Catastrophe bonds (also known as cat bonds) are risk-linked securities that transfer a specified set of risks from a sponsor to . They are often structured as floating rate corporate bonds whose principal is forgiven if specified trigger conditions are met. They are typically used by insurers as an alternative to traditional catastrophe .

For example, if an insurer has built up a portfolio of risks by insuring properties in Florida, then it might wish to pass some of this risk on so that it can remain solvent after a large hurricane. It could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or it could sponsor a cat , which would pass the risk on to investors. In consultation with an investment bank, it would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a of LIBOR plus a spread, generally (but not always) between 3 and 20%. If no hurricane hit Florida, then the investors would make a healthy return on their investment. But if a hurricane were to hit Florida and trigger the cat bond, then the principal initially paid by the investors would be forgiven, and instead used by the sponsor to pay its claims to policyholders.[1]

Michael Moriarty, Deputy Superintendant of the New York State Department, has been at the forefront of state regulatory efforts to have U.S. regulators encourage the development of insurance through cat bonds in the United States instead of off-shore, through encouraging two different methods — protected cells and special purpose reinsurance vehicles.[2]

In August 2007 Michael Lewis, the author of Liar's Poker and Moneyball, wrote an article about catastrophe bonds that appeared in The New York Times Magazine, entitled "In Nature's Casino."[3] Contents

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• 1 History • 2 Investors • 3 Ratings • 4 Structure • 5 Trigger types • 6 Market participants • 7 Patents • 8 References • 9 External links

• 10 See also [edit] History The notion of securitizing catastrophe risks became prominent in the aftermath of Hurricane Andrew, notably in work published by Richard Sandor, Ken Froot, and a group of professors at the Wharton School who were seeking vehicles to bring more risk-bearing capacity to the catastrophe reinsurance market. The first experimental transactions were completed in the mid-1990s by AIG, , St. Paul Re, and USAA. The market grew to $1-2 billion of issuance per year for the 1998-2001 period, and over $2 billion per year following 9-11. Issuance doubled again to a run rate of approximately $4 billion on an annual basis in 2006 following Hurricane Katrina, and was accompanied by the development of Reinsurance Sidecars. Issuance continued to increase through 2007 despite the passing of the post-Katrina "hard market," as a number of insurers sought diversification of coverage through the market, including , , Liberty Mutual, Chubb, and Travelers, along with long-time issuer USAA. Total issuance exceeded $4 billion in the second quarter of 2007 alone. [edit] Investors

Investors choose to invest in catastrophe bonds because their return is largely uncorrelated with the return on other investments in or in equities, so cat bonds help investors achieve diversification. Investors also buy these securities because they generally pay higher interest rates (in terms of spreads over funding rates) than comparably rated corporate instruments, as long as they are not triggered. Key categories of investors who participate in this market include hedge funds, specialized catastrophe-oriented funds, and asset managers. Life insurers, reinsurers, banks, pension funds, and other investors have also participated in offerings. A number of specialized catastrophe-oriented funds play a significant role in the sector, including Clariden Leu Ltd., Asset Management, Fermat Capital Management, Nephila, Stark, Securis, Coriolis, Banque AIG, Solidum, Pentelia Capital Management, Asset Management, Secquaero Advisors, and others. Several mutual fund managers also invest in catastrophe bonds, among them OppenheimerFunds, Pioneer Investments, and PIMCO. [edit] Ratings

Cat bonds are often rated by an agency such as Standard & Poor's, Moody's, or Fitch Ratings. A typical corporate bond is rated based on its probability of default due to the issuer going into bankruptcy. A catastrophe bond is rated based on its probability of default due to an earthquake or hurricane triggering loss of principal. This probability is determined with the use of catastrophe models. Most catastrophe bonds are rated below investment grade (BB and B category ratings), and the various rating agencies have recently moved toward a view that securities must require multiple events before occurrence of a loss in order to be rated investment grade. [edit] Structure Most catastrophe bonds are issued by special purpose reinsurance companies domicilied in the Cayman Islands, Bermuda, or Ireland. These companies typically write one or more reinsurance policies to protect buyers (most commonly, insurers or reinsurers) called "cedants." This contract may be structured as a in cases in which it is "triggered" by one or more indices or event parameters (see below), rather than losses of the cedant. Some bonds cover the risk that multiple losses will occur. The first second event bond (Atlas Re) was issued in 1999. The first third event bond (Atlas II) was issued in 2001. Subsequently, bonds triggered by fourth through ninth losses have been issued, including Avalon, Bay Haven, and Fremantle, each of which apply tranching technology to baskets of underlying events. The first actively managed pool of bonds and other contracts ("Catastrophe CDO") called Gamut was issued in 2007, with Nephila as the asset manager.

[edit] Trigger types

The sponsor and investment bank who structure the cat bond must choose how the principal impairment is triggered. Cat bonds can be categorized into four basic trigger types. The trigger types listed first are more correlated to the actual losses of the insurer sponsoring the cat bond. The trigger types listed farther down the list are not as highly correlated to the insurer's actual losses, so the cat bond has to be structured carefully and properly calibrated, but investors would not have to worry about the insurer's claims adjustment practices. Indemnity: triggered by the issuer's actual losses, so the sponsor is indemnified, as if they had purchased traditional catastrophe reinsurance. If the layer specified in the cat bond is $100 million excess of $500 million, and the total claims add up to more than $500 million, then the bond is triggered. Modeled loss: instead of dealing with the company's actual claims, an exposure portfolio is constructed for use with catastrophe modeling software, and then when there is a large event, the event parameters are run against the exposure database in the cat model. If the modeled losses are above a specified threshold, the bond is triggered. Indexed to industry loss: instead of adding up the insurer's claims, the cat bond is triggered when the insurance industry loss from a certain peril reaches a specified threshold, say $30 billion. The cat bond will specify who determines the industry loss; typically it is a recognized agency like PCS. "Modified index" linked securities customize the index to a company's own book of business by weighting the index results for various territories and lines of business. Parametric: instead of being based on any claims (the insurer's actual claims, the modeled claims, or the industry's claims), the trigger is indexed to the natural hazard caused by nature. So the parameter would be the windspeed (for a hurricane bond), the ground acceleration (for an earthquake bond), or whatever is appropriate for the peril. Data for this parameter is collected at multiple reporting stations and then entered into specified formulae. For example, if a typhoon generates windspeeds greater than X meters per second at 50 of the 150 weather observation stations of the Japanese Meteorological Agency, the cat bond is triggered. [edit] Market participants

Examples of cat bond sponsors include insurers, reinsurers, corporations, and government agencies. Over time, frequent issuers have included USAA, Hartford, , , Liberty Mutual, SCOR, Hannover Re, , and Tokio Marine & Fire. To date, all direct catastrophe bond investors have been institutional investors, since all broadly distributed transactions have been distributed in that form.[4] These have included specialized catastrophe bond funds, hedge funds, investment advisors (money managers), life insurers, reinsurers, pension funds, and others. Individual investors have generally purchased such securities through specialized funds. Examples of investment banks and other dealers that are active in the issuance of catastrophe bonds are ABN AMRO, Capital Markets, , BNP Paribas, Goldman Sachs, Merrill Lynch, MMC Securities Corp., Lehman Brothers, Swiss Re Capital Markets, and Willis Capital Markets. Some of these groups also make secondary markets in these bonds. Most bond offering documents include an expert modeling analysis, with the bulk of these being prepare by AIR, EQEcat, and Risk Management Solutions.[5] Applied Research Associates and Milliman [6] also provide research and technical support.[7] Numerous law firms have been active in this space, notably Cadwalader, Wickersham & Taft LLP,[8] Cleary, Gottlieb, Steen & Hamilton,[9] Dewey & LeBoeuf,[10] and Sidley Austin.[11] [edit] Patents

There are a number of issued US patents and pending US patent applications related to catastrophe bonds.[1] These are examples of insurance patents. Insurance patents are a recent trend since the 1998 State Street Bank decision affirmed that business method patents were allowed by United States patent law. There are approximately 150 new patent applications filed each year on new insurance products and processes. [2]

Catastrophe bonds were being talked about as far back as the early 1990s, but it was not until 1995 that they came into the limelight. In 1995, a series of devastating natural disasters in the United States pushed American insurers to reassess their hedging strategies against even greater catastrophes that could cripple them with claims. In November 1996, Morgan Stanley agreed to underwrite the first public issue of insurance-related securities-catastrophe bonds, or CAT bonds for short. The client was the California Earthquake Authority (CEA), created by the state to insure California homeowners forsaken by insurance companies after the Northridge earthquake. The plan was to market bonds to big institutional investors with a novel feature: Bondholders would earn a huge 10%, but if any earthquake were to cause more than $7 billion in losses to the CEA, bondholders could lose their principal. That the deal did not occur is another story altogether, but it did mark the launch of a new class of bonds on the street.

The first disaster-linked bonds to be actually issued in the US were then called "Act of God bonds." A landmark issue came in 1997 with Residential Reinsurance's US$477 million hurricane- linked bond to fund catastrophe reinsurance. The issue managed by Goldman Sachs, Merrill Lynch and Lehman Brothers would be triggered by a hurricane happening within a year that will lead to claims exceeding US$1 billion.

The success of this issue opened doors for similar securities from other insurance and reinsurance companies in the United States. In November 1997, Goldman Sachs and Swiss Re New Markets launched the first such in Asia with 10-year US$120 million Japanese earthquake-linked bonds for Tokio Marine and Fire Insurance. The deal was the first to use a parametric structure to determine loss on the face value of the bonds.

The emergence of catastrophe-linked securities heralded the convergence of insurance and capital markets. Later on, some issuers embedded derivatives like options in cat bonds. In April last year, Swiss Re introduced an earthquake swap transaction to back US$30 million reinsurance cover for Mitsui Marine and Fire against earthquakes in Tokyo

CAT bonds are designed to protect insurance companies from events like massive hurricanes and earthquakes, which happen rarely but cause enormous damage. The bonds pay interest and return principal the way other securities do -- as long as the issuer doesn't get whacked by a catastrophe that causes losses above an agreed-upon limit. For example, a San Antonio-based insurer floated a CAT bond issue with the loss threshold being $1 billion. As long as a hurricane didn’t hit their client for more, investors would enjoy their junk bond like yields of about 11%, and get their principal back. However, in the event of the losses exceeding $1 billion, the bondholders would lose their principal as well as the interest. The bonds were a big hit on the street and were majorly oversubscribed.

CAT bonds are an example of the new class of options on the street, linked to nature. They are extremely high risk and high return, with not only insurance companies but also big corporates hedging catastrophe risk by issuing CAT bonds. CAT bonds have come as a reprieve for companies working in high-risk areas like Oriental Land, the owner of the Tokyo Disneyland. Faced with the prospect of insuring a potential fatality (Tokyo is an earthquake prone area) insurance companies, in trying to manage their risk and returns, prescribe massive premiums on such insurance policies. Reinsurers balk at the idea of reinsuring such high-risk insurance policies. However, with the presence of the CAT on the street, companies are resting easy. For them, CAT bonds are an easy and safe option to raise money because if a calamity strikes, they don’t have to pay anything back.

CAT bonds do not come cheap, and are currently considered more expensive than insurance policies, with only the maximum risk segment ascribing to the idea. A proper management of such an issue can lead to the insured party not having to pay a penny, and be insured at the same time. A case of such a structuring option is that of Oriental land, the company which manages the Tokyo Disneyland. Their back to back issues of US$ 200 million of CAT bonds, along with the SPVs and structuring options created caused ripples on the street.

Oriental Land: How to manage your CAT risk!

Building a massive entertainment complex close to the sea, including hotels, shopping malls, entertainment complexes and a whole Disneyland is quite a daunting task, especially with the fear of earthquakes looming over all the time. The last major earthquake to strike this region caused an estimated US$ 145 billion of damage. For Oriental, aiming at building the best Disneyland in the world, insurance cover would not be sufficient to recoup losses if something like this happened, besides insurance being costly and coming for only one year at a time.

Since 1983, when the Tokyo Disneyland became operation, Oriental did not seek earthquake insurance of any kind, having had problems with insurance companies and faith in its construction of buildings. What Oriental was interested in was a cost-efficient, longer- term earthquake cover that extended beyond mere property damage to also cover the equally ruinous after effects of a disaster such as a decrease in Disneyland visitors. Till the advent of the CAT, such an option was unviable and needless to say, not available.

In May 1999, Oriental Land successfully raised a total of US$200 million in the first- ever deal of earthquake risk securitization by a corporate. Led by Goldman Sachs, the CAT is in two parts: a US$ 100-million, five-year note issue for the earthquake cover and a further US$ 100-million, standby post-earthquake fund facility. Both bonds have been issued through Cayman-registered special purpose vehicles.

Unlike the existing earthquake insurance policy, the cover is not pegged simply to physical damage. Rather, it is structured according to the magnitude, location and depth of the earthquake. The company had other objectives too. It wanted to make sure that the cost of rebuilding the facility is contained and it does not lose too many visitors to the aftereffects. For example, it did not want to pay a hefty premium for the cover and preferred to pay only minimal interest on the post-earthquake contingent portion.

The Structuring

For the structuring of the deal, Oriental entered into financial contracts with two SPVs (special purpose vehicles); both of them based in Cayman Islands (for tax benefits). The first SPV called Concentric limited would pay Oriental as much as US$ 100 million in case of an earthquake happening within five years, whether or not there would be any physical damages. Once the triggering earthquake happened, Oriental Land would be compensated with the appropriate amount, depending on the earthquake magnitude, depth and location as measured by the Japan Meteorological Agency.

In turn, Concentric would raise US$ 100 million in five year floating notes at 310 over six month LIBOR (translating to approximately 6.5%). Concentric engaged Goldman Sachs Mitsui Marine Derivative Products to collateralize its obligation to Oriental. Goldman would invest the proceeds of the issue in US government securities, A-1 or triple A class paper. The aim of this agreement was an interest rate swap whereby GSMMDP would ensure that the interest yield on the portfolio would convert to LIBOR flat the interest being accrued on the papers and ensure that Concentric receives the full amount to pay to Oriental Land on the trigger date. The losses, if any were to be compensated by GSMMDP who would get a flat fee for the services. Noteholders, on their part would lose entire or a part of the principle depending on the magnitude and location of the earthquake’s epicenter. (Oriental and Goldman sought the help of a US based firm called EqeCat for modeling the earthquake risk for creating the levels).

The second SPV, called Circle Maihama would extend Oriental a post earthquake reconstruction fund facility of US$ 100 million to be raised through issue of 5-year notes at 75 bp over six month LIBOR (approximately 4.2%). Circle Maihama entered into a similar interest swap with GSMMDP. On the trigger date, GSMMDP would liquidate the portfolio and allow Circle to subscribe to US$ 100 million worth of Oriental Land bonds at 25 bp over LIBOR, with Oriental enjoying an interest moratorium of three years. Once issued, the notes would also be extended for three years with the noteholders getting 5 bp over LIBOR in these three years.

In the end, the deal gave Oriental Land the best of both worlds. They got the needed earthquake cover without having to pay back the principal and an available line of credit for reconstruction without having to pay a hefty premium.

The Pricing of CAT Bonds – a Bird’s eye view

In a very basic manner, the pricing of the CAT depends on the probability of the event (called a stochastic event) being insured. An earthquake cover, say in California would more likely carry a larger cover than in Washington. This however, could be reversed for some other event. Alongwith the probability estimates are computed for the amount of loss the company might face on the bonds. Other factors like value of the property being insured, the quality of construction etc. is input. What results, in a basic manner is the exceeding probability curve. By analyzing the curve for the particular business, an estimate can be made of the expected loss to the transaction, which is usually expressed, as a percentage of the limit of coverage. This, in turn gets multiplied by the ’s and the rating agency’s perception about the possibility of the event occurring. This results in the expected yield on the CAT and forms the basis for the rate of return.

The writing’s on the wall

Over US$ 4 Billion of CAT bonds have been issued in the market since inception, with the number growing. Currently, CAT bond issue is an expensive proposition due to the complexity of the deal, often involving an investment banker to work closely with consultants like EqeCat for modeling the risk. However, they have presented a serious threat to the reinsurance industry. Reinsurers were at a high till 9/11, their coffers full of money, undercutting each other for a share of the business. However, post 9/11 and the fact of paying off massive sums in life and real estate insurance policies, the Cat looks ready to take the street… and it maybe here to stay.