1997 RISK MANAGEMENT: CATASTROPHE BONDS TAKE RISK FINANCING BY STORM

United Services Automobile Assn.'s offering of bonds linked to its exposure to catastrophe losses proved a watershed event in risk securitization.

The $477 million cat bond issue that provided USAA with a high-level reinsurance layer for East Coast hurricane risks proved so popular with investors that the size of the issue was increased dramatically from the $150 million bond sale the company had planned.

Ultimately, the USAA transaction in June also provided a model for similar catastrophe bond deals undertaken by Swiss Reinsurance Co. and Tokio Marine & Fire Insurance Co. Ltd. as those companies also looked to capital markets for reinsurance capacity.

That model saw the companies creating independent special-purpose reinsurers to be the bonds' formal issuers and then used the proceeds to provide reinsurance coverage.

In USAA's case, the bonds were issued by Residential Reinsurance Ltd., a Cayman Islands company created by USAA in 1996 as it worked with Merrill Lynch & Co. to craft a $500 million cat bond deal that never came to fruition.

In this year's deal, Residential Re's charge was to manage the bond proceeds and administer a $400 million reinsurance contract it provided USAA. The cat bond transaction provided USAA with 80% of its $500 million reinsurance layer for losses from a single East Coast hurricane this year.

The reinsurance contract with Residential Re covered USAA for a loss from a single Category 3, 4 or 5 hurricane resulting in insured losses between $1 billion and $1.5 billion to USAA policyholders in an area stretching from Texas, around the state of Florida and north along the Atlantic Coast to Maine.

The company never has suffered a $1 billion loss, but at the time of the deal Robert T. Herres, USAA's chairman and chief executive officer, noted that "that size natural disaster is possible with large populations residing in coastal areas and other areas vulnerable to hurricanes."

While USAA's planned 1996 deal never came to market for several reasons -- among them unattractive pricing and an inability to get the issue to market before a series of hurricanes made potential investors skittish -- this year's deal, co-managed by Merrill Lynch and Goldman Sachs & Co., was structured to satisfy investors.

The $477 million privately placed issue was split between two tranches, one of $163.8 million in which investors faced no risk to principal, and the other of 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, investors in the larger portion earn a higher return -- the London Interbank Offered Rate plus 576 basis points.

In contrast, the no-principal-risk tranche pays LIBOR -- the rate at which prime banks operating in the London Eurocurrency market offer Eurodollar deposits to other prime banks -- plus 273 basis points.

The two-tranche structure let certain investors buy bonds who would have been precluded from investing in bonds putting principal at risk.

The bonds' stated maturity is one year. If here is a covered loss before it matures in June 1998, USAA's reinsurance contract gives it the right to extend the maturity for six months while settling claims. USAA must pay investors interest during that time, though the principal is at risk only for the one-year period.

Meanwhile, if there is a loss, the principal-protected securities will be extended another 10 years, with no additional interest payments during that period.

While the total issue was for $477 million, only $400 million went to providing reinsurance. The remaining $77 million was set aside to purchase zero-coupon securities that would enable USAA to repay the principal-protected investors if there is a loss.

The Swiss Re deal in July and the Tokio Marine & Fire issue in November also found receptive markets, each providing variations on the theme of the USAA deal.

Swiss Re's $137 million two-year catastrophe bond deal provided $112.2 million in California earthquake coverage through SR Earthquake Fund Ltd., a Cayman Islands company that issued the notes.

The Swiss Re deal is split into several tranches exposing investors to various degrees of principal risk. And, unlike the USAA deal, which is based strictly on losses to USAA's book, the Swiss Re deal is tied to industry losses due to a single California earthquake.

Two of the deal's three tranches had trigger points at $18.5 billion, $21 billion and $24 billion, all considerably beyond the $12.5 billion in industry losses caused by California's 1994 Northridge earthquake. The third tranche was sold without a rating and was said to carry lower trigger points.

Tokio Marine's $100 million deal let the company obtain $90 million in reinsurance for Tokyo-area quakes.

Those 10-year bonds were sold through Cayman Islands-based special-purpose reinsurer Parametric Re Ltd. To meet Japanese regulations, Swiss Re actually provided the reinsurance contract to Tokio Marine, retroceding the risk to Parametric Re.

Setting the Tokio Marine deal apart was that instead of being tied to insured losses like the USAA and Swiss Re transactions, the repayment of its investors' principal is tied to the magnitude, location and depth of earthquakes in the Tokyo area.

At the time of USAA's cat bond deal, Mr. Herres said tapping capital markets for reinsurance "is essential for the long-term strength of the nation's property and casualty insurers."