Paul Scrivener, head of the insurance group at Cayman Islands law firm, Solomon Harris, takes a look at the catastrophe bonds industry and the role played by the Cayman Islands. Second in a two part series.
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 establishing a special purpose vehicle as a bankruptcy remote entity. As with a 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 per cent and 20 per cent 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 – a major hurricane hits Florida or there is a land-falling 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!
Whether the bond is triggered and losses have to be met can be a complicated issue and there are various trigger types. Some triggers are closely correlated to the sponsor’s actual losses and therefore operate more like traditional reinsurance whereas others are not correlated in this way and the payment made under the bond to the sponsor may bear little resemblance to the actual losses thereby providing a windfall for the sponsor. An example of the latter would be a bond which pays out to the sponsor based on a set wind speed at a specified number of weather stations but the actual loss exposure of the sponsor arises in locations away from the weather stations specified.
While traditionally cat bonds have been issued to cover the risk of a particular loss, they have also been structured to cover the risk that multiple losses will occur, with the first second event bond having been issued as long ago as 1999 and the first third event bond having been issued in 2001.
Cat bonds are frequently rated by the traditional rating agencies but whereas a typical corporate bond is rated based on the likelihood of issuer default, a cat bond is rated based on the likelihood of the catastrophe arising and the principal being impaired as a result.
Who invests in a cat bond? Not surprisingly, bearing in mind the high risk/high reward associated with cat bonds, the investors are typically institutionally-based and tend to comprise hedge funds, insurers, reinsurers, banks and pension funds. There is no doubt that the global financial crisis had a marked impact on cat bonds as hedge funds, in particular, bailed out because of the need to go into cash. The investors who remained had concerns about the transparency of the underlying collateral arrangements particularly in the light of collapse of Lehman in 2008. Lehman had acted as counterparty on a number of cat bonds. However, the lessons learned from Lehman have led to an improvement and simplification of the collateral arrangements, typically, through the use of US Treasuries and AAA rated securities. Consequently, 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.
As 2011 gets under way, the cat bond industry remains vibrant and Cayman appears to be in a very strong position to retain its position as the leading offshore domicile in this market. Its ambitions in this regard are not least reflected in the recently revised Insurance Law which for the first time establishes a separate licensed category for cat bond SPVs and no doubt the fact that in September last year Cayman was, for the second year running, named by UK banking and finance magazine, The Banker, the No. 1 specialised financial centre, globally, will do the jurisdiction no harm.