The record losses of nearly $12 billion for 2004 and 2005 have diminished the insurance industry's appetitive for the single greatest upstream risk-wind storm. What little windstorm capacity there is available is very expensive and covers only a fraction of the potential losses.

This lack of windstorm coverage affects producers in different ways. For the mega-majors, loss from windstorm is a risk that can be retained. The small and medium producers are most affected by the current lack of windstorm coverage.

Rapidly growing companies in the Gulf of Mexico are closing offshore asset acquisitions in excess of $1 billion. These asset purchases are, in many cases, debt-financed so insurance protection is critical, but these buyers are finding only limited coverage at extremely high prices. As a result, insurance cost is affecting the entire financing strategy for these companies.

Due to the scope of the losses, there simply isn't enough equipment, labor and replacement components to cover the need. This tight supply against the incredible demand is, as expected, driving prices up dramatically. Now loss modelers are even including this in their calculations of future losses as "loss amplification" or "demand surge."

Future expected loss calculations have increased dramatically. Meanwhile, the world's leading meteorologists agree that there are at least five to 10 more years of this heightened hurricane activity. Some say it could last another 15 years.

Needless to say, the likelihood of violent weather for years to come has had a significant effect on the cost of doing business in the Gulf of Mexico.

• Insurance rates for policies covering offshore platforms are up by at least 400%. When producers are able secure coverage, it comes with severe restriction on windstorm limits.

• Business-interruption insurance, known as "loss of production income" or LOPI, is available only at extremely high prices and reduced limits. "Contingent business interruption" (CBI), which covers losses to production due to problems upstream or downstream, is virtually unavailable.

• The energy-industry mutual insurance company known as OIL provides $250-million property-damage limits to its members. This has always had a $1-billion single-event aggregate limit, which before 2005 had never been penetrated. Both Katrina and Rita exceeded the $1-billion limit, so recoveries will be reduced for members for each storm. Katrina will be the most dramatic decrease with recoveries being reduced to approximately half the actual loss. Meanwhile, OIL has lowered its single-event aggregate from $1 billion to $500 million.

However, salvation may come from an unexpected quarter-the capital markets. For decades, experts have been predicting the convergence of the capital and insurance markets-that is the use of capital-markets financial products for transferring insurance risk. They forecast it after Hurricane Andrew in 1992, then after 9/11 and then after the hurricane season of 2004. But for a host of reasons, it never really caught on.

Katrina and Rita, however, are providing the incentive to "break the code." Now capital-markets investors and hedge funds are buying up products like catastrophe bonds, starting special-purpose insurance companies and toying with the use of products like industry loss warranties (ILWs) and weather derivatives to finance risk transfer.

Catastrophe bonds (or cat bonds) are by far the most popular capital-raising product. Cat bonds can be issued by insurers, reinsurers and even companies seeking to mitigate their own risk.

For a rate of return significantly higher than similarly rated bonds, investors bet that a highly defined set of circumstance does not occur in a defined area over a defined period of time. This set of circumstances is known as a parametric trigger. For Gulf energy assets, the triggers are usually wind speeds in excess of 122 miles per hour in a 20-by-20-mile area. Insurers call this kind of cat bond a "storm in a box."

If the parametric is triggered, investors can lose all or most of their money. However, cat-bond investors have experienced only one major loss: when they bet Zurich Financial Services would not have hurricane losses greater than $1 billion. Zurich had hurricane-related losses of $1.2 billion last year.

Great care must be taken to minimize basis risk in designing these programs. Initial attempts to utilize cat bonds on a direct basis for offshore risks have proven challenging both in terms of structure and capacity. However, this is the nature of most evolving market solutions. According to industry estimates, some $4 billion worth of cat bonds will be sold in 2006 to augment insurance and reinsurance capacity.

Sidecars are another way investors are adding significant risk capital. Sidecars, or special-purpose vehicles, are small, specialized insurance companies set up by reinsurance companies and designed to cover specific risks, such as oil platforms.

Unlike cat bonds, which provide large lump-sum payments in the event of a catastrophic loss, sidecars share losses and premiums with the reinsurer. If the loss experience is positive, investors can expect returns between 10% and 20%. While estimates vary, hedge funds have invested between $2- and $3 billion in sidecars this year alone.

Industry loss warranties (ILWs) are yet another way investors are creating risk capital. ILWs are investor-financed, index-based reinsurance contracts that have not one but two loss triggers. The first is the purchaser's loss. The second trigger is the loss to the insurance industry. Investors and buyers like ILWs because, like sidecars, they can be very specific in what they cover.

If weather forecasters prove correct in their prediction that we are in the middle of a long period of heightened hurricane activity, we may one day ultimately see a market for natural disaster derivatives.

Investors, especially hedge funds, like cat bonds, sidecars and ILWs because of their high rate of return and the fact that their risk is not correlated with their other risks, thereby enabling them to hedge their bets. Since most of these structures are designed to work in tandem with a company's insurance program, it is important that an insurance broker be involved for proper integration of these solutions.

Because conditions have changed so radically, only a handful of brokers are capable of providing the high level of analysis, catastrophe-risk modeling and dynamic financial analysis that capital-markets lenders and/or investors require. Therefore, risk managers need to seek out brokers with the financial analysts, actuaries, mathematicians and technology to package their risks. The expert front-end work greatly increases the probability of a successful transaction.

Gone are the days when policies were renewed at the same price and at the same terms. Going forward, policy-holder risks will be modeled comprehensively and the solutions will be much more tailored to that individual risk in terms of pricing and attachment points.

However, this high level of analysis, like virtue, is its own reward. Clients will always get the best pricing and best structure if their risk has been modeled before going to the insurance markets.



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