As turmoil convulses the world’s financial markets, the uncorrelated nature of catastrophe bonds makes them stand out from the crowd, writes David Sandham.

The financial crisis that began with the bursting of the US housing bubble in 2007, which spread like wildfire because of the securitisation and repackaging of debt based on subprime mortgages, and whose effects have been magnified through the boom in credit derivatives, shows no sign of abating.

But cat bonds, while not completely unaffected (see box on page 45: “Uncertainty over Lehman-related cats’”, remain in general a safe (though relatively modest in size) harbour in a storm.

“Its shocking to witness what’s going on in the financial markets,” said Mike Millette, partner, Goldman Sachs, speaking at the Standard & Poor’s

2nd Annual Insurance Linked Securities Conference in London on 16 September, the day after Lehman Brothers filed for Chapter 11 protection. “Very few sections of structured finance have remained open: only US auto loans, student loans, and credit cards. But cat bonds have remained open, and until recently most have been trading at premiums,” he said.

Goldman Sachs has been lead manager on six cat bonds so far in 2008, with a combined value totalling $1.425bn.

“2008 will see the second highest year for cat bond issuance,” Millette predicted. In 2007, a record $7bn of new cat bonds were issued. So far in 2008, about $2.7bn cats have been issued. In 2006 the annual total was $4.75bn. Therefore only a little over a further $2bn has to be issued by the end of 2008 for Millette’s prediction to prove correct. “We expect issuance to hold up at current levels through 2009,” he added.

According to Emmanuel Modu, managing director and global head of structured finance for AM Best, interviewed in Monte Carlo: “New cat bond issuance in 2008 probably will not outpace the 2007 issuance. Through August 2008, cat bond issuance was about $2.73bn, compared with about $5.38bn during the same period in 2007.” Modu added that many factors were impacting the pricing of catastrophe bonds in 2008, including credit market turmoil, as well as the soft reinsurance market.

According to Jamie Veghte, CEO, XL Re, “The issuance of cat bonds has increased substantially over the past few years, and represents about 10% placement of all cat reinsurance.”


According to Mark Hvidsten, CEO, Willis Capital Markets, new issues of cat bonds in 2008 will “perhaps total $5 to $6bn.

It is likely that the total will be smaller than last year,” he said, in an interview in Monte Carlo on 9 September. “For certain types of exposure, and given certain financial objectives, ILS is the best answer available, taking into account credit risk. He acknowledged, however, that the appetite of capital markets was cyclical. “When the reinsurance market is soft, traditional reinsurance is more appealing in a wider range of cases,” he said.

“But ILS is here to stay.”

This sentiment was echoed by others at the Monte Carlo Rendez-Vous. “The cat bond market is here to stay,” said Sarah Hibler, senior vp at Moody’s Investors Service. “The reason it took off post-Katrina is that traditional reinsurance dried up, and what was available was very highly priced. Now there is more capacity in the market and prices are cheaper, people are leaning more towards buying traditional reinsurance.”

Ed Noonan, chairman and CEO, Validus Re, when asked during an interview with this magazine if the future of reinsurance was integration with the capital markets, replied: “My opinion is evolving. There is integration with the capital markets, but it will be more periodic than joined at the hip. There are times when they have the appetite and times they don’t. It’s complementary.”

Indeed, the word “complementary” was the one heard most often when questioning reinsurance leaders about the relation of the capital markets to traditional reinsurance. “The capital markets are a good safety valve,” Noonan added.

Despite the general tone of measured optimism, some sections of the reinsurance industry remain more sceptical about the importance of cat bonds.

“Sometimes this figure of $7bn is celebrated like a new invention in science!” remarked Dr Torsten Jeworrek, member of the board of management, Munich Re, speaking at Global Reinsurance magazine’s ‘Reinsurance Buying Strategy Roundtable: Trends for 2009’ in Monte Carlo on 8 September. “The big cat programmes of single larger buyers in the US have a capacity of US$3.5bn.

So it’s double the size, not more!” he said. He also called for more efficient and standardised products.

“It is much too complicated now.”

Munich Re has been much more circumspect than its rival, Swiss Re, in getting involved with the cat bond business. Munich Re started hiring people to build a risk trading unit 18 months ago. By contrast, Swiss Re became established early as a leading player in ILS.

Jean-Louis Monnier, Swiss Re’s London-based director of Insurance-Linked Securities, speaking at the S&P conference in London, listed the following reasons why sponsors get involved in cats: “collateralisation, diversification of sources of capacity, capital access, return on equity, multi-year cover, and, in the case of parametric or modelled loss

triggers, a fast claims process,” he said.

According to Luca Albertini, formerly of Swiss Re, but now chief executive of Leadenhall Capital Partners, a joint venture with the Amlin Group, diversification is key for sponsors: “The wrong answer is to have everything in traditional reinsurance or everything in capital markets. Correct is to have feet in both pools,” he said. Monnier also pointed to Solvency II in Europe as positive for the cat bond sector. “The potential impact of Solvency II is the need for additional capacity for peak peril protection,” he said.


Whereas for sponsors cat bonds provide diversification from traditional reinsurance, for investors they provide uncorrelated risk. Cat bonds cover hurricane or earthquake: the wind and the earth do not care what the capital markets are doing.

According to Millette of Goldman Sachs: “Fifteen months into the credit crisis we have seen very little contagion (of the ILS sector).”

The problem cat bonds have to overcome in attracting investors is that they are complicated to understand. Investors need to make an effort.

Interestingly, there has been a shift in the kinds of firms investing in the ILS sector. “In 2006, the investor base was heavily driven by opportunistic hedge funds, but they have receded,” Millette said.

“The investor base has been supplemented by the formation of several new specialist funds, and by new capital inflows. Cat is not a passive investor sector. It is an active investor sector and that’s healthy.”

Even though the number of funds dedicated to ILS investment remains small, they are less likely to exit the sector. By contrast, “a hedge fund in trouble will often blow out a well-performing asset class at near par”, Millette said.

Another sign of health in the ILS sector is that secondary market trading volume has increased.

Trading in already-issued bonds is “over $3bn in the year to date”, Millette said. This figure is higher than the total number of new issues in 2008 to date.

“Trading exceeds issuance for the first time ever,” he pointed out.

Albertini told Global Reinsurance that he sees bids or offers for cat bonds on a daily basis now. Part of the reason for the increased trading volume is precisely the effect noted above; the exiting of hedge funds from the sector, with trading volume up because they are selling their cat positions, often to cover losses in other sectors. “We saw at least one hedge fund exiting because it was exiting its own existence,” Millette said.

He listed four reasons why the cat bond sector has performed well: fundamental non-correlation, mitigation of contagion by credit risk, a dedicated investor base, and low levels of leverage used by investors (he put leverage at 20% average (across the sector).

However, much progress remains to be made.

Albertini called for information to be updated more often. “In the capital markets, information is provided on a quarterly basis. In insurance it is only on a yearly basis,” he said. If there are material changes on the portfolio underlying an indemnity trigger cat bond, investors needed to know about it.

“The protection buyer does not want an angry hedge fund investor at his door.”

David Sandham is Editor of Global Reinsurance

ILS: Parametric wind swap closed by Aon

Aon Capital Markets arranged a privately placed nat cat swap transaction. The size and parties to the deal were kept confidential, though market rumours suggested that RenRe was involved.

The deal, which covers named storms based on wind speed data at several wind stations is Florida, is the first to use the WindX parametric index solution.

This is of interest, because so far this year there has been a tendency to indemnity rather than parametric triggers.

“You are going to see cycles in structure as well as price,” said Paul Schultz, president, Aon Capital Markets.

“As we have been in a softening reinsurance market generally, the capital markets have had to soften, so we have seen more willingness to invest in indemnity issues than in previous years.”

Parametric issues, on the other hand, are more favoured by investors. “They are easier for investors to understand more quickly,” Schultz said.

This particular transaction took about two months to get placed, mainly because it was the industry’s first transaction using WindX, and investors needed to be educated on the new structure.

Subsequent WindX transactions could take less time.

WindX uses a network of hurricane-hardened weather stations specifically designed to measure hurricane-force winds up to and exceeding 140 miles an hour.

Cat fight

With many uncertain about the position of cat bonds in the world of reinsurance, David Sandham provides some perspective.

You could be forgiven for suspecting that the disagreement about the significance of natural catastrophe bonds (cat bonds) for the insurance industry betrays vested interests. A recent investment bankers’ report points out, correctly, that the use of capital markets as a tool for insurance companies has grown massively since its inception more than a decade ago. A recent insurance brokers’ report, published about the same time, points out – equally correctly – that cat bond activity has slowed.


Who is right? It all depends on your perspective: given a long enough period in retrospect, cat bond activity may be shown to be still high. On the other hand, compared to 2007 (a record), the current year is turning out to be slower.

There are reasons for the boom in cat bonds over the past few years. After hurricane Katrina (the most expensive natural disaster ever to strike the United States), there was a surge in demand for reinsurance, and not enough capacity.

Traditional reinsurance, when it was available, was highly priced. Cat bonds filled a need, and brought in addition the advantages of full collateralisation (the funds raised in a cat bond issue are held in trust), and the glamorous idea of insurers being able to access the world’s capital markets.

Equally, there are reasons for cat bonds’ recent slowdown. Today, there is sufficient capacity in the reinsurance market, and prices are cheaper. With cat bonds still positioned as providing surplus capacity, it is no wonder that new cat issues have slowed.

Also, cat bonds are complex securities for investors to understand, and take much longer to set up than traditional reinsurance.

Will cat bounce?

Whereas new issues of cat bonds could well reach about $5bn for the whole of 2008, it is too early to be confident about a forecast for 2009. We are currently in the midst of the hurricane season.

Hurricane Gustav, which, as it neared New Orleans, brought back feelings of déjà-vu for 2005 (the year when Hurricane Katrina struck), turned out, after the event, to be far less destructive. Hurricane Ike was larger and has caused more losses. But current (early) estimates for the insured losses caused by Gustav and Ike, though serious, are relatively moderate reinsurance industry terms. Failing a major vent, reinsurance capacity will remain high. And high reinsurance capacity could mean that cats are left out in the cold.

David Sandham is Editor of Global Reinsurance

ILS Parametric wind swap closed by Aon

On 19 September, a few days after Lehman Brothers filed for protection under Chapter 11 of the US Bankruptcy Code, ratings agency AM Best placed the debt ratings of a number of Lehman-related cat bonds under review with negative implications. The affected cats are: Newton Re, whose sponsor was Catlin; Willow Re (sponsor Allstate); Ajax Re (sponsor Aspen Re). Lehman is the swap counterparty on each of these bonds, and there is some doubt as to whether the bank will meet its obligation under the swap agreement. The Chapter 11 filing caused a notice of default under the swap greement. The impact of the early termination of the swap agreement is unclear. It is possible that the swap counterparty could be replaced.

ILS: Uncertainty over Lehman-related cats

On 19 September, a few days after Lehman Brothers filed for protection under Chapter 11 of the US Bankruptcy Code, ratings agency AM Best placed the debt ratings of a number of Lehman-related cat bonds under review with negative implications. The affected cats are: Newton Re, whose sponsor was Catlin; Willow Re (sponsor Allstate); Ajax Re (sponsor Aspen Re). Lehman is the swap counterparty on each of these bonds, and there is some doubt as to whether the bank will meet itsobligation under the swap agreement. The Chapter 11 filing caused a notice of default under the swap agreement. The impact of the early termination of the swap agreement is unclear. It is possible that the swap counterparty could be replaced.

ILS Cat bonds: for or against?


Provide alternative form of capital to sponsors

Provide full collateralisation to sponsors

Provide uncorrelated risk to investors


Slower and more expensive to arrange than traditional reinsurance

Complex for non-specialist investors to understand

Secondary market improving, but currently not very active

ILS: Derivatives action

Cat bonds are not the only game in town. According to Tats Hoshina, president and CEO, Tokio Millennium Re Ltd: “The capital market’s entry into the reinsurance market has markedly increased through hedge funds accepting reinsurance contracts via transformer business whereby a reinsurance company (represented by companies like ourselves) would write reinsurance contracts on behalf of hedge funds and cede the business to the hedge fund by way of derivative,” he said.

“This allows the capital markets to enter into the reinsurance market and achieve further diversification in their portfolio, which is difficult to achieve merely by investing in cat bonds.” There appears to be increasing demand for this type of transaction.

“At Tokio Millennium we have more than doubled our transactions of this nature in the last 12 months.”