California To Approve More Cat Bonds

December 19, 2011

California is set to approve more catastrophe bonds for earthquake coverage following the success of its inaugural venture with a  Bermuda special-purpose reinsurance vehicle.

The California Earthquake Authority, the largest earthquake insurer in the United States, is currently tapping the capital markets and federal legislation to make coverage more affordable so more homeowners purchase it, CEO Glenn Pomeroy said.

The take-up rate for earthquake insurance is “terrible,” Mr. Pomeroy told ratings agency A.M. Best’s news service today [Dec.19]. Less than 10% of California homeowners have purchased the coverage.

That means “90 percent of homes in California, home to two-thirds of the nation’s earthquake risk, have absolutely no protection from earthquake damage,” Mr. Pomeroy said. The CEA only writes business in California.

Cost is a big factor in why more homeowners don’t buy the policy, he said. Earthquake insurance is excluded from homeowners insurance, and in some cases, earthquake insurance is more expensive than the standard homeowners policy, Mr. Pomeroy said.

The CEA is lobbying for the US Congress to pass the Earthquake Insurance Affordability Act, which would allow the CEA to borrow a limited amount of money from the private debt markets after an earthquake, with a federal guaranty backing the debt. This would save the CEA some $100 million a year in reinsurance costs, which would result in lower premiums and deductibles, Mr. Pomeroy said.

Other public earthquake insurance authorities would be eligible under the proposed federal law, but the CEA is the only entity of its kind at the moment.

The publicly managed but privately funded CEA also tapped the capital markets for the first time this year, and plans to do so again in 2012, said Tim Richison, chief financial officer of the CEA.

In a landmark transaction expected to be a benchmark for future deals, the three-year cat bonds were sold to investors at a floating rate 6.6% above one-year US Treasurys, with proceeds placed in a collateral trust account where the CEA can draw funds, if needed, for insured losses and loss-related expenses in the event of an earthquake.

The nonprofit, state-run authority entered into a reinsurance contract with a Bermuda-based special-purpose reinsurance vehicle, Embarcadero Reinsurance Ltd. Assisted by Deutsche Bank, Embarcadero sold the $150 million in three-year cat bonds.

Last week, the CEA board approved a second cat bond for up to $300 million, which will be issued in early 2012, Mr. Richison said. “We see many more cat bonds in the future,” Richison said. “We’ll be out there in the capital markets as long as there is investor interest.”

The first cat bond was oversubscribed by a factor of three, Mr. Richison said, which shows there’s strong interest from investors.

“We need to diversify our claims-paying capacity,” Mr. Richison said. While the CEA will always be depending on traditional reinsurance, it’s hoping to continue to expand into nontraditional, fully collateralized reinsurance, he said.

Another advantage of cat bonds is they offer three years of coverage, instead of one year offered by traditional reinsurance.

CEA must spend 40 cents of every premium dollar to buy reinsurance. Since it opened in 1996, two years after the Northridge earthquake, the CEA has paid reinsurers $2.9 billion in premiums, and reinsurers have paid the CEA just $250,000 in claims, the CEA said.

The five largest writers of earthquake insurance in the United States by 2010 direct premiums written are: the California Earthquake Authority, with a 24 percent market share; State Farm Group, with nine percent; American International Group, with 6.9 percent; Zurich Financial Services, with 6.85 percent; and Travelers Group, with five percent.

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