Catastrophe bonds

With fears that the Kamp Re deal could be the first catastrophe bond to face losses, Credit asks whether newer transactions should include better protection measures for investors

Mark Azzopardi, Head of insurance and pensions, BNP Paribas

The catastrophe bond market has stood firm in the face of the past two hurricane seasons. The market will pay its losses on the Kamp Re deal and has responded by increasing its capacity rather than by withdrawing it. It may struggle to cope with increases in peak peril capacity, but it has done well to accommodate the amount of additional risk that it has seen since the 2005 hurricane season.

The catastrophe bond market caters for a broad range of investor risk appetites and issuer needs. Meaningful capacity exists at a variety of risk levels and perils and this is exactly what the issuers need: catastrophe bonds are risk transfer mechanisms for them and they need to be able to transfer a spectrum of risks. It is also exactly what investors need: they have a variety of risk/reward requirements and take the risk knowingly. Higher trigger points simply reduce flexibility and deprive issuers of risk transfer and investors of risk/reward profile.

The best protection is for issuers to provide clarity and for investors to ensure that they understand the information they have been given. The market will strive to make improvements but there is no obvious shortcoming in this area right now.

Shiv Kumar, Vice-president, Goldman Sachs

In the post-Katrina environment, investors have benefited from the increased supply of catastrophe bonds. The total catastrophe bond and sidecar issuance in 2005 exceeded $4 billion and this figure is expected to grow in 2006. While the asset class is providing diversification and attractive returns, improvement in the modelling of individual transactions has gone relatively unnoticed.

Transactions have moved towards transparency of triggers, with all the new issues being offered on a parametric or PCS/modelled-loss basis. Examples include Champlain, Atlantic & Western, Foundation and Tartan transactions. Even if the information for determination of a trigger is publicly available, an independent third-party calculation agent is used so the possibility of any disputes is minimised. Coverage for unmodelled risks, extra-contractual obligations or payment in excess of policy limits is excluded. Other refinements address potential credit risk arising from a transaction sponsor.

Recently, sponsors have agreed to pre-fund six months of spread in the SPV if the ratings were to fall below A3/A- level. Since the coupon is paid quarterly in arrears, it ensures that the investors have not provided coverage without being paid for it and are always guaranteed at least a year of coupon.

The rating agencies now insist that the models be run with all the 'switches' turned on. The trigger levels have had to be raised substantially to stay at the same ratings as those from a year ago.

While the investors are providing additional capacity, the pricing in the capital markets has kept pace with the hardening of the reinsurance markets. This is reflected in investors benchmarking the risk using sensitivity case analyses as well as getting spreads at higher multiples of expected loss than before.

Pano Karambelas, Vice-president, Moody's

The dynamics that we're seeing in the traditional catastrophe reinsurance sectors are price increases reflecting both contraction in the capacity and a heightened awareness of the volatility in the business. These factors are expected to continue, pending release by modelling firms of updated mean frequency and intensity parameters for natural catastrophes, as well as adjustments to other factors driving loss severities.

Greater scrutiny of catastrophe risk by rating agencies is expected to cause insurers and reinsurers to review levels of capitalisation relative to tail exposures. Increased demand and contraction in capacity are expected to drive alternative risk transfer strategies, including catastrophe bonds or other forms of risk securitisation.

One potential concern for investors with excess of loss structures is their asymmetric risk/return relationship with the underlying ceding company. The idea is that the greater the loss to investors the greater the reinsurance benefit to cedants. Conversely, for quota share structures the interests of investors and cedants are likely to be more closely aligned. Although it is difficult to assess whether future deals will be high risk, current and future capital market solutions will likely benefit from lessons learned from the 2005 storms.

Keith Ashton, Director, asset-backed securities, TIAA-CREF

From 2002 to 2005, cat bond spreads declined and risk crept upwards. Consequently, only a small percentage of transactions offered relative value. Not only did last year's hurricane season affect supply dynamics in the reinsurance market, it is having an impact on the relative value of these investments.

Cat bonds generally present low volatility risk, uncorrelated with interest rates and business cycles. However cat bonds are exotic securities offered within a relatively small market defined by supply technicals, limited liquidity and a high degree of sophistication. Cat bonds are also unique in that investors are wholly reliant on catastrophe modelling agencies to quantify the risk.

Some modelling agencies recently revised their models to account for the correlation between ocean temperatures and the frequency of hurricanes. These revisions resulted in a change in the risk quantum of US hurricane bonds at nearly every trigger level. All of this suggests the need for conservative structures and a relatively high risk premium.

The quality and availability of reinsurance capital in 2006 and the recent updates to risk models are driving today's spreads higher. We hope issuers begin to present transactions that return supply in the 1/100 to 1/500 layers, where large money managers find greater opportunities. Given the implications of the recent model updates and credit risk considerations, I believe there is a need for permitting insurers to seek this type of cover in the cat bond market.

Christopher McGhee, Head of the investment banking specialty practice, Guy Carpenter

There were 13 bonds exposed to Hurricane Katrina, and despite the fact that it was the largest insured loss in the past 20 years, only one of those bonds - Kamp Re - is likely to have been affected by loss. As the Katrina situation clearly demonstrates, it is important to recognise that cat bonds are not homogeneous. They have different payout triggering mechanisms, widely varying attachment points, estimated loss probabilities and covered perils.

We have already seen a reaction in the marketplace to last year's hurricane activity, though this has been more in response to the tightness of capacity and sharply higher prices for peak US perils in the reinsurance market. Since Katrina, cat bond investors, with their capacity very much in demand, are proving to be more selective with trigger type and other structure details in the issuance of cat bond transactions. This is the natural evolution of any developing market and not a sign of any inherent weakness in it. This year's expected significant growth of the total outstanding principal amounts in the cat bond market suggests that investors continue to have a strong appetite for this asset class.

Disclaimer

Securities or investments, as applicable, are offered in the (i) United States through MMC Securities Corp., a US registered broker-dealer and member NASD/SIPC, and (ii) European Union through Marsh Advanced Risk Solutions Ltd. ("MARS Ltd."), regulated by the Financial Services Authority for the conduct of investment business in the United Kingdom. Reinsurance products are placed through Guy Carpenter and insurance products are placed through qualified affiliates of Guy Carpenter. MMC Securities Corp. and MARS Ltd. are affiliates of Guy Carpenter.