Cat Bond Market Still Seeking Collateral Solution

By Catherine Evans | June 29, 2009

Insurers are still seeking a universal solution to weaknesses in catastrophe bonds exposed by Lehman Brothers’ collapse, though structural improvements have helped push sales past $1 billion this year.

This year’s nine catastrophe bonds have employed innovative structures to neutralize credit risk, but disagreement over whether such securities must continue to offer a Libor-based return is hampering the search for a new industry standard.

Catastrophe bonds, used by insurers since the 1990’s to manage their exposure to natural disasters, have traditionally used London Interbank Offered Rates — a standardized set of indicative money market rates — as a benchmark for returns.

Some investors want that to remain so, but others argue that Libor increases correlation with other financial instruments and undermines catastrophe bonds’ appeal as a diversifying asset.

“It’s the Libor piece of the puzzle that’s complicated,” said Erik Manning, a director within Deutsche Bank’s Structured Products and Alternative Risks Group. “Libor is not a risk-free rate, although perhaps at the peak of the boom people treated it as such, and it’s tricky to find credit-neutral structures that will deliver a Libor return.”

Catastrophe bonds transfer insurers’ losses from hurricanes or earthquakes to investors, who receive a high rate of interest but risk losing their principal if a disaster occurs.

They were among the few assets to withstand last year’s meltdown in global markets, but their reputation was damaged when four bonds guaranteed by a unit of Lehman were downgraded following its insolvency, and issuance halted for six months.

French reinsurer SCOR reopened the market with a $200 million transaction in February, since when about $1.4 billion of new bonds have been sold.

SCOR’s deal, and subsequent transactions by U.S. insurers Liberty Mutual, Chubb Corp and Assurant, were structured like older catastrophe bonds, with a counterparty employed via a total return swap (TRS) to manage the underlying collateral and make up any shortfall.

The counterparty role was taken by Lehman in the four bonds that were downgraded by credit rating agency Standard & Poor’s, which cited deficits in their collateral accounts. Two of the bonds are now in default.

“The collateral management process was relatively low profile until the Lehman debacle, which made it a point of focus for issuers and investors,” said Mark Gibson of the Capital Markets Structuring group at BNP Paribas, which has proposed a new repo-based collateral mechanism.

“In hindsight, it was a flawed decision to save 5 or 10 basis points (in running costs) for several ratings’ worth of counterparty credit quality, given the collateral provision element was meant to be about securing low credit risk.”

Bonds using a counterparty this year have set strict rules for monitoring collateral, which has mostly been invested in debt issued under the U.S. government’s bank rescue package and guaranteed by the Federal Deposit Insurance Corporation (FDIC).

Investors said they liked the security offered by such assets, but felt the 2012 expiry date of the FDIC debt program meant such a solution could only be temporary.

“It fits neatly with a three-year bond now but what assets will be available next year to generate Libor and at what cost?” said Richard Lowther of Validus Holdings’ AlphaCat, an insurance-linked securities (ILS) fund with $100 million invested in catastrophe bonds and collateralized reinsurance.

Manning at Deutsche, which helped launch SCOR’s Atlas V transaction, said the FDIC assets it purchased in February were then yielding more than Libor but had subsequently become more expensive, raising the cost of such a solution for the issuer.

The first catastrophe bond not to employ a counterparty was sold in April by German insurer Allianz. Collateral for its $180 million deal was instead invested in floating-rate notes issued especially by Germany’s triple-A rated state development bank Kreditanstalt fuer Wiederaufbau (KfW).

Insa Adena, Head of Advanced Risk Intermediation in Allianz’s reinsurance division, said the insurer had wanted to bypass concerns about investment banks’ creditworthiness. “Our feeling was, wouldn’t we all be better off without that additional counterparty?” she said, adding Allianz had found issuance costs attractive compared to other suggested solutions.

She said using the KfW notes, which include non-standard features such as regular puts, addressed credit and liquidity concerns and technical issues such as alignment of cash flows.

Calabash Re III, a $100 million bond sold in June by Swiss Re used a similar structure, with collateral invested entirely in a special debt issue by the World Bank, while Munich Re also used KfW notes to back its recent issue.

Again, investors felt the new structure offered sufficient credit insulation but said other sponsors’ access to such a solution would depend on their persuading a top-rated issuer to make a bespoke issuance, as KfW and the World Bank had done.

Residential Re III, a $250 million catastrophe bond sold in May by U.S. military insurer USAA, brought a further twist, with its collateral invested entirely in U.S. money market funds.

Other players favor the use of U.S. Treasuries, which are often used in collateralized reinsurance transactions. Both are stable investments with minimal credit risk, but the yields they generate are generally less than Libor.

Lowther at Validus said the simplicity of the money market fund option would appeal to non Libor-based investors.

“The new TRS structures, while more robust, still require a considerable amount of time evaluating the credit risk, whereas we would prefer to focus on evaluating natural catastrophe risks,” Lowther said. “One of the core attractions of this asset class is its low correlation with financial markets, and in our view anything that increases that correlation would be a negative.”

Adena said there was “an implicit discussion” taking place about what benchmark should be used, but that Allianz had felt while structuring its deal that investors still favored a Libor-based return despite wanting government-type security.

She warned that a big divergence between Libor and Treasury yields could make issuance too costly for sponsors, however. “We have to make the case internally why there is benefit in issuing a cat bond rather purchasing reinsurance, and if the economics drift apart significantly we will struggle to justify the cat bond alternative,” Adena said.

The three-month Treasury-Eurodollar, or TED, spread is currently stable at around 50 basis points, but blew out to around 500 basis points at the peak of the credit crisis.

BNP Paribas has proposed another solution, based around a tri-party repurchase agreement between an investment bank, the issuer, and clearing house Euroclear. The scheme would use the bank’s portfolio of investment-grade corporate bonds, a liquid and transparent asset, to generate Libor returns, with overcollateralization to give additional security.

Gibson at BNP Paribas said a key aim is to reduce the costs borne by sponsors, but acknowledged the proposal needs to be tested in the market.

A single new standard for collateral could help drive expansion of the market. But the dispute over Libor may mean sponsors and structurers continue to come up with ad hoc solutions for new bonds.

“If the market is going to continue down the Libor path we’ll always have to look around for assets,” said Deutsche’s Manning. “I don’t see anything wrong with keeping your ear to the ground and looking for the best bang for your buck.” (Editing by Sitaraman Shankar)

(For more information on the insurance-linked securities market, go to )

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