Lehman Brothers’ filing for Chapter 11 protection has had a direct effect on the cat bond sector, and will change the rules governing the assets underlying cat bonds, writes David Sandham.

Goldman Sachs has said there should be increased transparency on the assets which underpin the Total Return Swaps (TRS) for cat bonds, after the collapse of Lehman affected a number of cat bonds, where Lehman was TRS counterparty.

“The underlying assets sitting in total return swaps need to be far more transparent,” said Michael Eakins, executive director, insurance financing group, Goldman Sachs, speaking at Insurance Times’ ‘Commercial Lines Forum’ in London on 13 October. “Currently, if an investor seeks to buy a cat bond in the secondary market, there is no way to find out what the underlying assets are invested in, whether Treasuries, CDOs, or CDOs-squared. That’s not going to be tenable going forward,” he said. “It will have to change.”

Eakins also pointed to another issue that needs to be dealt with. “For the majority of in-force cat bonds, there is no feature such that if the underlying assets fall below say 95% then the swap counterparty has to top it up,” he pointed out. “These two issues will have to be fixed before new issuance can reach $5bn for 2008,” he added. The figure of $5bn for the full year had been widely predicted before Lehman entered Chapter 11.

CATS EXPOSED TO CDOS

According to Henry Kus, executive director at ABN AMRO, speaking at the same conference: “Some of the investments went into CDOs.” Kus added: “Expect to see a lot more rigour applied so that cannot happen again.”

Cat bonds normally pride themselves on being uncorrelated from capital markets turmoil. Investorsin cat bonds expect the complex structure to provide them with pure natural catastrophe risk. Investors do not expect to be obliged to factor in the credit risk of the swap counterparty and the risk on the underlying investments.

The problems were brought into focus only after four cat bonds were downgraded after Lehman Brothers entered Chapter 11 on 15 September.

Lehman was swap counterparty on the following cat bonds: Newton Re, whose sponsor was Catlin; Willow Re (sponsor Allstate); Ajax Re (sponsor Aspen Re) and Carillon (sponsor Munich Re). The Chapter 11 filing caused a notice of event of default under the swap agreement. In the immediate aftermath, dealers were unable to offer prices on these bonds. Once information started to flow then dealers began to quote prices. Jean-Louis Monnier, Director, ILS, Swiss Re Capital Markets, said: “It took several days for market participants to reach some consensus on the value of these bonds.”

What improvements in cat bonds should be made?

According to Mark Hvidsten, CEO, Willis Capital Markets: “Both investors and sponsors will require a tightening up of collateral provisions. This could include more stringent ‘Permitted Investment’ restrictions; obligations for swap counterparties to cash top-up any mark to market shortfalls; active asset management; and greater transparency.”

Michael Eakins of Goldman Sachs suggests that transparency could be increased by using online data rooms. The online data room would be kept live throughout the term of the bond and any information required to be shared with investors would be posted there. Rules governing investment of assets underpinning the TRS for cat bonds should be strengthened: certain structured asset classes should be excluded. There should be frequent marking to market, with collateral being posted below threshold levels and potentially independent third party review of the asset valuation, he suggested.

ILS: Key points

One of the advantages cat bonds have over traditional
reinsurance is full collateralisation.
But there has been insufficient transparency over
what the underlying assets are invested in.
Problems have emerged because of the collapse of
Lehman, swap counterparty on four cat bonds.
The way forward involves more transparency and
stronger rules.

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