Winds of change for cat bond market

Weaknesses in the structural make-up of catastrophe bonds, exposed by Lehman's collapse, have prompted issuers to introduce a series of updates to the asset class aimed at de-correlating insurance risk from credit risk.

Confidence is returning to the catastrophe bond market. A set of structural enhancements and measures to increase transparency have alleviated investor concerns and led to strong primary issuance. Those concerns had centred on the bankruptcy of Lehman Brothers, which exposed weaknesses in the total return swap (TRS) counterparty and collateral arrangements. Bonds that included Lehman as the TRS suffered downgrades as they failed to meet interest and principal repayments.

If there is a drop in collateral value and the TRS counterparty is unable to perform on the swap then it can affect the whole transaction, says Donald Thorpe, global head of insurance-linked securities at Fitch Ratings. "Sponsors could be left with collateral that does not cover the full amount of the reinsurance contract if there are catastrophes, while investors might not receive their full principal and interest if there are no catastrophes. The improvements benefit both parties," he says.

New measures include tightened permitted investment criteria, ensuring investment in only liquid obligations like government-backed debt, and better matching of durations of assets to maturities of bonds. Other features are daily mark-to-market of collateral valuations and more frequent topping-up mechanics if collateral value declines. Hard-wired mechanics also help to address swap counterparty default and better reporting requirements have led to a greater disclosure of assets and documentation.

The landmark $200 million Atlas V transaction launched in February by French reinsurer SCOR re-opened the market after a six-month hiatus and paved the way for the next generation of structures to evolve. The deal improved procedures behind the TRS counterparty, collateral and transparency to make the structure more robust. "Atlas V set a benchmark for future placements as the enhancements were replicated in subsequent deals or maintained in spirit in one fashion or other," says Erik Manning of Deutsche Bank's structured products and alternative risks group.

A core investor base of dedicated reinsurance/insurance professionals now accounts for about 90% of investment in the catastrophe bond and insurance-linked securities sectors. These investors raise capital because of the de-correlation of ILS from the credit markets, explains Manning.

He says Atlas V rethinks the way collateral is managed to ensure catastrophe bonds remain a bona fide de-correlated asset class. "Once you remove the credit elements and leave a credit-neutral structure, it becomes a pure play on insurance risk," he says.

Augustin Glas, head of ILS at SCOR, adds that the transaction addresses credit and counterparty concerns by investing collateral in non-volatile long-term US government-backed debt and fulfils investors' needs by offering returns above Libor. "It is a cost-effective and highly secure financial instrument," he says.

Additional transparency measures include giving potential buyers access to transaction documents, collateral information and loss estimates via intralink sites. "We are providing symmetry of knowledge which should help the secondary market take off," adds Emmanuel Durousseau, SCOR's head of retrocession management.

Variations on a theme

Innovation has continued with the successful launches of a range of alternative structural and collateral solutions. Allianz's $180 million Blue Fin bond was the first bond to replace a TRS counterparty with a quarterly puttable note issued by Kreditanstalt fur Wiederaufbau (KfW) and guaranteed by the German government. United Services Automobile Association's $250 million Residential Reinsurance offering also lacked a TRS, with the collateral invested in low-risk and highly rated US Treasury money market funds.

Munich Re similarly used a KfW puttable bond for its EUR50 million Ianus Capital deal covering European windstorms and Turkish earthquakes, the first non-US peril catastrophe bond of 2009. Meanwhile, Swiss Re's Calabash $100 million catastrophe bond invested in a bond issued by the International Bank for Reconstruction and Development.

BNP Paribas is working on a tri-party repo structure to launch within the next few months, proposing investment grade corporate bonds the bank houses with Euroclear as collateral. "This mechanism both reduces costs to the sponsor and offers Libor returns to investors. Transaction costs, especially spread levels, are considered by potential sponsors to be becoming too expensive," says Mark Gibson, who focuses on ILS within the capital markets structuring/insurance solutions team at BNP Paribas in London.

Euroclear provides daily observable independent pricing and ensures that any assets with stale prices for three to five business days are replaced and that over-collateralisation ratios are maintained. The structure could offer, for example, a 5% over-collateralisation cushion, which increases by 2-3% for each notch downgrade to BNP Paribas' credit rating. The repo will pay at least Libor/Euribor, depending on market conditions at the time and what types of assets are used. "Rather than just one risk, we think it is better to have a liquid diversified portfolio, which at all times contains tradable assets and could actually generate cashflow to the sponsor to reduce its overall costs," says Gibson.

Stretching the limits

The market is currently in an experimental phase and the emergence of so many different solutions could cause difficulties for investors, says Christian Bruns, vice-president of insurance-linked investments at Swiss asset manager Clariden Leu. "ILS investors are good at analysing the underlying risk of natural catastrophes and other insured risks, our core ability is not to look at 10 different structures and collateral," he says.

Harald Borner, chief executive officer of RSB-Securities, believes that having a range of structures could present opportunities for investors. "You will be able to diversify not only over different perils and geographical areas but also over different legal structures. This form of diversification could help improve or customise an investor's portfolio," he says.

The market has found the right balance between transparency and mitigation of credit risk in new transactions resulting in less concern over the swap counterparty, says Christophe Fritsch, head of ILS at Axa Investment Managers. He questions the need for a TRS counterparty, which can be complex to understand, when a very simple and transparent structure could include a government-guaranteed puttable bond or a safe government asset as the underlying collateral. "This allows investors to focus on the real analysis of a catastrophe bond which is insurance risk," he says.

Calabash III invests in IBRD, a secure asset with long-term and senior unsecured debt that is rated triple-A, says RSB-Securities' Borner. In addition, Calabash III has the right to put the IBRD notes, in whole or in part, at par to obtain funds to make issuer payments under the reinsurance agreement, and to redeem the IBRD notes upon the occurrence of an IBRD default event. "This is a step in the right direction and a meaningful change that gives investors confidence as many fear exposure to counterparty risk," he adds.

There is ongoing debate over what should constitute the basis for catastrophe bond returns, notes Stefan Muller, CEO of Solidum Partners. He sees two camps emerging, one favouring a Libor spread that provides a higher total return but introduces credit risk into a transaction. While the second group favours returns based on US Treasuries or other government securities that reduce credit risk. "The outcome is still open but we prefer credit-remote structures," he says.

"There is an ongoing discussion in the market about moving to a Treasury-based return instead of Libor because the additional credit risk dilutes one of the key benefits of ILS - an asset class with low correlation to other markets," says Richard White, global head of ILS at Thomson Reuters.

Even if all proceeds were invested in Treasuries, investors could still incur a small principal loss if the Treasuries had to be sold prior to maturity, argues Kevin Lee, senior credit officer at Moody's. "A TRS would resolve this cash flow timing problem. Furthermore, a TRS would give the investor a better return of Libor plus a spread. This helps cat bonds to be more competitive with other asset classes," he says.

Libor has been a major component of returns for many catastrophe bond funds in the past, accounting for about 40-50% of the total return up to three years ago, notes Dirk Lohmann, managing partner at insurance risk consultancy Secquaero Advisors. He views Residential Re as an interesting test for the market as the money market funds on the transaction are generating 8bp, which is a tenth or less of three-month Libor, a difference of between 80-100bp. "Historically that difference was bigger and I am not sure how willing investors will be to completely sacrifice Libor in favour of money markets or Treasuries," he says. Christian Bruns believes Res Re's money market fund is a good solution and simpler to understand than a TRS containing various heterogeneous eligible assets or a tri-party repo structure.

Fitch Ratings' Thorpe says that structures need to be easily replicated so it is not too difficult to issue bonds on a high volume basis. "We are in a period of transition and the market is trying to strike a balance between what makes economic sense so that the whole transaction is cost-effective, and also provides the desired protection," he says.