Cat Bonds Stuck in Neutral

Wiped out by “Hurricane Lehman,” catastrophe bond specialists are wrenching their minds to find ways to unclog the deal pipeline.

Everything from new collateral structures to recasting cat bonds as “capital efficient” investments is being considered.

Sponsors, issuers and investors all understand they face an uphill battle given the current climate in the credit and reinsurance markets, with some prepared to wait years for normalcy to return.

“The capital efficiency idea is interesting, but the pricing needs to come down. More importantly is what happens with the total return swap,” said Greg Hendrick, president and chief underwriting officer of XL Re. “You need to keep it simple. At the moment there is a fear of the complex.”

Hendrick made his comments at the Insurance Linked Securities Summit sponsored by Finance IQ in New York.

Deal flow for catastrophe bonds came to a screeching halt last year with the collapse of Lehman Brothers, which acted as the counterparty to many of the total return swap structures embedded in the bond collateral programs.

Lehman’s demise caused several bonds to lose value even though there was no catastrophic event to trigger the securities, and investors fled the market.

The irony of the timing of the cat bond market’s collapse is not lost on industry professionals.

“2008 was the second-most-active year in terms of natural catastrophes but the single biggest event was Hurricane Lehman,” said Tom Weinberger, a partner with the law firm of Stroock & Stroock & Lavan in New York. “The market that was once demand-driven is currently supply-driven.”

Market conditions in 2009 could be perfect for new ILS issues with carriers hobbled by investment losses and very little replacement capital available to reinsurers in case of an active loss year, said Paul Schultz, president of Aon Benfield’s Investment Banking Group.

He pointed out that many property/casualty balance sheets have been hurt in 2008, with insurer capital falling 25 to 30 percent on a year-over-year basis. “Much of the excess capital is gone mostly due to investment losses,” Schultz said. “Only 10 percent [of those losses] are due to hurricanes.”

And while reinsurer balance sheets are relatively healthy when compared to those of carriers, there is little to no replacement capital available to meet a major loss because hedge funds no longer have assets to pledge to the industry. “You have a very healthy capital provider on the one hand and a significantly damaged investor base on the other,” Shultz explained.

A combination of needy carriers and a limited reinsurance market would have been a perfect mix for past catastrophe bond markets, but today’s credit questions regarding the collateral programs are holding everything back.

Some suggestions for ways to address the credit issue is including greater transparency around the total return swap that is often the heart of cat bond collateral programs. Others suggest the use of higher-rated collateral, such as the bank guaranteed securities.

Bank guaranteed securities are reportedly part of the collateral program with the recently issued Atlas V, a $200 million securitization from Scor that is the first cat bond to hit the market in months.

Once past the credit issue, there needs to be a complete change of focus for the cat bond industry, said Karsten Bronmann, PhD, managing partner and CRO of Solidium Partners in Zurich. “To grow the market the whole paradigm needs to change from risk management to capital efficiency,” he said.

To make catastrophe bonds capital efficient, they would need to offer a better return or be cheaper for carriers than traditional reinsurance.

Bronmann explained that the capital efficiency pitch would be helped along by the push for Solvency II, leading primary insurers into securitizing the primary layers by moving from a risk warehousing model.

The capital efficiency pitch may work, but it will likely take time, added Jay Nichols, head of securitization for Renaissance Re.

“Deals going forward should be about the insurance risk, but now it’s all about the credit risk,” he said.

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