David Sandham reports on how the cat bond market is currently on hold while key participants sort out how to provide greater transparency and stronger rules for underlying assets.

So far in 2008 there have been $2.7bn of new issues of cat bonds, and this figure may not become much higher before the end of the year. This compares unfavourably with last year’s record figure of $7bn. Hopes in the summer for about $5bn of new issues in 2008 now look certain to be disappointed. The last new issue was in August, when Goldman Sachs lead managed the $200m Topiary bond for Platinum Underwriters. A number of new issues that had been planned are now delayed due to the knock-on effect of the default of Lehman in mid-September as Total Return Swap (TRS) counterparty on four cat bonds (see last issue).

However, there could well be some cat bond new issues in the first quarter of 2009. “We would expect to see a number of transactions that are still in the structuring phase now, come to market in the first quarter of 2009,” says Michael Eakins, executive director, insurance financing group, Goldman Sachs. Part of the reason for the delay is that “issuers, structurers and legal counsel have had to rethink the TRS arrangements. That takes some time.” A potential new requirement is that investments held as collateral be marked-to-market on a daily basis. “As with any new technology, we need to test it, and make sure it works from a legal and practical point of view and still remain economic for sponsors,” he says. “In a typical BB-rated cat bond yielding Libor plus 600 basis points, the proceeds raised are held on deposit in a security account at the Special Purpose Vehicle (SPV) level, and you also enter into a TRS with a bank that would guarantee the Libor leg of the premium. The issuer pays the spread,” (600 basis points in this example). He called the marked-to-market requirement a “positive development for the asset class which is Insurance Linked Securities”.

Some investors have called for funds held as collateral to be invested in ultra-safe investments such as US Treasuries. But this would raise a problem. US Treasuries do not yield enough to pay Libor. The question would then become, who pays that difference. Issuers would not want to pay it, because traditional reinsurance would be cheaper; and investors would not want to pay it, because they demand a high yield to compensate them for being exposed to the risk of the trigger event (a natural catastrophe).

Though Eakins does not favour restricting collateral investments to US Treasuries, he does agree that “there should be restrictions”. He lists the following: that assets cannot be invested in debt obligations of insurance or reinsurance companies, as this could involve a doubling-up of risk; that assets cannot be invested in paper from the swap counterparty or affiliates of it; and that investments in structured securities should be limited.

Due to the complexity of cat bonds, investment is currently mainly in the hands of specialist funds who understand the instruments and the market well. Although secondary market prices for cat bonds have dipped recently, over the longer term they have outperformed many other high yielding bonds. Many hedge funds which previously invested in the cat bond sector have been exiting it lately, as they can sell at or above par. Goldman is keen to broaden the investor base. Over recent months, members of the Goldman team have been on roadshows or talked with a range of potential new investors, including pension funds, sovereign wealth funds and others in Scandinavia, the Middle East, the Far East, and Australasia. “Investors with a large pool of assets will not invest in cat bonds overnight. It takes time to build up that expertise. Part of our business strategy is to enable new investors to enter this asset class, through providing them with the details of the underlying mechanics,” Eakins says.

David Sandham is Editor of Global Reinsurance

ILS - PERILS to be set up soon

Swiss Re, Munich Re, Allianz, AXA, and Zurich have been working together to develop PERILS, an independent organisation or company that would create a European Industry Loss Index. By aggregating European industry exposures and post-event loss estimates the new Index could further facilitate ILS growth. The working group says it is “confident of significant industry support for the entity, therefore ensuring robust estimates”. The new organisation or company could be established by the end of 2008.