Catastrophe Bonds: An Attractive Alternative to Traditional Insurance
Notwithstanding the premium, it is likely that the cover obtained by the IOC for the Athens Olympics will contain numerous exclusions and limitations restricting the overall scope of the coverage.
Leaving aside any particular concerns relating to the Athens Games, sport events insurance has generally become harder to obtain, particularly since the September 11 terrorist attacks in the US. There is now less capacity and appetite in the insurance market to underwrite the risks associated with such events, especially high-profile events which are regarded by many insurers as a prime and, in many cases, soft target for a terrorist attack.
As an alternative to traditional insurance, the IOC could have turned to the alternative risk transfer market and issued catastrophe bonds (or, as they are commonly called, ‘cat bonds’). In very general terms, cat bonds involve the transfer of risk (typically in respect of natural catastrophes such as earthquakes or hurricanes) out of the insurance sector and into the capital markets sector. FIFA, world football’s governing body, recently issued a US$260 million cat bond to protect itself against cancellation of the 2006 World Cup in Germany. This is the first cat bond in which the risk of staging a sports event has been transferred to the capital markets, and in which the risks covered extend to both terrorism risk as well as natural perils.
This article considers cat bonds in some more detail, and, in particular, the structure of a cat bond issue, and the regulatory and commercial issues relating to cat bonds.
Essentially, cat bonds are a form of insurance securitisation where what is being sold to the investors are the rights under an insurance, reinsurance or retrocession treaty (as the case may be). Cat bonds are debt instruments issued typically on behalf of an insurer or a reinsurer to capital market investors (such as life insurers, hedge funds and pensions funds). These debt instruments have a defined maturity date, which may be fixed by reference to the period of the underlying risk, and they will take the form of notes. Often the notes will be listed for marketing and tax reasons, but there have also been a number of private unlisted issues.
The investors will pay the principal amount of the notes on issue. They will be entitled to interest, usually payable at prescribed intervals, on the principal amount. The interest rate payable will reflect the risk inherent in the bonds, and, in most cases, will be higher than the interest payable on ‘straight’ corporate debt.
The principle underlying a cat bond is that if a trigger (insurable) event occurs, the proceeds of issue are used to meet the loss suffered. Simultaneously, the bonds are written down to the extent of the claim. Provided that no trigger (or insurable) event has occurred, at the end of the term of the cat bonds, each investor will be repaid its principal plus any accrued interest on that principal. These trigger events can be quite varied, and can include ‘indemnity type’ triggers which respond when a specified event happens, such as the cancellation of a sporting event, or when a loss is incurred in excess of a specified amount. Other triggers include ‘index-linked’ triggers which respond when there is, for example, a prescribed change in a publicly available index, such as a country’s mortality index, or ‘parametric index’ triggers, where payouts are based on observable, usually physical, parameters, such as, for example, a particular reading on the Richter Scale in respect of earthquake activity.
If a trigger event occurs before the maturity date, then, in the case of ‘at risk’ bonds, the principal value of the bonds and any interest accrued on them are forfeited by the investors, In the case of ‘principal protected’ bonds, however, only the interest will be forfeited. Any amount forfeited will be available to the relevant (re)insurer concerned by way of compensation, which will, in effect, represent ‘(re)insurance proceeds’.
The market for cat bonds is relatively small at the moment, but there is huge potential for growth. The outstanding volume of cat bonds is currently believed to be about US$2 billion (compared to an estimated reinsurance capacity of US$100-200 billion).
A typical structure will involve a (re)insurer, or less typically, a corporate (in either case an ‘originator’) establishing a special purpose vehicle (SPV). In order to safeguard the SPV against any insolvency of the originator (ie, to make it ‘bankruptcy remote’), the shares in the SPV will usually be held by a charitable trust and its activities will be strictly limited. Typically, the SPV will be incorporated in an offshore jurisdiction (for tax and regulatory reasons) as a (re)insurer.
The SPV will typically be established in a jurisdiction that is tax transparent so that the SPV is not itself taxable, and any interest payable to investors is treated as a tax deductible debt. Furthermore, the laws regarding capital requirements, reserving and financial recording obligations will usually be less onerous than equivalent obligations in certain other jurisdictions, such as the UK or the US.
The SPV will enter into an insurance treaty with a corporate if the corporate has established it, a reinsurance treaty with an insurer if the insurer has established it, or a retrocession treaty with a reinsurer if the reinsurer has established it. The cover provided by the SPV is sometimes referred to as ‘synthetic’ cover. The SPV will then issue the cat bonds to the investors. This will typically be done by way of a private placement.
The premium paid by the originator to the SPV and the funds received by the SPV from the investors will usually be placed in an interest-earning trust account to ‘ringfence’ them. The trust account will provide collateral for the SPV’s obligations in respect of its payment obligations under the cat bonds, and the interest earned, when added to the premium, will service the SPV’s interest payment obligations. As an alternative to a trust account, the obligations of the SPV can be collateralised in some other way (eg, by the SPV obtaining a letter of credit or a bank guarantee or depositing collateral (such as government stocks) with a highly rated security agent), the critical structural feature being that they are ring-fenced from the insolvency of the originator.
Collateral need not be limited to cash deposits, but the originator, the investors and possibly also the rating agencies will need to ensure that the SPV’s investment policy is a prudent one and will be limited to investing in low-risk investments, such as treasury bonds, although this may, in turn, have an impact on the level of potential return to the investors. Furthermore, the activities of the SPV must be strictly limited to the issue of the bonds and the entry into the (re)insurance contract. This will be achieved by including appropriate restrictions in the SPV’s constitutional documents.
Cat bonds require careful structuring. There will be a number of regulatory and legal issues to address, some of which are highlighted below.
The SPV will need to determine whether, in issuing the cat bonds, it is carrying on a non-insurance activity. If this is the case, then if, by way of an example, the SPV were authorised as an insurer in the UK, it would not be permitted to carry on any commercial business in the UK or elsewhere ‘other than insurance business and activities directly arising from that business’. The consequence of carrying out any such noninsurance activity would possibly be FSA disciplinary action. In this case, a practical solution would be for the SPV to establish a subsidiary, which must not be an insurance company, to issue the cat bonds.
The investor will need to determine whether, in purchasing a cat bond, it has capacity under its constitutional documents to do so, and that, in so doing, it is not carrying on an insurance business under the insurance laws of its home jurisdiction or the jurisdiction in which the bonds are issued. This is very important because in most cases the investor will not be so authorised, and will not want to be. In the UK, for example, the consequence of carrying on insurance business without authorisation is that the insurance contract will be unenforceable and monies paid under it may be recovered by the counterparty together with compensation for loss and the possibility of criminal sanctions.
If the repayment of the cat bond is too closely tied to the occurrence of the trigger event, then this may increase the likelihood that the cat bonds will be characterised as insurance and increase the risk that the investor is carrying on insurance. The terms of the cat bond should not be made completely ‘back to back’ with those of the insurance contract. Practical ways in which this can be achieved include ensuring that the insurance contract has its own self-contained terms (and not incorporating or annexing the terms from the cat bond issue documentation), and ensuring that the liability under the insurance contract does not exactly match the issuer’s liability under the cat bond. Analysis of this issue may involve seeking local advice in a number of different jurisdictions.
Other issues that need to be considered include: determining whether the originator will receive full credit in its solvency margin calculation for entering into the (re)insurance treaty with the SPV (the fact that the SPV is likely to be established in a comparatively unregulated jurisdiction could adversely affect this determination); considering whether the cat bonds are likely to constitute investment securities and, consequently, whether they are subject to any relevant securities laws in the jurisdiction in which they are offered; and potential liability issues for issuers and their advisers in connection with the prospectus or other offering documentation. In general terms, as well as complying with any applicable listing rules, the offering documentation must be accurate, complete and not misleading and, amongst other matters, must highlight the risk factors for the investors in subscribing for the cat bonds.
Cat bond trigger events are usually set at such a level that it is only in very catastrophic circumstances that the investors’ principal and/or interest will actually be forfeited. As a result, the originator could be left with insurance risk exposure. However, so long as the underlying risk and any potential losses are accurately modelled and quantified, then it may be possible both to address investor concerns and to set the trigger events at commercially attractive levels.
For an investor, provided that it is comfortable that the trigger event is not set at too low a level, cat bonds represent a potentially high-yielding investment and enable the investor to acquire a more diversified and balanced portfolio of investments. The value of the cat bonds is largely uncorrelated with other investments as the investors are essentially investing in underwriting risk and not equity, credit interest or exchange rate risk.
However, cat bonds are generally illiquid, and there is not much of a secondary market in which to trade them. Any onward sale of cat bonds is usually on the basis of a significant liquidity discount.
For an originator, provided that it is comfortable that the trigger event is not set at too high a level, cat bonds represent a means of securing fully collateralised (re)insurance capacity, and, by transferring insurance risk to the capital markets, the originator is diversifying its (re)insurance providers and reducing its risk concentration. Counterparty, credit and timing risk are also reduced as the originator knows that any funds required to meet any claim are safely ring-fenced and will be paid out on a timely basis.
An issue of cat bonds is a document-intensive and expensive process, and as a result it is unlikely that cat bonds will ever replace conventional (re)insurance. However, together with other financial instruments, cat bonds do provide an alternative source of (re)insurance capacity and provide investors who have sufficient appetite for risk with a source of potentially very competitive returns.
It remains to be seen whether the issue by FIFA of a cat bond has blazed a trail down which other sporting organisers will follow. With some careful planning, the complexity and time involved in a cat bond issue can be accommodated in the long lead-in period which most sports organisers have before hosting a sporting event. Moreover, if such issues were to become more commonplace, there is scope for them to become more commoditised and, consequently, for the costs involved to be reduced. Finally, in the case of a cat bond issue in connection with a sporting event, the risks involved may be able to be more effectively quantified, and, consequently, made more attractive to investors. Watch this space for further developments!