Disaster derivs in demand as US wind season looms

Thu May 27, 2010 10:24am EDT

* Imminent U.S. hurricane season prompts more ILW trading

* High cat losses in Q1 leave companies without enough cover

* ILW prices increase by 10-15 percent

* Busy cat bond market leaves no free additional capacity

By Sarah Hills

LONDON, May 27 (Reuters) - Catastrophe derivative prices and trading have increased sharply in all U.S. natural peril risks in the run-up to the start of the hurricane season, making it more dfficult for reinsurance companies to hedge against a repeat of Hurricane Katrina, brokers say.

Demand for industry-loss warranties (ILWs) and derivatives, used by reinsurers such as Munich Re (MUVGn.DE), Swiss Re RUKN.VX and Credit Suisse (CSGN.VX) to cover their losses from natural disasters, remains brisk in the run-up to the six-month long North Atlantic storm season, brokers said.

But a price decline in the ILW market in the last six months has reversed as buyers look to protect themselves against possible further catastrophe losses following the active first and second quarters in 2010.

ILWs are reinsurance contracts, typically covering a calendar year, that pay out according to the total loss to the insurance industry of a hurricane or earthquake, rather than the buyer's own losses. Similar derivatives are traded on an exchange or over-the-counter.

"Events in Chile, Australia and offshore have impacted upon (re)insurers' appetite to retain loss and so they are looking to enhance those reinsurance protections already in place," said Larry Rothstein, vice president, analytics and capital markets for reinsurance brokerage Guy Carpenter's ILW Desk.

He said a sharp increase in traded volumes had resulted in terms hardening by more than 10 percent after what has been a sustained period of softening since early 2009.

Derivatives such as IFEX's Event-Linked Futures (ELF), traded by the Chicago Climate Futures Exchange, have also increased in price. An ELF, the capital markets equivalent of an ILW, paying out on a $10 billion North America hurricane event currently carries a premium of $46, compared with $39.25 in April.

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Catastrophe losses were modest last year, after costly 2008 disasters such as Hurricanes Ike and Gustav, but this year has seen a number of disasters, including the massive Gulf of Mexico oil spill off the U.S. coast.

This could cause problems if there is a higher-than-normal frequency of hurricanes, earthquakes and risk losses for the remainder of the year, say brokers.

"Some companies have found themselves in a situation where their protection has been partially eroded by events in the first quarter of 2010. They need additional capacity to protect against the wind season, so they may look to buy ILWs," said Stefano Nicolini, senior vice president for broker (re)insurance BMS's ILW team.

Demand for ILWs has increased prior to the June and July renewals, particularly in U.S. wind, before the start of the season. But brokers said pricing has increased by 10 to 15 percent in the last month due to a lack of capacity in the market.

The abundance of capacity in the traditional reinsurance market -- particularly retrocession, the passing of reinsurance risks to other reinsurers -- has contributed to a decrease in demand for ILW as buyers can find suitable capacity in the traditional market, brokers say.

"Retrocession capacity is tight for U.S. wind as there is not much capacity available for U.S. wind nationwide covers," said Stephen Breen, a partner at boutique reinsurance broker TigerRisk.

"Capacity is available when you get down to single state, but that's not what people are asking for on retro covers - their first choice is to buy nationwide," he said.

U.S. nationwide risks are seeing the highest increase in pricing since the beginning of the year, but now there is no new capacity coming in, added Nicolini.

"Suddenly there is less wind capacity in the ILW market, but still demand and therefore pricing for wind is staying flat or going up," he said.

Forecasters are predicting above average tropical storm activity this year. (Additional reporting by Daniel Fineren; Editing by David Holmes)

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