tornadoes ripped through Joplin, Mo. Earlier this year, an earthquake and Hurricane Irene surprised much of the East Coast.

But those disasters and near-misses don't scare investors as much as the world's volatile financial markets. Ms. Klugman said investors are savvy enough to know the risks they're taking when they get into the market. So a few rumbles here and there aren't going to push them away.

"Investors in our market get paid to take those risks," she said. "Our investors, their eyes are very wide open about the risks they take."

Furthermore, chances are slight that cat bonds will ever be redeemed by the issuer. The "triggers" on the bonds are so specific, covering things such as location, time and degree of destruction, that they are rarely used.

For example, California could issue a catastrophe bond that covers Los Angeles from a magnitude 7.2 or greater earthquake for a period of three years. If there's a magnitude 8 earthquake in San Francisco, the bond wouldn't be redeemable. If there was a magnitude 7.1 earthquake in Los Angeles, it also wouldn't be redeemable.

"They cover very specific areas," Ms. Klugman explained.

For insurers, cat bonds can offer a cheaper backup option. Reinsurers serve as the backup to the backup, protecting insurers against claims so big and sudden that they can't repay their policyholders.

The reinsurance industry, however, is less regulated than traditional insurance, said Erwann Michel-Kerjan, an industry specialist at the Wharton School of Business at the University of Pennsylvania, so reinsurers have an easier time raising prices on traditional insurers. He pointed out that the price of reinsurance doubled after the major hurricanes of 2004 and 2005. It went up another 90 percent to 95 percent in Chile after the earthquake there last year.

"After every major disaster," he said, "the price of reinsurance increased very significantly."

Hoping to deflect some of this cost, some traditional insurers are looking to cat bonds as a new form of reinsurance. The California Earthquake Authority just completed a $150 million deal in which it has issued three-year catastrophe bonds.

"So they were like, 'Wow, is there any way we can get a more stable price?' " Mr. Michel-Kerjan said. "And that's what cat bonds provide."

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