John Wells, chairman of Leadenhall Capital Partners, forecasts increasing demand for and issuance of catastrophe bonds in Q2

2011 will go down in history as one of the costliest years on record for insured losses from natural catastrophes, with Swiss Re estimating it to be the second worst to date, given losses of around US$116bn. With global news media focusing on an astonishing array of earthquakes, tsunamis, floods and tornadoes that have severely dented the balance sheets of insurance businesses around the world, investors could be forgiven for thinking that putting their money into insurance-linked investments was a bad idea.

As counterintuitive as it may seem, even in the face of last year's extraordinary losses for the insurance industry, insurance-linked securities (ILS) - including catastrophe bonds - are continuing to deliver excellent results. They have certainly showed a markedly better performance than both equities and fixed income investments. The Swiss Re BB Catastrophe Bond Index has shown that between its launch in 2002 and the end of 2011, cat bonds have delivered average returns of around 9% per annum.

The first quarter of 2012 has seen record numbers of cat bonds issued. Figures from Aon Benfield in April show that ILS achieved a record US$1.49bn first quarter issuance - the highest figure ever recorded, as investors deployed additional capital into the sector.

Cat bonds and other ILS are instruments that allow insurance companies to transfer some of the risk linked to catastrophic events, such as major earthquakes or windstorms, to investors in the capital markets. The bonds are created through SPVs, which are then sold on to investors with the capital held in trust, usually for three years, although some are as short as one year.

An increasing number of institutional investors such as pension funds are turning to ILS because of the attractive returns and because they help to diversify their portfolios away from poorly performing equities markets and the comparatively low returns of fixed income investments. At a time of extreme uncertainty and volatility in the equities markets, the low correlation of cat bonds to these markets makes them a very attractive asset class for institutional investors.

In the event of a catastrophe, an insurance company will pay out claims using its own funds, supplemented, if necessary, by any reinsurance cover it has purchased. It is only in very extreme events, when all the normal sources of insurance and lower levels of reinsurance cover have been exhausted, that a cat bond is triggered and investors face losing some or all of their capital.

In most cases the likelihood that a weather event is so extreme that it results in a cat bond being triggered is very remote. According to statistics from Willis Group, only nine cat bonds out of 194 issued between 1996 and March of this year have been triggered.

Last year, for the first time, three cat bonds were total losses. One was related to Japanese earthquake claims and the other two related to US tornadoes.

Apart from these bonds, the other six that were triggered only had partial losses. Thus, even if an individual cat bond is triggered, a portfolio that is diversified with other insurance-linked instruments may still perform well.

After a big catastrophe such as a US hurricane, premiums on reinsurance normally go up as there is a rush of insurance companies seeking cover, which provides much-needed capital for insurers and reinsurers. As a result, the demand for cat bonds also rises, as do the yields available. In line with this trend, following the record losses in 2011, prices have been rising for catastrophe cover in reinsurance and cat bond issuance has been following apace.

At the annual SIFMA conference on insurance and risk-linked securities in New York in March, estimates of issuance of cat bonds for 2012 ranged from US$5bn to US$7bn, compared to a reported issuance of US$4.3bn in 2011.

Cat bonds are undoubtedly an increasingly attractive asset class for institutional investors, but the cat bond market itself is relatively small, worth around an estimated US$14bn-US$15bn. To put that in context, the global property catastrophe reinsurance market is worth an estimated US$400bn-US$500bn, and private placement on notes and reinsurance derivatives is about US$30bn-US$35bn.

Because of the attractive returns and low correlation to other markets, more and more investors are taking an interest in cat bonds and the wider range of ILS and we are seeing this interest crystallise into solid investments in this asset class.

Over the past three years, investors have realised that returns from property and casualty reinsurance are attractive, and we are confident demand for ILS will continue to grow because uncertainty in both the equity markets and credit markets is simply not going away. For investors who require daily or weekly liquidity, cat bonds are a very good asset class to have in their portfolio.

Other investors seeking an illiquidity premium may want to build in other insurance-related instruments, such as catastrophe swaps and collateralised reinsurance private placements, that provide a wider range of risks than cat bonds and, in some cases, can offer higher rewards. With a lack of yield from traditional markets, going into the second half of the year, we will continue to see more investors looking at ILS as the search for yield goes on.