HURRICANE BOND ISSUE TAKES MARKET BY STORM

SAN ANTONIO-A $477 million catastrophe bond issue that will provide United Services Automobile Assn. with a high-level reinsurance layer for East Coast hurricane risks could prove to be a watershed event in risk securitization.

The privately placed bond issue, which was completed last Monday and is by far the largest such deal to date, generated tremendous interest among investors. In fact, the offering was oversubscribed, with many investors unable to purchase as big a piece of the issue as they desired.

"I was kind of surprised by the amount and the quality of the USAA deal," said Steven I. Goldstein, vp of underwriting and trading for PXRE Corp. in Edison, N.J., and portfolio manager for Cat Bond Investors, a joint venture of PXRE and Phoenix Home Life Mutual Insurance Co. that was created to invest in catastrophe bonds.

Cat Bond Investors sought to purchase $9 million in USAA bonds, ultimately settling for $3 million.

Such evidence of a ready market for the bonds should spur other insurers to transfer risk to the capital markets, an approach that has been the subject of considerable discussion in recent years but has seen little real action.

According to Andrew Kaiser, a vp at Goldman Sachs & Co. in New York, the USAA deal represents a turning point in the effort to tap the capital markets for insurance coverage "in that it raised significant supplemental capacity and attracted a broad range of sophisticated investors."

Those investors included asset managers, mutual funds, life insurance companies, hedge funds and only a small percentage of traditional reinsurers and traditional property and casualty insurers, said Mr. Kaiser. "So it really was supplemental capital markets' capacity for insurance risk."

Goldman Sachs was co-lead underwriter on the USAA deal with Merrill Lynch & Co. and Lehman Brothers.

The USAA deal has "ramped up the size of these deals," and "exposed the fact that there is an appetite out there for well-priced deals," said Morton N. Lane, president of Sedgwick Lane Financial L.L.C. in Chicago. But it also is significant because investors unable to buy as many of the USAA bonds as they wanted will be looking for other deals in which to invest, he said.

"I think it was a tremendous step forward," said Mr. Lane, whose Sedgwick Group unit is active in both the insurance bond and derivatives markets. "I think we'll be seeing some other deals coming forward rather quickly now."

Among the bond deals expected to come to market in the near future is an issue that Swiss Reinsurance Co. reportedly is crafting. Swiss Re officials could not be reached for comment.

Essentially, USAA's cat bond issue provides the San Antonio-based insurer with 80% of its $500 million reinsurance layer for losses from a single East Coast hurricane this year.

The bonds were issued by Residential Reinsurance Ltd., an independent Cayman Islands special-purpose reinsurer created last year by USAA as it worked with Merrill Lynch to develop a $500 million cat bond deal that never came to fruition.

Residential Re will manage the funds raised through this year's bond issue and will administer a reinsurance contract it has provided USAA.

That reinsurance contract covers the insurer for a loss caused by a single Category 3, 4 or 5 hurricane resulting in insured losses between $1 billion and $1.5 billion to USAA policyholders in the area stretching from Texas, around the state of Florida and north along the Atlantic Coast to Maine.

The $477 million deal was split between two tranches. The first was $163.8 million in bonds in which the purchasers face no risk to the principal. The second was nearly $313.2 million in which all of the investors' principal is at risk if there is a loss.

In exchange for the greater risk, the purchasers of the principal-risk bonds earn a higher return, with the bonds set to pay a rate equal to the London Interbank Offered Rate plus 576 basis points.

The no-principal-risk tranche, meanwhile, pays an interest rate of LIBOR plus 273 basis points.

Similar to the U.S. prime rate, LIBOR, the rate at which prime banks operating in the London Eurocurrency market offer Eurodollar deposits to other prime banks, is frequently used as a standard in pricing bond deals.

The two-tranche structure "allows certain types of companies to invest when they otherwise might not be able to," said Mr. Goldstein of PXRE and Cat Bond Investors, who noted that investments placing principal at risk might be off-limits to some institutional investors.

The stated maturity on the bonds is one year. If there is a covered loss, under its reinsurance contract USAA has the right to extend the maturity for six months while it settles claims. It must pay bondholders additional interest for that six-month period, though investor principal is only at risk for the one-year period.

If there is a loss, the principal-protected securities will be extended another 10 years, and they will not pay interest during that period.

Although the bond issue was for $477 million, investors will provide only $400 million in reinsurance coverage since $77 million of the bond proceeds are set aside to purchase zero-coupon securities that will enable the issuer to repay principal to the principal-protected bondholders if there is a loss.

In a statement released after the deal was completed, Robert T. Herres, USAA's chairman and chief executive officer, noted the insurer never has sustained a $1 billion loss but said "that size natural disaster is possible with large populations residing in coastal areas and other areas vulnerable to hurricanes."

Tapping the capital markets for reinsurance "is essential for the long-term strength of the nation's property and casualty insurers," Mr. Herres said.

"For a large property and casualty company that cannot buy as much risk protection from the traditional reinsurance market as they would like, the capital markets are a competitive alternative for additional or supplemental risk protection," according to Goldman Sachs' Mr. Kaiser.

"I think there are a variety of situations that can offer various degrees of risk financing," he said. Depending on the needs of the issuer, bonds could be issued through a special purpose facility, as with the USAA deal, or they could be issued directly by the cedent.

Mr. Kaiser said he expects to see different sorts of risks transferred to the capital markets. While bonds will continue to be used to transfer natural hazard risks, "you'll also see other types of risk, like industrial hazard-based risk or even more actuarial risk," he said.

And, as the market grows for bonds that transfer various risks, the competitive advantages will increase, he said.

"In the future, capital markets transactions should become even more price-competitive with traditional reinsurance as investors realize the benefit of more liquidity from additional transactions and more risk diversification," Mr. Kaiser said.

Sedgwick Lane Financial's Mr. Lane expects the USAA deal to benefit not just the insurance bond market but also markets for other sorts of financial risk transfer, such as the Chicago Board of Trade's catastrophe options contract.

"It may be coincidental, but there is a pickup in the derivative markets as well," he said. "For the first time, you're seeing the linking of the insurance bond markets with the insurance derivatives markets, and we'll see more and more of that as we go on."

As the markets advance together, both issuers and investors will recognize they have alternatives when looking for the most advantageous way to use financial instruments to transfer or take on risk, Mr. Lane said.

"If it's cheaper in the derivatives markets, then possibly the issuer of the bonds could have gone to the derivatives markets and laid off that risk there," he said. "If it's more expensive in the derivatives markets, then perhaps the people who bought the bonds should have been there instead."

USAA's first attempt at a catastrophe bond deal failed last autumn because "Merrill didn't have all its ducks in a row; it was August, and there had just been a series of hurricanes and the market was skittish; and the pricing wasn't good enough," said one reinsurance underwriter.

But this year's deal was structured in a fashion that investors found more appealing, and the group of investment banks leading the underwriting marketed it effectively to those investors.

Indeed, investor interest in the deal prompted USAA to increase its offering from its original plans of $150 million.