The cat bond market had a record year in 2007. What are prospects for the current year? David Sandham spoke to some of the leading players.

Shiv Kumar, managing director and head of Goldman Sachs’ financial institutions group – structured finance, believes that cat bond new issues will probably exceed $5bn for the whole year 2008. As of 5 August, about $2.7bn of new cat bonds had been issued, compared with about $7bn last year (a record).

“A lot depends on how the hurricane season goes,” he said. “But even if there is no strong storm activity, we shall easily pass US$5bn. If there are severe storms, then it will be more.”

Other investment bankers were also positive. “We expect to have a busy second half of the year,” said Jean-Louis Monnier, senior vice president, ABS/ILS distribution, Swiss Re Capital Markets. He expected that 2008 would be at least in line with 2006, which saw US$4.7bn in new issues. “2007 was quite a high issuance year,” he said, “It’s too early to say whether it will be matched, but we expect total outstanding issuances to continue to grow.”

Michael Halsband, vice president in Goldman Sachs’ financial institutions group – structured finance, described the current state of the cat bond market as “stable, active and orderly.” Goldman Sachs saw strong investor demand for all its 2008 cat bond new issues. “They were all successfully placed within original price guidance,” said Halsband.

John Stroughair, vice president, riskmarkets at cat modelling company RMS is also positive: “I think long term the cat bond market is a booming one. A number of short term factors are depressing the market at present. The insurance market is very soft. Cedants can get good deals there,” he said. Stroughair also pointed to the subprime crisis as weakening the cat bond market short term. “The credit crunch has led to mispricing of credit instruments. A lot of people in fixed income funds are having to give that their attention, rather than taking a look at the ILS market,” he said.

Halsband outlined the main advantages of cat bonds from a sponsor’s point of view: “Firstly, it’s the ability to lock in pricing over multiple years,” he said. “Traditional reinsurance is renewed on an annual basis, in which case one is subject to the vagaries of the market.” Whilst in the current soft reinsurance market, renewals involve negotiations on price - downwards; over the long term, pricing volatility tends to smooth out in multi-year cat bond placements. Halsband acknowledged that most cat bonds have maturities of only two or three years.

“Secondly, these transactions are fully collateralised,” he said. “So the full amount of the limit is funded in advance.” Collateralisation is an attractive feature given contemporary worries about credit exposure. A third factor in favour of cat bonds is that they provide a broader access to new sources of capital.

But, on the other hand, aren’t cat bonds more expensive than traditional reinsurance? Halsband agreed that there may be a price differential of “from 25 basis points to 75 basis points, probably in the middle of that range”. But “let’s not forget that sponsors are buying credit protection,” he added. This is because, in a cat bond transaction, the principal amount is held in trust in the Special Purpose Vehicle.

Cat bonds were estimated by Guy Carpenter (at the end of 2007) to have 8% of world property limits. What does the future hold? Will cat bonds erode traditional reinsurance, like a new and more efficient species driving out the old? “I don’t see cat bonds overtaking and replacing the traditional reinsurance market,” said Halsband. “There will always be a place for traditional reinsurance. But you will see a measured level of growth over time, perhaps with market share of as much as 10% to 15% or 20%. It will exceed 10% in the near future.”

David Sandham is Editor of Global Reinsurance.

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ILS Latest deals: $200m for Topiary, $120m for Blue Coast

In August, Goldman Sachs closed a $200m cat bond for sponsor Platinum Underwriters. The issuer is Topiary Capital Ltd, a special purpose vehicle set up in the Cayman Islands. The notes are due due August 5, 2011.

The Topiary cat bond provides coverage of qualifying U.S. hurricane, U.S. earthquake, Europe windstorm and Japan earthquake events. Triggers are based on the following: U.S. hurricane and U.S. earthquake on modified PCS index; European windstorm on Paradex data from RMS; and Japan earthquake events on reports from the Japanese National Research Institute for Earth Science and Disaster Prevention.

Additional notes could be issued under the Topiary program.

Meanwhile, in July, Deutsche Bank and GC Securities (the Guy Carpenter affiliate) closed a $120m cat bond for Allianz. They were joint bookrunners on the deal. The bond, issued by Blue Coast Ltd, is for hurricane risk in coastal areas of the southeastern US.

“Cat bonds offer us a valuable tool to manage residual retained risk in our proprietary and client books,” said Chris Fischer Hirs, CEO of Allianz Risk Transfer.

The trigger structure allocates industry losses at the county level along coastal areas of the southeastern US.

"By calibrating the trigger structure of the cat bond protection at a county level, rather than a state level, we can improve our ability to hedge certain underlying US hurricane risks and manage our balance sheet while better minimising and managing our basis risk relative to other non-indemnity hedging alternatives," said Bill Guffey, head of Allianz Risk Transfer’s insurance-linked securities business.

The coupons on the three classes of securities issued by Blue Coast were 9.52, 14.75 and 18.89 percentage points over three-month LIBOR. The notes are to be redeemed in December 2010, and were rated BB-, B+ and B by Standard & Poor’s.

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ILS Six cats for Goldman so far in 2008

Goldman Sachs has been Lead Manager on :

• East Lane Re II (US$200m) for Chubb

• Residential Re 2008 (US$350m) for USAA

• Nelson Re (US$175m) for Glacier Re

• Willow Re 2008 (US$250m) for Allstate

• Caelus Re (US$250m) for Nationwide

• Topiary (US$200m) for Platinum Underwriters

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ILS Parametric or indemnity trigger?

“There’s been a marked shift to transactions with indemnity based triggers in 2008,” said Michael Halsband, vice president in Goldman Sachs’ financial institutions group – structured finance. From an issuer perspective, the main advantage of indemnity triggers over parametric triggers is the reduction of basis risk. “Though there is still some basis risk in indemnity transactions,” Halsband pointed out, as sponsors are exposed not only to the named events but to other perils as well. “We highlight for our clients the positive and the negative aspects of both,” Halsband said. Four of the first five Goldman Sachs-led cat bonds issued in 2008 had indemnity triggers. Of the 10 first new issues in 2008, six had indemnity triggers.

Vega gets closer to the money

Swiss Re’s most recent cat bond had some innovative features, discovered David Sandham.

Swiss Re’s latest transaction, issued in June, is Vega Capital, a four tranche multi peril, multi region bond of three year maturity and totaling US$150m. Vega’s four tranches, from A to D, are structured to provide increasing risk to the investor. Pricing increases through the layers, from Libor plus 250 basis points (bp) for the US$21m tranche A (rated A- by S&P); then Libor plus 300bp for the US$63.90m tranche B (rated BBB by S&P); then Libor plus 575bp for the US$22.50m Tranche C. There is no coupon attached to the US$42.60m Tranche D, the riskiest layer.

“Tranche D is issued as a zero-coupon note and provides equity type return and risk profile,” said Jean-Louis Monnier, senior vice president, ABS/ILS distribution, Swiss Re Capital Markets. “It will pay at the end from trapped premiums, based on the performance of the transaction at the end of the three years.” Vega was structured in four layers to appeal to a wide range of investors. “What we achieved is to be able to have a broader range of investors with different profiles,” Monnier said.

All four tranches reference the same five underlying perils using parametric, modelled loss and industry loss triggers. The modelling firm used is Equecat.

Digging down

Another interesting aspect of Vega is that is digs down deeper into the sponsor’s risk than is usual with cat bonds, which have traditionally been used to transfer remote, low frequency/high severity risks. “We can take a diversified pool of risks at relatively low attachment levels, with the objective of managing earnings volatility,” Monnier said. “Swiss Re has demonstrated that cat bonds can be used closer to the money.” The sponsor in the case of Vega is Swiss Re itself, and Swiss Re’s Capital Markets unit was Lead Manager on the transaction. Since 2003, this arm of Swiss Re has done about two thirds of its cat bond deals for external clients, and the remaining third for Swiss Re.

Swiss Re has five ILS specialists in its cat bond distribution team, with Monnier, who has 13 years experience in structured assets and risk transfer solutions leading the European effort. Origination and secondary market trading are combined in the same team. “Swiss Re is one of the largest traders in the secondary [cat bond] market,” Monnier said. “We have had a busy beginning of the year. In the first five months we traded over US$1bn in the secondary market, compared with US$1.7bn for the whole of 2007.”

Monnier mentioned Solvency II, the benefits of AAA collateralisation and access to alternative capacity as among the reasons insurers favour cat bonds as one of the mechanisms to transfer risk. He did not agree, however, that cat bonds would ever replace traditional reinsurance. “Cat bonds provide insurers with additional capacity and reinsurers with an alternative to retro. They can be an attractive way for reinsurers to buy protection in a collateralised form,” he said. “It makes sense for Swiss Re to access capital markets rather than to rely solely on retro, bearing in mind credit risk. Credit risk, and the value of collateralisation, is more and more taken into account by the industry at large, especially on peak perils.”

Monnier said that a precise figure could not be put on the pricing gap between cat bonds and traditional reinsurance, because this difference depends on a number of variables such as the perils involved. “In the US it’s quite close, though in Europe there’s still a gap,” he said.

“Maturities [of cat bonds] tend to be between one and three years,” Monnier said. “You can go longer, at the option of the issuer. A three year maturity seems to be the sweet spot. Issuers of one year cat bonds tend to set up shelf programmes to reduce the costs of subsequent issuance.”

David Sandham is Editor of Global Reinsurance.

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ILS Modelling cat portfolio risk

RMS is currently marketing Miu, a software product for risk analysis of ILS portfolios. Targeted users are bond investors.

John Stroughair vice president, riskmarkets at RMS said that there are three key pieces of information that Miu provides on any ILS portfolio over any time period: “Our view of the expected loss, our view of the probability of attachment, and our view of the probability of exhaustion.”

Miu should prove convenient to investors who wish to know the risk of a whole portfolio of cat bonds. Whereas for a single bond they can refer to the offer documentation, investors also need to quantify risks across an entire portfolio, in which several bonds could be exposed to perils in the same region. Indeed, the idea for the Miu software package grew out of consultancy work undertaken by RMS for investors.

Miu generates the risk as an output figure (for example 1.3% loss at twelve months), and a graph showing that risk growing over subsequent years, for any ILS portfolio selected by the user. The user of Miu simply ticks a box to add a new ILS to the portfolio. Each ILS (cat bonds, mostly) has been individually modeled by RMS, which took on several additional staff last year to accomplish the task. Diego Jimenez-Huerta, manager, strategy group, RMS, who personally oversaw development of Miu, said that a total of 119 bond tranches for around 60 different bonds had been modelled and input into the Miu software. “To include a new bond we need the offering circular, pricing supplements, any stickers added at marketing stage, and reset information,” he said.

Stroughair explained that this information is typically provided by RMS’ clients, potential investors, rather than by the bond issuer. RMS aims to model and include new bonds quickly enough for Miu to be of use to investors considering whether or not to participate in new issues. But RMS is at no disadvantage in the case of bonds where it has not been appointed by the issuer as modeller. “The modeller appointed to advise on a bond cannot then make use of the information it receives to adviser investors,” Stroughair explained. “They must set up a Chinese Wall.”

Diego Jimenez-Huerta added: “There is a subtle difference between modelling risk for a sponsor and for an investor. Investors are interested in the likelihood of facing a reduction in principal. If the payment mechanism of a bond is locked [to a certain model] then even if our view of the risk is different that would not be of much use to the investor,” he pointed out. RMS did not reveal the price of Miu.

Stroughair joined RMS last April from management consulting firm Oliver Wyman. At RMS, he is responsible for all RMS capital markets activities. The RMS riskmarkets team, which he heads up, currently numbers 15, most of whom are based in the UK. As well as Miu, the team also runs Paradex (parametric indices for risk transfer).

The simple life

BarCap has developed special expertise in VIF securitisations. David Sandham went to see them at their offices in Canary Wharf, London.

Barclays Capital (BarCap) closed a £250m value in force (VIF) securitisation for sponsor AEGON Scottish Equitable on Friday 18 July. No pricing details were released for this private placement of fixed rate notes, which is the second such transaction BarCap has done for AEGON.

The transaction used a lightweight, cost-efficient structure, with neither a monoline wrapper (i.e. it had no financial insurance) nor a Special Purpose Vehicle (SPV). BarCap believes this simple structure is readily applicable to most of its European insurance clients. “Most of our clients ask for simplicity,” said Kory Sorenson, head of insurance capital markets at BarCap. “We tried to develop a structure that was as little disruptive as possible to the [sponsor’s] business,” she said.

Another benefit is that “they get the cash up front,” she said. Zest featured no collateralisation of bond proceeds: instead of being placed in a trust, or having to be invested in specified assets, bond proceeds are available to the sponsor for general purposes. “We are also transferring risk, and creating Tier 1 regulatory capital,” Sorenson added.

Inside hybrids

With all these benefits, why is it that there are not more VIF securitisations? Historically, VIF securitisations have been more expensive for the sponsor than both traditional reinsurance and hybrid securities. However, with respect to hybrids at least, “in the current market this relationship has inverted,” with VIF securitisation “coming inside [cheaper than] hybrids,” Sorenson said.

On the other hand, as bespoke financial instruments, VIF securitisations can take three to six months to set up, and “markets change,” she pointed out. Furthermore, insurers have had excess capital recently, and so have been under little pressure to raise more.

Sponsors have to devote considerable effort to “getting their systems in place” for a VIF securitisation, Sorenson said. But “these transactions are well received by ratings agencies and equity analysts,” she pointed out, because sponsors “are demonstrating that their systems stand up to third party due diligence.”

The secondary market in VIF securitisations is “not active” Sorenson said. “Investors tend to buy and hold.” However, BarCap is “working at increasing the investor base.”

The flipside of Zest’s simple structure is that it required sophistication from investors. There are relatively few bond investors who understand the life insurance business, whose key risks are persistency (policies terminating early), mortality, longevity and market risk (a crash in the equity market reducing the sponsor’s funds under management).

During the first three years of the Zest notes’ lifetime, the sponsor can top up a revolving block of policies. If the surplus is sufficient, the first principal payment date is in 4 years but if there is insufficient surplus then the notes will not be repaid. BarCap expects the notes to be fully repaid in 8 years, though it could be sooner or later than that, depending on the surplus. Legal final maturity is 15 years.

Ratings agency Fitch rated Zest as single A, which means it thinks the probability that the notes will default is 2.575% over 15 years. (Triple AAA would have meant 0.497%, and BB almost 22%.).

David Sandham is Editor of Global Reinsurance.

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