February 1, 2004 by Dennis Kuzak
Catastrophe bonds, otherwise known as “Act of God” bonds, are part of a newly emerging asset class of insurance-linked securities enabling insurers to diversify their risk capital sources. These bonds enable corporations, insurers, reinsurers, or even government entities to issue fully collateralized “debt” securities, which pay the issuer all or some of the proceeds of the issue after the occurrence of damaging natural hazard events.
The cat bond market has been evolving since the mid-1990s. The first cat bonds were issued in 1996, but the marketplace really developed in 1997 with the issuance by USAA of a cat bond to provide protection to their U.S. insurance portfolio from a large hurricane (i.e., such as Hurricane Andrew). The motivation for the transaction reflected recognition that even more destructive hurricane events were possible. If they did occur, observers asked, would the global reinsurance industry be able to fully reimburse every insurance company claim? In fact, since 1996, more than US$6 billion cat bonds have been issued, with more than $3 billion currently outstanding (chart 1 shows the annual issuance from 1996 to July 2003).
Since the first “hurricane bond,” the number of perils and regions has expanded to seven, including a recent Taiwan earthquake bond. The accompanying chart (chart 2) shows the distribution of issuance by peril, with U.S. hurricanes, California earthquakes and Japanese earthquakes as the top three perils. These three regions also represent the largest reinsurance industry exposures to severe natural perils, and thus their interest in accessing additional risk capital.
Currently, most of the reinsurance and insurance issuers are from the U.S, Europe and Japan. However, two non-insurer corporations, theme parks in Japan and California, have now joined the list, and more corporations are expected to access the market, as regions and perils expand.
Cat bond investors represent a wide spectrum of the “fixed income” capital markets investors, with pension funds, life insurers, commercial banks, hedge funds, mutual funds, and reinsurance companies, largely from the U.S., plus others from Canada and Europe, representing the typical players.
Since cat bond financial returns are uncorrelated with other fixed income instruments in terms of yields, they are especially attractive to portfolio managers. In addition, the relative transparency of the risk – clear disclosure of the risk and the loss probabilities – has resulted in investors having a strong demand for additional cat bond investing opportunities.
Direct participation in the insurance industry grew from a technique developed more than two decades ago in the residential mortgage business. In the late 1970s, investors began to participate directly in residential mortgages, which previously were originated by and retained by banks and savings institutions.
Through creation of standardized mortgage loans and mortgage pass-through securities, investors received cash payments based on the underlying mortgage rate, while being exposed to the prepayment risk inherent in fixed-rate mortgages, a process known as securitization. The process converts a financial contract, such as a loan, mortgage, lease, or insurance/reinsurance contract, into a security, which can be issued to capital market investors, and traded in secondary markets. Securities included in insurance-related contracts, or proxies of insurance policies, are called “insurance linked securities” (ILS).
In essence, investors put money into a “trust account” for the benefit of the issuer, with funds to be paid to the issuer, in case of a hazardous event. The event is defined by a “loss trigger” described in a prospectus (chart 3 shows cashflows in a typical cat bond deal).
The issuer is a “special purpose vehicle” (SPV) created by the sponsor, such as an insurance company, which acts as an ad-hoc reinsurance company. Its purpose is to reinsure the sponsor under the terms and conditions specified in the prospectus. The swap counter-party is a financial service company, which invests the premium paid by the sponsor into an equivalent cash flow consistent with the quarterly bond payments made to the bondholders. If a defined loss event occurs, all or part of the principal funds owned by the SPV are paid to the sponsor according to the terms of the prospectus. If a loss event does not occur, the principal is returned to the investors at the maturity date of the security.
Virtually all cat bond transactions are rated by agencies such as Moody’s or Standard and Poor’s. Their ratings are based on the expected loss to the investors and the legal structure of the transaction.
Likewise, risk-modelers such as EQECAT provide disclosure to the investors of the risk being ceded, description of the peril and hazard, and the expected loss and sensitivity analyses. Thus far, most cat bonds have been structured to provide an expected loss ranging from around 0.5% (50 basis points) to 1.3% annually. This results in bond ratings of “BB”, or one level below investment grade level. Actual premiums range from multiples of four to seven times the expected loss. For example, for an 80 basis point expected loss, the premium would be about 500 basis points over the risk free floating interest rate. The actual multiples and premiums are based on market conditions at the time of issuance.
The process of issuing a cat bond is more complex than purchasing reinsurance, but the overall process has become standardized among experienced modeling companies, rating agencies, legal firms and underwriters. Given the additional complexity of issuing a cat bond versus traditional reinsurance, the first step for any potential issuer is to conduct a careful analysis of the needs and the benefits. Primary among the factors to be explored are:
Credit quality: Cat bonds have near “AAA” credit quality since they are fully collateralized at closing. Given the dramatic decline in credit quality of even the largest reinsurers, total reliance on the reinsurance market must be questioned.
Additional risk capital: Cat bonds provide insurers with another source of risk capital to complement traditional reinsurance, and a lower cost alternate to issuance of additional equity or debt.
Multi-year financing: Risk financing should be no different than debt financing. Corporate treasurers usually stagger debt maturities and terms to minimize “rollover risk” and dependence on any one market. Risk managers now can emulate the practices of the corporate financiers. Multi-year deals stabilize risk-financing costs, and lower the effective issuance costs.
Price discovery: Secondary trading of cat bonds provides insurers with valuable market pricing of their cat risks. Using such information provides companies with information on the appropriate rates they must pass on to their policyholders for such coverage.
Costs: The total costs of a cat bond should include the premium paid and the issuance costs. To minimize the annualized impact of issuance costs, issuers are selecting deals with three to five terms, thus spreading out the costs over the longer term. Reinsurance costs should also include the cost of reinsurance credit default.
Overall, cat bonds should be considered as a part of any insurer’s risk-management program, especially in the current environment when cat bond spreads have been declining and property cat reinsurance prices are relatively high.