Fund manager: These cat bonds offer an attractive return. You say they are uncorrelated with the rest of my portfolio. Do you really know what would happen to the stock market if there is a big windstorm on the eastern seaboard of the United States?

Barney Schauble: When we look at correlation of risk-linked securities with other financial instruments, we know intuitively that in one direction there is no correlation. Whatever happens in bond or in equity markets today is not going to influence the temperature in a US city or cause a natural catastrophe in some other part of the world.

From our experience, investors are concerned mainly about the behaviour in one part of their portfolio impacting others. Generally speaking, this market is small right now, so the portion of any one person's portfolio in these securities is very small relative to their investment in other fixed income or equity markets.

Yes, there is the potential that, if it were big enough, from an insured or economic loss standpoint a large natural catastrophe could have an impact on financial markets, but when we look at history and examples like the Kobe earthquake in Japan, like some of the big hurricanes or the Northridge earthquake, that impact has been relatively hard to discern.

Fund manager: Do I lose everything if there is a catastrophe?

Barney Schauble: None of the securities that have been placed to date has been binary, in the sense that if there is a loss of $99, you do not lose any money, but if there is a loss of $101, you lose it all. Like any other bond, there is a window of defaults, where there could be a partial loss or there could be an entire loss. In the risk analysis that is provided with the securities, there is some modelled estimation of the likelihood of default: of any impact on the instrument, and then the smaller likelihood of a total loss. In some securities, that window between partial and total default is very large.

Fund manager: How do I get a spread in cat risks? Most of what I have seen is pretty well inevitable. I am just gambling on when it is going to happen. Could I not balance California or Japanese earthquake or Florida windstorm with something which is less volatile and less likely to happen?

Barney Schauble: There are two ways that investors in the market today have of balancing their portfolios. This is the same way that insurance and reinsurance companies in Bermuda, London or elsewhere do it. One way is just by geography. If you buy a bond that is linked to a hurricane in Florida, you can diversify that investment or diversify your pool by allocating your investment over Florida, New England, California earthquake, Japanese earthquake, Japanese typhoon- events that you know are uncorrelated and do not arise from the same natural hazard. You can do that not only across regions but also sometimes even within the same country. In the US or Japan, for example, there are different, independent seismic regions – in Europe as well. We have worked in the past to bring to market an array of different risks, not simply more and more Florida hurricane or some other very peak exposure.

Secondly, in terms of level of risk, the bonds are rated by rating agencies. Some are more risky than others. We have looked at – and we are spending more time on – higher frequency but lower severity types of risks as well. We have looked at risks that are not natural hazards, like credit default, mortgage default or the residual value of automobile leases, all of which have been securitised as risk linked securities, and again will diversify within a portfolio. Weather risk is another good example of an increasingly popular area for corporations and insurance companies to think about managing their risk. Temperature or rainfall in a given area will, again, be uncorrelated with the likelihood of an earthquake.

Fund manager: If I invest in catastrophe and other risk related instruments, am I stuck in a position? There does not seem to be much of a secondary market, certainly in cat bonds, at the moment.

Barney Schauble: Goldman Sachs, and other broker dealers who have brought securities to the market and some of the reinsurance companies do trade these securities in the secondary market. For every security that we have issued, there has been some secondary market activity. We and some of the other players in the marketplace accept calls from people who are looking to sell or buy these various securities. That varies according to the season of the year. There is much more interest in secondary trading of wind bonds, for example, during the wind season or immediately before or immediately after. But that is a function of the number of players in the marketplace and varies according to the size of a particular issue and the complexity of a particular bond. A lot of the investors have bought these bonds to hold them. It is still a small marketplace, so it is not as big and liquid as the high yield bond market or the mortgage backed securities market. But there is a secondary trading market and there are multiple players involved.

Fund manager: I am neither a geologist nor a meteorologist nor an insurance underwriter. How do I know that I am being offered a fair price for the risk? Pricing in the insurance and reinsurance market is far from transparent.

Barney Schauble: That is true. Pricing in the insurance and reinsurance market is far from transparent. We and every other broker-dealer or issuer in this marketplace have tried to provide information to help investors make a judgement on whether they think they are being paid a fair price for the risk. None of these placements is offered at a fixed price. It goes out at a price which is determined by investor appetite.

Each security has in the prospectus a risk analysis which is provided by an independent, outside expert firm comprised of meteorologists, geologists, physicists and statisticians who spend their lives looking at the likelihood of specific natural hazard or other extreme events. They provide an estimate of what they think the statistical likelihood is over a long time period of a particular type of event. In addition, they provide information on the historical experience.

This is not a forecast, and there is no ability to say whether it will be this year or 100 years from now. But outside experts are hired for each transaction, and there are additional outside experts whom you as an investor can go and talk to. They sell their software and statistical models to third parties. In addition, there is an enormous academic body of literature and area of study around the world that focuses on natural catastrophes for a lot of reasons beyond financial markets: for insurance markets, for safety, for governments. So there is a huge community which is constantly looking at how to evaluate this type of risk, and it is simply taking that measurement and placing it into the form of a financial instrument. You have to look at what sort of risk analysis you are provided when you invest in any other financial instrument, any other bond or any other stock.

Fund manager: As I understand it, none of the cat bonds issued so far has defaulted at all. What would happen to the secondary market if one does? Will the resale price collapse?

Barney Schauble: Every conversation we have ever had with an institutional investor, this question comes up and for good reason. These are bonds that transfer risk from one party to another. At some point, an event will occur which triggers a payment to a person buying the protection. But this occurs in every bond or option market where people are buying protection or lending money. Sometimes the person you have lent money to is not able to make the payments on time or at all. Sometimes the hedge that you have sold somebody on a commodity means that you have to pay them that money.

We will not know for sure until events occur in this marketplace what the impact will be. Some investors may exit the marketplace; others may at that point enter the marketplace because they feel that following a major event, the insurance market will have different pricing or a different dynamic. We draw some comfort from the development of all other financial markets, the high yield market, asset-backed markets and equity markets. Despite periods of volatility or large, sometimes negative impacts, it is rare that investors exit a market and never return. You may see some change in the marketplace; you will see fluctuations in price, but that will be for individual securities.

Fund manager: We have been talking about bonds. Is there any other way I can get involved in this market?

Barney Schauble: Sure. The attraction of the bond or the reason that the bond form of financial instrument was first used is that it is a collateralised obligation. Unlike a typical insurance contract, the money that would be used to pay a loss is placed into a trust. It remains in that trust until either the bond matures and goes back to the investors or it goes to pay the beneficiary. It is possible to do this in other forms, for example, some have used a similar structure to issue preference shares, or. have actually offered equity in the special purpose vehicle.

The other alternative that some people have used is derivative form that does not require investors to post collateral, and it potentially requires less documentation. It is a slightly different instrument but the economics are basically the same, where payment is made which is equivalent of an insurance premium and following a contingent event, the stream of those payments may change. Whoever has the risk will receive compensation. To date, bonds have been the biggest component of this marketplace, but in the weather market, for example, it is much more common for people to transact using derivatives. We own a company in Bermuda, Arrow Re, which was set up to help facilitate transfer between people who want risk in one form to people who want business in another form, to transform risk.

  • Barney Schauble is with the risk markets group of Goldman Sachs International, London. E-mail: