By Menachem Feder

[The author is a partner in the law firm of Caspi & Co. in Tel Aviv and specializes in finance and international transcactions. He can be contacted at nmf@caspilaw.co.il. This article was published in Haaretz in English on January 24, 2002 and in Hebrew on January 22, 2002 ]

Losses spreading from last year's September 11^th tragedy can be measured not only in human terms, but in economic ones. Certainly, one of the consequences of the terrorist attacks on New York’s World Trade Center will be more insurance liability than in any previous catastrophe. This only spotlights the shortcomings of the surprisingly critical reinsurance market. More than ever, catastrophe risks require efficient management and the ever-growing financial world of securitization may provide the necessary service.

As arcane as reinsurance sounds, a proper reinsurance market is essential to efficient allocation of catastrophe risk. This too sounds arcane, but this allocation can be critical to even the average citizen. The average citizen depends on insurance, but insurance often depends on reinusrance.

A business or household normally insures against the risk of natural catastrophe – in Israel, primarily earthquake – because alone it cannot bear the economic loss of a building or home. But, primary insurers too cannot healthily bear all that risk. Because the natural catastrophe risk that they insure concentrates in a single geographic region, they cannot survive a sizable local catastrophe. Thus, they sell portions of the risk to global reinsurance companies. These reinsurers, in contrast, regularly retain the risk because they consider themselves protected – they pool exposures to all kinds of risk events around the world, diversifying the risk to the presumed point of manageability.

The traditional reinsurance model, however, is imperfect. For one, not even the reinsurance companies may be able to easily handle the capital obligation that arises from a mega-catastrophe. Almost certainly, they would struggle with one such disaster following closely on the heels of another such disaster.

The final losses arising from September 11^th can only be guessed at – size of claims and legal issues have yet to clarify. Nonetheless, the prospective liability has already so much reduced reinsurance capacity that many types of reinsurance have become prohibitively expensive. This leaves those facing oppressive risk with the prospect of expending great sums for insurance, maintaining an unsound risk profile or, in the case of insurers, limiting business.

Additionally, it is sometimes thought that, as a general matter, primary insurers do not pass on enough of their catastrophe risk to reinsirance companies to survive a sizeable disaster. Various barriers to efficient reinsurance -- insufficient reinsurance supply, reinsurance company market power and opacity and the like – are theorized to lead to insufficient reinsurance. Whatever the reason, over-exposure by a primary insurer exposes the unsuspecting insured.

One way to expand and improve catastrophe reinsurance is to access efficiently new sources of risk capital. If the capacity of the traditional reinsurance industry is tight or if its reliablity is not convincing, then non-traditional capacity should fill the void by recapitalizing reinsurers or by directly reinsuring primary insurers. The most logical supplier of alternative and efficient capacity are the highly liquid and highly-volumed capital markets. To access these markets, all one needs to do is issue an appropriate security.

Enter the catastrophe, or "cat" bond. Essentially, a cat bond is a tradable capital market instrument that creates reliable reinsurancey in the event of a catastrophe. It is the end-product of a financial process called securitization, which transforms risk into liquid security instruments. A cat bond can take many forms, but it always involves reward if no catastrophe occurs and, depending on certain conditions, debt forgiveness if one does.

In one cat bond variation, an insurance or reinsurance company seeks to pass on natural catastrophe risk by issuing a short-term bond with attractive rates of interest. If a triggering catastrophe occurs in a specified geographic region within a stipulated period of time, and if losses exceed a certain threshold, the bondholder will lose some aspect of its investment. For the relatively conservative investor, the bond can offer a principal protected tranche – interest will accrue at a moderate premium over prevailing rates, but will be confiscated in the event of the triggering catastrophe. For the investor willing to stomach more risk, the bond can offer a tranche with interest at a great premium, but which exposes the principal to confiscation upon an insured event.

For the investor, the cat bond can be alluring not just because of its nominally attractive rate of return, but because of its unique nature. Since the risk to the cat bond investor is linked to Acts-of-God and not market conditions, a cat bond offers a money manager diversification from the normal risks of market investments. Of course, it may not be efficient to sequester the maximimum potential loss, as cat bonds usually do, instead of pooling uncorrelated risks, as traditional reinsurers do. Nonetheles, the sequestration allows the capital markets to act as truly dependable reinsurers.

Securitization of natural catastrophe risks was not possible even a decade ago. Capital market instruments require a lot of information for accurate pricing and, for many years, insurers and reinsurers alone collected and analyzed systematically the geophysical, meteorological, and developed real estate information required for an economic understanding of natural catastrophes. But, today, a number of specialty firms develop and sell to all comers models that simulate the economic aftershocks of, say, an earthquake.

In Israel, economic exposure to earthquake is growing as both population and building construction grow. This only magnifies the importance of laying off reliably significant earthquake risk. In today’s environment, securitization via cat bonds may provide the best allocation of that risk.

Securitization has been around for only a short time and cat bonds for even less. Nonetheless, we know already that securitization works well where large capital capacity is required and when the risks involved can be relatively understood. For the natural catastrophe overexposed, this means that they may no longer have an excuse to put off risk transfer, especially since earthquakes wait for no one.