Cat Bonds Demystified RMS Guide to the Asset Class INTRODUCTION Catastrophe (cat) bonds have government bonds offer ‘return-free attracted investor interest as one of risk.’ Investors looking for viable the few asset classes not correlated to uncorrelated alternatives to equities the global financial markets. who typically turn to investments in infrastructure or agricultural land will Cat bonds were first issued in the find that catastrophe bonds fit well aftermath of Hurricane Andrew and into an alternative strategy. Relative the Northridge Earthquake in the mid- to other alternative investments, cat 1990s and the market has grown bonds offer both low correlation to the robustly since. They are the best- market and higher yields for the same known example of a broader class of level of risk, as can be seen in the insurance-linked securities (ILS). Table 1. Cat bonds are the most suitable ILS Many institutional investors are instrument for novice investors already successfully including ILS in because they are 1) rated and 2) their portfolios, either through freely tradable by qualified investors. outsourcing to dedicated funds or They are also an effective way to investing directly. enhance the risk-return profile of an investment portfolio. This guide explores the main features and considerations of a cat bond In the current low interest rate investment, including different environment, the value of cash is investment routes and key questions being eroded by inflation and asked by new investors in the space. Table 1: Comparison of historical returns Index Historical Volatility and volatility since 2002 Annual Returns Swiss Re Cat Bond Total Return Index 7.98% 2.97% Dow Jones Credit Suisse Hedge Fund Index 6.38% 5.91% S&P 500 Index 1.06% 16.24% Dow Jones Corporate Bond Index 1.19% 6.70% Private Equity Total Return Index -2.26% 30.23% ©2012 Risk Management Solutions 1 WHAT ARE CAT BONDS? Cat bonds are a standardized method Mechanics of a cat bond of transferring insurance risk to the capital markets. The proceeds from The basic structure of a cat bond the sale of the bond are invested in (Figure 1) includes five key elements: near risk-free assets to generate money market returns, which 1. The sponsoring (ceding) combined with an insurance insurance company company’s premium, allow the bond to establishes a special purpose pay a substantial spread over money vehicle in a tax efficient market returns as a quarterly coupon jurisdiction. to the investor. If no insurance events 2. The SPV establishes a occur the investor enjoys the reinsurance agreement with enhanced coupon for the term of the the sponsoring insurance bond, typically three years, and company receives the principal back at maturity. 3. The SPV issues a note to If one of the designated events investors; this note has default occurs, all or part of the principal is provisions that mirror the terms transferred to the insurance company, of the reinsurance agreement the investor’s coupon payments cease 4. The proceeds from the note or are reduced, and at maturity there sale are managed in a is either zero, or a reduced amount of segregated collateral account principal repaid. to generate money market returns It is helpful at this point to delve more 5. If no trigger events occur deeply into cat bond structures, to during the risk period, the SPV explore the key features of any cat returns the principal to bond that need to be understood by a investors with the final coupon potential investor. payment. Figure 1: Structure of a cat bond transaction ©2012 Risk Management Solutions 2 Cat bond risk reasonably sure of the return of their principal absent an insurance event. Those who invest in cat bonds are Most current cat bonds restrict subject to two distinct sources of risk, collateral account investment to U.S. the first being the insurance risk that Treasury Money Market Funds, but the cat bond assumes; the second is other common solutions include the credit risk associated with the specially issued puttable Structured collateral account. Investors need to Notes from the International and be sure that the constraints on the European Banks for Reconstruction collateral account provide sufficient and Development (IBRD and EBRD), protection so that they can be and Tri-Party Repos. Lessons Learned – The Lehman Brothers Bankruptcy The significance of the collateral structures has been brought to light by the Lehman collapse. Originally the typical cat bond structure used a Total Return Swap (TRS) by which the counterparty guaranteed that the SPV will receive a return equivalent to LIBOR on its investments in the collateral account. Lehman Brothers was the TRS counterparty for 4 of 119 live cat bonds in the market at the time of its demise; while only a small number of bonds was affected, this caused the market to focus on the safety of underlying assets and design new, more conservative collateral structures that decreased the counterparty risk even further. ©2012 Risk Management Solutions 3 TRIGGER TYPES Turning now to the insurance risk inherent in a cat bond, we will discuss Indemnity transactions and other risk how the triggering events that would transfer mechanisms triggered by cause a reduction in the principal of direct insurance or reinsurance losses the cat bond are defined. have a clear benefit to the sponsor of the transaction. Because the sponsor’s The three trigger types commonly specific loss experience is used as the used in the cat bond market— trigger, the funds recovered from the indemnity, industry loss, and catastrophe bond will match the parametric—are described below. A underlying claims very closely, fourth type, modeled loss, is minimizing the sponsor’s basis risk essentially an expansion of the (the difference between incurred parametric concept and uses a model losses and the bond payout). in place of an index function. However, these risk transfer mechanisms make the underlying risk Indemnity less transparent to investors, as they cannot access detailed information on every policy or judge the quality of the For an indemnity trigger, the triggering sponsoring insurance company’s event is the actual loss incurred by the underwriting or loss adjusting. Also, sponsoring insurer following the indemnity transactions can take a occurrence of a specified catastrophe significant amount of time to settle event, in a specified geographic following a catastrophe event, as the region, for a specified line of business. insurer must first assess and tally all claims, which can take a significant For example, a bond might be time. In some cases the bond will structured to trigger if the sponsoring extend beyond the scheduled maturity insurer’s residential property losses to allow the sponsoring insurer total all from a single hurricane in the U.S. claims, especially if an event has state of Georgia exceed $25 million, in occurred near the end of the bond’s the time period from April 1, 2012 to risk period. This extension period can March 31, 2015. be detrimental to investors, as their funds are locked up at significantly A bond of this type requires extensive lower rates than during the risk period. legal definitions of the key terms, such as the book of business, recognition of loss, and what constitutes a hurricane. Figure 2: Comparison of trigger types ©2012 Risk Management Solutions 4 Industry Loss catastrophe event as the trigger. For example, a pure parametric bond might trigger if an earthquake with a In the U.S. and Europe, the main magnitude greater than 7.1 occurs accepted providers of insurance within a 50-km radius of Tokyo. Most industry loss estimates are Property parametric transactions are based on Claims Services (PCS) and PERILS, an index of the event parameters respectively. Both firms undertake to whereby appropriate weights are provide estimates of the total loss applied to measurements from a larger experienced by the insurance industry area, which is designed to match the after a major catastrophe. Cat bonds actual losses expected for the based on industry loss operate under sponsoring insurer’s business. the assumption that the sponsoring company’s portfolio is aligned with the Because event parameters are industry and therefore the sponsor available shortly after an event occurs, recovers a percentage of total industry parametric transactions are settled losses. much more rapidly than other trigger types and the risk of bond extension is Industry loss-based structures are reduced. However, since parametric essentially a ‘pooled indemnity’ triggers make no reference to insured solution—the indemnity loss loss, there is a likelihood that the experiences of many companies are sponsor will not receive the precise used to determine the industry loss loss amount experienced from an estimate. Industry loss triggers are event. To mitigate this risk, the indices more transparent than pure indemnity used in the bond trigger are often transactions as first industry loss finely tuned to the sponsoring insurer’s estimates from modelling companies exposure. Parametric triggers have are usually available within a couple of proven popular with investors as the weeks after the event. It can, however, trigger is very transparent—the take more time for the official loss probability of a region experiencing amount to be released. As for the risk 100 mph winds can be easier to of the bond being extended, it is understand than the probability of a roughly at the same level as for a pure particular insurer incurring $1 billion of indemnity bond, and higher than for a losses. parametric trigger. There is no consensus as to which is the optimal trigger type, and the Parametric balance of issuance swings depending A parametric transaction uses the on whether investor demand or issuer physical characteristics of a supply is the key market driver.