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Euro Cat Bonds: Banking on Disaster
Asset Securitization Report--SourceMedia (July 9, 2007)
The catastrophe market is surging, but not without growing pains. In times of peril, people often react with "either/or" responses. When a storm is about to hit a house, occupants of the home will posit such questions as, "Do I leave now, or do I go looking for the cat?" So it is no surprise that investors looking at insurance-linked securities (ILS) either do catastrophe bonds or don't. What's more, the "do" crew remain defensively bullish and will continue to invest, often on the basis of fuzzy numbers, while the "don't" camp defend their reasons, even in light of the industry's latest initiatives to perk up growth.
"With investors demanding higher revenues, cat bond spreads seem too thin," said one investment banker on his bank's refusal to consider cat bond investments. "There are no solid numbers and no adequate rating methodology. It's an invention based on ifs,' and we don't do ifs.'"
The source added that the recent introduction of a cat bond performance index by the world's largest reinsurer, Swiss Re, which is intended to bring more mainstream investors into the market, provided little incentive to participate in the cat bond market because no one at the bank wished to be "glued to the weather channel." Nonetheless, the new index is poised to push the cat bond market into an area of explosive growth, according to a Swiss Re spokesman.
"We have a projection of [cat bond] growth by 2010 that is way more than three or four times what it is today," said Luca Albertini, head of European ABS/ILS origination and structuring for Swiss Re Capital Management, who said the average cat bond yield compares favorably with more typical ABS deals. "In order for the ILS sector to grow, you need more transparency and liquidity, and the index will provide that. The index offers weekly pricing monitors so that investors can just go to Bloomberg to check for updates."
Starting Small and Spreading Wings
Initially, back in the late 1990s, cat bonds were single-territory, single-peril deals, typically rated around double-B and characteristically displayed digital payoff behavior, according to Henry Kus, who works on structured insurance products at ABN Amro. In 2007, the cat bond industry is worth nearly $4 billion globally and is on track to outpace the $5 billion issuance in 2006, which had already doubled issuance in 2005. Kus added that this is attributable to the latest cat bond structures and rating methodology, which are helping fuel growth in the market.
"Now it is possible to create a whole basket of such double-B-rated, uncorrelated, individual exposures that can then be further sliced into highly rated tranches," Kus said. "Such securities display a far more familiar credit migration profile, and this was one of the reasons [Standard & Poor's] modified its ratings methodology appropriately so that natural catastrophe deals could be much more senior-rated."
S&P announced its new criteria in mid-May, stating that the changes will allow these bonds to achieve ratings as high as triple-B-plus if the one-year probability of attachment is less than or equal to 20 basis points, and triple-B-minus if the one-year probability of attachment is less than or equal to 40 basis points. "The modeled probability of attachment based on the tenor of the transaction must also be consistent with the rating level," said the report. "We would expect the remoteness of an event occurring that would cause a loss of principal to remain as remote for the entire duration of the transaction."
S&P is not alone in its modifications. Fitch Ratings is also keeping a keen eye on developments in the ILS industry. "There is currently a lot of research and development in the cat bond market, which shows it has potential to be a huge market," said Don Thorpe, a senior director in Fitch's Chicago-based insurance team. Thorpe added that cat bonds were often rated double-B or single-B, but as ratings improve, the bonds are attracting "more investment-grade buyers."
Further, the triggers have evolved, Thorpe said, which may increase cat bond activity. For example, the more traditional insurance indemnification trigger paid the exact amount of losses suffered, but that was taking too long to assess after a catastrophic event. On the other end, parametric triggers were developed, based on event parameters, so that investors know in a couple of days whether they have suffered a loss. But there are new developments in so-called "hybrid" triggers, a combination of the good elements of the two other triggers, which helps minimize sponsors' basis risk.
Cat bonds still have a way to go, however. Take the aforementioned numbers of the market's worth, based on global deals: Attempts by rating agencies and investment banks alike to put together region-specific data - such as cat bond flow in Europe - is bound to end in frustration. "For instance, a European reinsurer recovering on U.S. wind, is that Europe or America?" asked Albertini, whose concerns are shared by the rating agencies.
"Cat bonds are really a global market," Thorpe said. "The structures typically offer a good combination for investors: low correlation to other investments and high yield." This makes risk-assessment models as unpredictable as the weather patterns. "One of the problems facing the cat bond market is, where do you get appropriate loss-risk statistics?" he said. "Also, there is a reliance on issuers, investors and rating agencies to accept such models as reasonable estimates of risk."
These problems have led to trepidation among investment banks. Societe Generale, for instance, has no intention of moving into the cat bond market anytime soon. Insurance and cat bond risk exposures are too hard for the bank to quantify, requiring a different skill base from other securitized assets, according to SocGen senior analyst Chris Greener. "Insurance companies are likely to find cat bonds attractive when they undercut the cost of offsetting risk via more traditional insurance syndication, suggesting to us that bond investors may misprice the risk," he said.
Other banks, such as ABN Amro, are confident in the structure of their latest cat bond deals, which recently implemented a CDO form. The bank first used this pioneering method with its Bay Haven issue in 2006. Now, as of late June, its latest cat bond deal, arranged for Brit Insurance and known as "Fremantle Limited," will provide up to $200 million in the event of multiple qualifying natural catastrophes during the next three years, thus cementing the applicability of the model for cat bonds.
"There were two reasons why the CDO structure worked well for cat bonds," said Steve Lobb, head of credit and alternatives marketing at ABN Amro. "There was a need on the insurance side, after Hurricane Katrina, to generate greater returns. There was also a big need from credit investors looking to diversify their portfolios with rated insurance-linked products."
"Bay Haven was two and a half times oversubscribed, and Fremantle four times, so there is significant investor demand," said Lobb, who dismissed the notion that Fremantle carries significant risk. "The class A tranche in Fremantle has seven events of subordination, and it pays 90 basis points. So it could withstand seven Hurricane Katrinas within three years and not lose any principal."
Hurricane Katrina destroyed lives, as is well chronicled, but the devastatingly costly effects of the 2005 hurricane season in the U.S. pretty much stopped at the cat bond line. In fact, of the cat bonds issued in 2005 that dealt with "U.S. wind," only one was affected by Katrina. And the lessons learned from that risk exposure, lovers of cat bonds say, mean that future losses remain highly unlikely as more and more variables are added to deals, usually with professional wrestling-type names such as "U.K. windstorm" and "Japanese Typhoon," in order to further reduce risk.
Yet, despite lessons learned from Hurricane Katrina and the other storms that ravaged the U.S. that year, the ILS and cat bond markets are in a position similar to America's Gulf Coast - in that there is still a need for some cleaning up. "There can be more convergence of the ILS sector with traditional reinsurance pricing if there are more offerings. Triple-A or double-A tranches don't fit with investment return requirements of dedicated ILS portfolio managers," Albertini said.
Critics say cat bonds are too expensive for issuers, yet at the same time, they deliver better returns for investors, so the process of convergence ILS would help serve as both a good relative value investment for investors and an attractive proposition for issuers, Albertini added.
Verily, the voices of critics have also been in the head of Lobb, who reacts to their words in a familiar way. "In 1997, when we worked on early credit derivative deals, some said that the credit derivative market would face limitations, And yet, as we know, the credit derivative market has experienced phenomenal growth and success," Lobb said. "As we look at how to contribute to the expected growth of the natural catastrophe market, we are looking to create the next big thing, not based on volume but based on quality ideas and structures."
Now if we can only find the cat before we leave.
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