News from the Cat House Part Deux: Bondage and Discipline sometimes missing from the equation

I’ve been sent several articles on the Cat Bond market of late, some very good and some not necessarily worthy of the publication in which they were printed. I’ll start with an article from The Banker Magazine which is not yet online which I read courtesy of Factiva. While the article is generally good the author, Edward Russell-Walling parrots some long discredited facts about Cat Bonds, such as their being non correlated with the broader financial markets which the financial crisis of last year exposed as pure BS and it is there we start:

In 2008, the annus horribilis, non-correlation did not prevent it slumping to $2.7bn. Some hedge funds, which had been prominent players in this market, became distressed sellers and depressed pricing. The situation was aggravated by the downgrade of four cat bonds exposed to Lehman Brothers which, as total return swap counterparty, was effectively holding the investors’ capital.

What the author neglects to mention was “the innovation” of stuffing issues full of subprime mortgages whose accompanying (illusory) high yields no doubt drastically lowered the cost to the issuer. Lehman, as the guarantor, is cited as a problem because of its insolvency but the fact is TARP and the United States taxpayers are what has propped up every such issue so structured as major guarantors like AIG and the other Wall Street investment banks were essentially insolvent meaning their financial guarantees were worthless. Without the Lehman guarantee for instance Allstate’s Willow Re, which defaulted on their interest payments to investors earlier this year, plunged to around 50 cents on the dollar or roughly about what the underlying subprime mortgages were worth.

That said Russell-Walling did give a good explanation of the concept of the “trigger” in these agreements and it is there we pick back up:

One important choice that had to be made was the nature of the trigger. An indemnity trigger is activated by the issuer’s actual losses. So if the cover is for $100m with an excess of $400m, the bond is triggered once claims exceed $400m. Non-indemnity triggers may be based on other mechanisms, such as modelled loss, insured industry loss or physical parameters such as earthquake magnitude or wind speed.

While indemnity triggers might seem to be the simplest solution, it is not that straightforward. “Indemnity is do-able, but the issue is data quality,” explains Mr Gibson. “With reinsurer sponsors, investors are at least two steps away from the original data, making it harder to assess the risk and establish losses. It’s all about transparency.”

The trigger is a key difference between Cat Bonds and more traditional reinsurance. Traditional reinsurance for instance kicks in when covered losses exceed certain attachment points so there is a direct relationship between what a carrier pays and their recoveries under their RE contracts. That is not necessarily the case with Cat Bonds thus there has been some specualtion that the Kamp Re bonds triggered by Hurricane Katrina did not go to pay a dime in claims. The advantages to an insurer are thus obvious in this scenario making it possible, for example, to reinterpret policy language such as Anti Concurrent Causation to deny claims while simultaneously collecting the reinsurance proceeds from the Cat Bond trust. I’m not saying this happened but the lack of transparency and effective regulation in the global insurance markets will forever fuel such speculation.

Next up is a post from a Reuters blog by Neil Unmack that inspired this post’s title. Neil gives us a more realistic look at the Cat Bond market as he quotes from an International Association of Insurance Supervisors whitepaper on developments in the reinsurance securitisation markets (H/T Mr CLS):

Catastrophe bond lovers and other insurance-linked securities enthusiasts should take a look at a report on insurance securitisation published today by the International Association of Insurance Supervisors (IAIS).

There is an interesting section in the report looking at the various cat bonds that have gone pear-shaped since the dawn of the market in the 1990s.

The first bond in which investors suffered losses was Georgetown Re, sold by Goldman in 1996. The report explores four other deals that have come under stress since then due to losses from natural disasters or other insured risks.

All in all, the track record is pretty good for most of the 300-odd deals sold. Unfortunately, the dogs start to mount up after the financial crisis broke in 2007.

Most of the more recent deals that ran into trouble did so not because of the insured risks, but as a result of the way the deals were put together, and bankers’ occasional fondness for using them as dumping grounds for dodgy assets.

First there are the four cat bonds in which Lehman acted as a derivative counterparty and which were collateralised in some cases by asset-backed debt. Investors were left out of pocket when Lehman failed and the bonds’ had to rely on the toxic debt to pay interest and principal.

Then there is Ballantyne Re, sold by Bermudan insurer Scottish Re. This deal was supposed to provide the insurer with regulatory capital, but the collateral it held as cover for that insurance turned out to be subprime and other mortgage assets. That left Scottish Re short of insurance cover and hurt investors. A similar situation developed with Orkney Re II.

The report looks at where the deals went wrong, how the structures worked under stress and what the impact was on investors and the insurers

Unmack did not mention Allstate’s Willow Re whose implosion left a several hundred million dollar hole in Allstate’s reinsurance coverage for hurricane risks in the northeastern US. While Allstate’s retreat from writing coastal homeowner’s insurance has been well documented perhaps the continued shedding of risks in places like Long Island has more to do with Willow Re’s default than the team in Northbrook has let on. Meantime as this post yesterday evening on Yahoo Allstate illustrates, the need for a comprehensive solution to America’s coastal insurance crisis is needed now more than ever. Mississippians should also note that the gentleman’s quote from the Travelers for wind included HO totaled only $2,800 while Mississippians, with intrinsically lower property values pay that for just wind insurance which is generally not widely available from private market sources. How ironic that residents in the poorest state in the union get charged some of the highest premiums in the country.

The ISIA white paper covered by Unmack, Developments in (Re)Insurance Securitisation, Global Reinsurance Market Report, Midyear Edition can be found here for those so interested.