New structures to boost the market Cat Bonds

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March 30, 2009

950 words

New structures revive market for cat bonds; Terms allay concerns on collateral security, but deals’ costs rise

COLLEEN McCARTHY

New catastrophe bonds featuring improved structures and tighter collateral requirements have kick-started the struggling insurance-linked securities sector, despite higher prices for sponsors to issue the bonds.

The latest deal, a $150 million cat bond planned by German insurer Allianz S.E., is the fourth such transaction this year. If successful, the offering will take new issuance so far in 2009 to $725 million.

Three other transactions already have closed in the first quarter (see box, page 31), and more deals are expected to be brought to market as the start of the U.S. hurricane season draws near, observers say.

The recent transactions ended a six-month halt in new cat bond issuance. That drought began after the collapse of Lehman Bros. last September resulted in downgrades on four catastrophe bonds effectively guaranteed by the investment firm. The fallout raised investor fears about credit risk in a sector once touted as uncorrelated with the wider financial markets.

The new deals have been well-received and the market is on track for a solid year, experts say. Overall, issuance could reach $3 billion for 2009, said Dan Ozizmir, managing director and head-insurance risk at Swiss Re Capital Markets in New York. The estimate exceeds the $2.7 billion issuance volume in 2008, but would be less than half of the nearly $7 billion record volume of 2007.

``There is a significant difference in the way the market is being viewed now,'' Mr. Ozizmir said during a presentation at the recent SIFMA insurance and risk-linked securities conference in New York.

One of this year's deals—Liberty Mutual Group Inc.'s Mystic Re II, which closed March 13—even was increased to $225 million from $200 million, due to investor demand. The transaction provides Liberty Mutual with thee-year cover for U.S. hurricanes and earthquakes.

Reducing risk

Observers say the new cat bond deals have been carefully structured with investors and sponsors in mind, and the overall improvements ``go a long way to minimizing credit risk exposure,'' said Gary Martucci, director, financial institutions ratings at Standard & Poor's Corp. in New York.

Much of the focus for the new transactions has been on improving so-called collateral management, experts say.

While typical cat bond transactions use a total return swap counterparty—usually an investment bank—to guarantee the collateral pool backing the bonds, the new deals impose strict rules on how the collateral is invested, experts say.

The permitted investment criteria have shifted toward more conservative U.S. government-backed assets, said Erik Manning, director-structured products and alternative risk group at Deutsche Bank A.G. in London. Previously, permitted investments included highly rated corporate debt and structured finance obligations, often with long-dated maturities, he said. Deutsche Bank and BNP Paribas structured the recent $200 million SCOR S.E. bond, which closed Feb. 19 and was the first post-Lehman transaction.

The recent deals also feature daily mark-to-market accounting on the collateral accounts, and have some form of collateral provision, also known as cash markups to top off the assets and ensure adequate collateral exists, experts say. Previously, cash markups were conducted quarterly.

The new structures also feature improved transparency and easier access to information on the underlying assets, ``so the investor knows exactly what he is buying,'' Mr. Manning said.

The new bonds address the potential of swap counterparty default through provisions that allow for replacing the swap counterparty or unwinding the structure in the event of default, Mr. Manning said.

Unlike most transactions, Allianz's Blue Fin II bond does not include a total return swap counterparty. Instead, the proceeds from the sale of the notes will be invested in floating-rate notes issued by German development bank Kreditanstalt fur Wiederaufbau, which is guaranteed by the Federal Republic of Germany, according to S&P.

The bond, which S&P last week assigned a preliminary rating of BB-, provides three-year protection against U.S. hurricane and earthquake losses. The deal is expected to close in April, according to market sources, and observers say it's too soon to determine how effective this approach will be.

Costs rise

The market resurgence, however, has come at a price for cedents. They are paying more for the protection, largely because investors are demanding higher returns, experts say.

Prior to the Lehman fallout, deals were priced at LIBOR minus 5-10 basis points, while the most recent deals have seen swap spreads at LIBOR minus 50-60 basis points, said S&P's Mr. Martucci. On a $200 million dollar bond, the cedent would be paying roughly $1 million more a year in their premium payment, he noted.

``Pricing is a key issue right now,'' said Asha Attoh-Okine, managing senior financial analyst, insurance linked securities group, with A.M. Best Co. Inc. in Oldwick, N.J. Mr. Okine said that while issuer interest is strong, several potential sponsors have put deals on hold due to higher prices.

But the expected hardening in the traditional reinsurance market should help to close the gap between cat bond pricing and reinsurance prices, experts say. In addition, the increasingly constrained capacity for U.S. hurricane and earthquake perils is likely to drive interest, some say.

``I think sponsor demand will continue to be strong, particularly for peak-zone perils'' said Robert Porter, chief executive officer of Platinum Underwriters Bermuda Ltd. Last August, Platinum entered the cat bond market with its $200 million Topiary Capital Ltd. But Mr. Porter noted issuers are ``less likely to pay spreads on other perils.''

April 2, 2009