Cat bonds may be thought of as the place where insurance and
the capital markets truly come together. They provide additional capacity in the insurance market and offer an alternative to traditional reinsurance and retrocession contracts. They provide the insurance industry access to the deep pockets of the capital markets and reduce insurance costs to end users. A.M. Best describes a cat bond as: “A structured debt instrument that transfers risks associated with low-frequency/high-severity events to investors.” The key feature of a cat bond, which contrasts with traditional reinsurance, is that risk in relation to the particular peril is transferred to investors rather than reinsurers. A cat bond enables insurers or reinsurers to spread risk so as to avoid their balance sheets being substantially impaired where huge losses arise from natural disasters. In that sense, a cat bond is a form of insurance securitisation. The nature of the bond is a high-yield debt instrument that is linked to an insurance risk and, as the name would suggest, the insurance risk is typically a catastrophic risk arising from a natural disaster such as a hurricane, earthquake or flood.
Cat bonds: a history Historically, cat bonds have been used principally to cover the
risk of US hurricanes, US earthquakes, Japanese typhoons and earthquakes, and European hurricanes. However, whilst cat bonds have been traditionally limited to the world of natural disasters, they need not be so as evidenced by the issue by FIFA of cat bonds worth $260 million against cancellation of the 2002 World Cup in South Korea and Japan.
Cat bonds first came into vogue in the aftermath of the devastating
Hurricane Andrew, which hit South Florida in 1992, the most costly Atlantic hurricane in US history (costing $26.5 billion), until it was surpassed by Hurricane Katrina in 2005. Cat bonds emerged from the search for a vehicle that would bring more risk-bearing capacity to the catastrophe reinsurance market or, to put it another way, one that would enable reinsurers to spread the burden and protect their balance sheets in the event of a truly catastrophic claim. The first cat bonds emerged in the mid-to-late 1990s with sponsors such as AIG, Hannover Re and St Paul Re, and continued to develop over the coming years with 9/11 and Hurricane Katrina not surprisingly stimulating further growth in the sector. To date, more than $30 billion of securities have been issued and the indications for 2010 are that cat bonds are on course for one of their strongest-ever years. According to Aon Benfield Securities, up to the end of June this year, there were 20 deals worth $4.6 billion, compared to only 11 deals totalling $1.7 billion during the same period to June 2009.
Their structure How are cat bonds typically structured and how do they work? The
structure has much in common with the traditional securitisation model used with asset-backed securities. The Cayman Islands has always been strong in the asset-backed securities market, particularly CDOs, and therefore it is perhaps no surprise that the Cayman Islands would become a participant in insurance securitisations, with the first Cayman cat bond listed on the Cayman Islands Stock Exchange in 2007.
The traditional structure involves an insurance company or
a reinsurance company (the sponsor) establishing a special purpose vehicle (SPV) as a bankruptcy remote entity. As with a
60 CAYMAN CAPTIVE
“Investors have returned, attracted not only by the higher coupon compared
to corporate bonds, but by the diversification and lack of correlation to traditional assets classes that cat bonds can provide.”
CDO, the SPV will typically be set up in a tax-neutral offshore jurisdiction such as the Cayman Islands. The sponsor pays premiums to the SPV, with the SPV acting as a reinsurer of the sponsor, and the SPV raises its capital by the issuance of the cat bond to investors in the capital markets. The usual model in the Cayman Islands is for the funds provided by the investors to be deposited into a collateral account and invested in investment- grade securities such as money market funds. The funds in the collateral account are available to satisfy the catastrophic losses reinsured by the SPV. The cat bond obviously carries a coupon—usually a floating rate coupon—which is serviced from the premiums paid by the sponsor to the SPV and from the investment income earned on the funds in the collateral account.
Because of the high risk for the investor in the bond, the
coupon needs to be attractive and would typically be anywhere between 3 and 20 percent over LIBOR. One particular advantage of the SPV being domiciled in a jurisdiction such as the Cayman Islands is that there is no withholding tax on the payment of the coupon. The typical term of a cat bond is three to five years. If the catastrophe covered by the bond does not occur, the investors receive their principal back at the end of the term and, of course, their interest during the term of the bond. In these circumstances, the return on investment should be very healthy. However, if the catastrophe arises—the major hurricane hits Florida or there is a landfalling typhoon in Japan—and the bond is triggered, the entirety of the investors’ funds could be wiped out. Investment in cat bonds is therefore not for the faint of heart.
Squeezing the trigger Whether or not the bond is triggered and losses have to be met
can be a complicated issue, and there are various trigger types.
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