State Quake-Risk Bond Offering Available to Investors Next Year

Earthquake-risk bonds that would pay investors reduced returns if a major California earthquake struck during a four-year period are being rolled out for sale to institutional investors next year.

The bonds will be sold for the new California Earthquake Authority, which is scheduled to start selling policies Dec. 1.

If the earthquake-risk bond offering succeeds, it could be one of the first broadly distributed offerings that would allow an insurer to reduce its catastrophic risk by passing it into the general capital markets, market sources said. Indirectly, this process allows insurance risks to be divided and sold to many investors. Some earlier efforts to sell such bonds on Wall Street have failed, but the California earthquake funds are designed to be safer investments.

Since Hurricane Andrew in 1992, which generated insured losses of $15 billion, U.S. insurers have grown increasingly worried about the possibility of a “mega-catastrophe,” producing insured losses of up to $100 billion.

Such an event would push some insurers to the brink of insolvency and also overwhelm reinsurers, the industry’s traditional financial safety net. Reinsurers provide insurance to insurance companies seeking additional protection.

Early feedback on the proposed offering, which is being led by Morgan Stanley and co-managed by Bear Stearns and Goldman Sachs, appears to be generally positive, a Morgan Stanley banker said.

Unlike some of the other attempted catastrophe-linked bond offerings, the earthquake-risk bonds would not put an investor’s principal at risk, said Jim Tilley, a Morgan Stanley banker leading the deal.

But if a major earthquake struck California in the first four years of the 10-year life of the bond, investors would receive a reduced rate of interest, he said.

“That structure is going to be pretty attractive,” Tilley said. “It won’t be attractive to everybody . . , but there are many who have said they are interested.”

Investors, however, have said they need to understand more about earthquake risk, and they want to see risk-savvy reinsurers participate in the bond offering as a validation of the deal, he said.

Official marketing of the earthquake-risk bonds will take place during the two to three months after the Earthquake Authority is up and running, Tilley said.

If the privately financed, publicly managed authority launches operations on Dec. 1 as planned, the bonds would be priced in early to mid-March, Tilley said.

However, companies representing at least 70% of the California residential insurance market must agree to participate in the earthquake authority by Friday for it to become operational.

Although several other insurers have attempted similar catastrophe bond deals in the United States in the last few months, none has succeeded, the sources said.

ACE Ltd. earlier this year attempted to raise $25 million to $40 million through a private placement offering of catastrophe-linked bonds that would have put both principal and interest at risk, industry sources said.

But the deal, which was managed by Goldman Sachs, fell through over a disagreement about terms and conditions, sources said.

ACE declined to discuss the details of the deal.