Stronger demand for insurance-linked securities is putting pressure on traditional reinsurers, spurring innovation as reinsurers and brokers develop novel investment structures for institutional investors and the hedge fund managers who invest on their behalf.

This surge in insurance-linked securities is evident in the increased issuance of catastrophe bonds. According to a Swiss Re Ltd. report released in July, the total value of outstanding catastrophe bonds as of July 1 was $17.1 billion, exceeding the previous full-year record of $17 billion set in 2007 in the aftermath of Hurricane Katrina.

Unlike the upswing in the catastrophe bond market after Katrina, however, market dynamics now are being driven by investor demand from a variety of new sources, most notably institutional investors and traditional money managers.

“Everything is changing in the insurance-linked securities market, from the size of deals to the players involved,” said Tim Faries, a partner in the insurance group at Appleby Global Group Services Ltd., a Hamilton, Bermuda-based financial services firm that advises on insurance-linked securities.

“Historically, our market was dominated by single-strategy hedge funds,” said Judith Klugman, head of insurance-linked securities distribution and sales for Swiss Re. “They have been extremely successful and still make up a big percentage of our market, but that is beginning to shift as more generalist money managers take an interest.”

The mix of institutional investors investing in catastrophe bonds and other securities linked to insurance now includes more pension funds, endowments and sovereign wealth funds.

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“What we've seen is that pension funds have largely been behind the capital that has continued to flow into the market,” said Chicago-based Paul Schultz, CEO of Aon Benfield Securities.

Institutional investors increasingly have become enamored with insurance-linked investment strategies because catastrophe bond annual investment returns tend to fall in a range between 7% and 8%, topping ho-hum returns of traditional fixed-income securities in a low interest-rate environment — and they are uncorrelated with financial markets. The biggest investment area for institutions and hedge funds has been catastrophe bonds, by far the largest segment of insurance-linked securities, but there are other investments such as industry loss warrants and sidecars.

Increased transparency and education, as well as structural changes, have increased investor and issuer comfort with insurance-linked securities, sources said.

For example, a higher percentage of catastrophe bonds now use indemnity triggers, based on the losses suffered by the bond issuer and have gained popularity at the expense of both parametric triggers, which rely on measures such as wind speed to trigger the bond and indexed triggers, based on an industrywide index of losses, Ms. Klugman said.

“What we are finding is that as our investors have become more sophisticated, there is a greater acceptance of indemnity triggers,” she said.

Two of the most recent institutional investors to jump into insurance-linked securities are:

• The $13.2 billion West Virginia Investment Management Board, Charleston, which invested $40 million in Chicago-based Elementum Advisors L.L.C.'s specialist catastrophe reinsurance hedge fund; and

• The 23 billion New Zealand dollar ($18 billion) New Zealand Superannuation Fund, Auckland, which committed up to $275 million in London-based Leadenhall Capital Partners L.L.P.'s property catastrophe hedge fund, having previously invested $250 million in 2010 in Elementum's hedge fund.

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On a short-term basis, Aon Benfield's Mr. Schultz said demand for catastrophe bonds has experienced ebbs and flows.

“In the early part of the year, there was significantly more capital looking to be deployed than transactions coming to market. Since then, we've seen a healthy stream of issuances, and supply and demand is now about the same,” Mr. Schultz said.

Aside from the New Zealand Superannuation Fund's outsized $500 million investment, most institutional reinsurance allocations are fairly small, in the $30 million to $50 million range, sources said.

Over the long haul, the aggregation of even such small investments has the potential to crowd out the traditional sources of reinsurance market capital, sources said.

Currently, only 15% of the total $300 billion property catastrophe reinsurance market now is from nonreinsurance industry sources known in the industry as “alternative capital,” according to an estimate by Goldman Sachs Global Investment Research in its “The Search for Creative Destruction” report distributed Aug. 7. However, if pension funds with an estimated $2 trillion of aggregate assets allocated just 50 basis points of their funds to property catastrophe investments, the resulting $100 billion would be more than double the existing amount of alternative capital in the reinsurance industry, according to the report.

“The total amount of pension fund assets so dwarfs the size of the whole reinsurance industry. Even a small fraction of those trillions would completely swamp the reinsurance industry,” said Michael Luft, managing director and consultant for insurance-linked securities at investment consultant Rocaton Investment Advisors L.L.C., Norwalk, Conn.

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The volume of new capital flowing into their reinsurance space already has altered the supply/ demand dynamic and driven the cost of issuing bonds down relative to traditional reinsurance, said David Foley, global practice leader of actuarial and advanced analytics for Deloitte Consulting L.L.P.

“The frictional cost of catastrophe bonds is falling,” Mr. Foley said. “So even from a price standpoint, they are becoming competitive with traditional reinsurance.”

This diminishing price differential has prompted differing reactions from reinsurers.

“Some traditional reinsurance players are following the adage of 'If you can't beat 'em, join 'em' and investing in building teams that are capital markets desks,” Appleby's Mr. Faries said.

Conversely, during a July conference call with equity analysts, Evan Greenberg, CEO of Zurich-based insurer and reinsurer Ace Ltd., said his insurance company was being more selective about writing reinsurance as the influx of alternative capital has exerted downward pressure on rates, especially in catastrophe-exposed regions.

“You see alternate capital coming in, capital markets in addition to traditional players,” Mr. Greenberg said. “So you've got that pond, with more drinking out of it.”

Bill Kenealy is an associate editor at Business Insurance; Christine Williamson is a senior reporter at sister publication Pensions & Investments.