Cayman: riding the cat bond surge

Cayman: leading the way

No doubt it raised a few eyebrows in Bermuda when it was announced in July this year that new figures revealed that the Cayman Islands had become the leading offshore jurisdiction for listed catastrophe bonds (cat bonds). Even Bermuda’s main newspaper, The Royal Gazette, was forced to acknowledge that Bermuda had a lot of catching up to do to match its offshore rival in the competition for cat bond business. The July figures showed that there were 74 cat bonds listed on the Cayman Islands Stock Exchange with a value of over $7.7 billion, whereas, in contrast, Bermuda’s own statistics showed 10 listed bonds having an aggregate value of $1.17 billion. For those involved in Cayman’s structured finance and captive insurance industries, there was much less surprise as the figures simply bore testimony to the jurisdiction’s continuing ability to adapt and embrace innovative financial products.

From lunacy to triumph

In an article in QFinance published in January this year, Anthony Harrington describes cat bonds in a particularly graphic way when he says: “Catastrophe bonds are either complete lunacy or an outstanding triumph of statistics and probability theory over common sense, depending on your point of view.” This comment speaks to two particular features of a cat bond—the high risk taken by investors with a view to achieving a significant investment return and the importance of the modelling undertaken by the specialist catastrophe modelling houses to assess the likelihood of a particular catastrophe occurring.

"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."

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 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 investmentgrade 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.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 that 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.

Whilst 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.

Institutional investors

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 the 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.

Cayman: a vibrant market

As we approach the end of 2010, 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 Insurance Law (2010 Revision), which for the first time, establishes a separate licensed category for cat bond SPV s. And further cementing its reputation, Cayman was, for the second year running, named by UK banking and finance magazine, The Banker, the number one specialised financial centre, globally. Such plaudits are unlikely to do Cayman any harm.

Paul Scrivener is head of the insurance group at Solomon Harris. He can be contacted at: pscrivener@solomonharris.com