Issuers and investors will spend the next several months discovering just how complicated things can get when a catastrophe bond defaults.
The trickiest issue, industry experts say, will be what to do with the underlying reinsurance agreement and the host of financial, legal and regulatory questions that can emerge if the bond instrument defaults.
“The [reinsurance] agreements are pretty well spelled-out, but many bondholders still do not have a good understanding of their rights,” says Malcolm Wattman, a partner with the law firm of Cadwalader, Wickersham & Taft in New York. “That’s even though they have been buying these things for years.”
At least one cat bond issue — Willow Re — has already reportedly gone into default by missing an interest payment to investors. Three other cat bond deals are hugging junk status and threaten default, according to analysts.
The bonds at risk were all managed by Lehman Brothers before its collapse, and their collateral trust accounts have been impaired by poor investments.
“The expectation is that all the Lehman deals will suffer losses, whether that’s now or at maturity,” says Gary Martucci, a director with Standard & Poor’s in New York.
The default of a catastrophe bond, however, does not void the underlying reinsurance agreement put in place to transfer the risk. The agreement allows carriers to claim the bond against its regulatory and capital requirements.
“As long as the carrier continues to make its premium payments every quarter then the investor cannot force an unwinding of the transaction,” says Martucci.
This could come as a surprise to some investors who might assume a cat bond would act in the same way in default as a corporate bond, especially if the default was not caused by a triggering natural catastrophe event.
“With the reinsurance agreement in place bondholders can’t do anything,” says Wattman. “They can’t exercise any remedies.”
He explains “remedies” for bondholders could include cutting their losses and shutting the deal down by having the trustee sell collateral and distribute the proceeds.
Defaulting on the bond interest payments but keeping the reinsurance agreement could be a way for the carriers to limit the damage to capital.
Martucci explains that if a $250 million cat bond defaults and the reinsurance agreement is terminated, the carrier would need to find reinsurance to replace the entire amount to satisfy state regulators and rating agencies.
But if that same $250 million bond defaults but has remaining collateral value of $150 million, the carrier can claim that amount against its reinsurance requirement and only look to cover the difference.
“It’s not like tomorrow that if there was a triggering event the note holders would kick in another $100 million [to cover the loss]” says Martucci. “There is no reason for the carrier to pay more money. They’ve technically met their obligation.”
Cat bond investors — already smarting by losing principal on a “non-correlated” investment — may may also have an interest in keeping the reinsurance agreement in place for the near term.
“They could be taking 50 cents worth of risk for a dollar of premium,” Wattman says. “The carriers may even want to unwind the deal for cheaper reinsurance, but from an investor perspective they would push back by arguing ‘Why should I do that when you are paying me a premium with no hurricane risk in February.”
Many agree that once the cat bonds likely to default move through the system, issuers and investors alike will make sure the same mistakes are not made again.
“This risk is going to small going forwards,” says Wattman.“Either you are going to have high quality collateral or a diverse group of credits that are marked to market daily. ”People will no longer [want] to take collateral risk.”
Striking a positive note, S&P’s Martucci says that at least credit defaults will no longer be an unknown quantity for the industry.
“Kamp Re defaulted because of the cat trigger and another bond went into technical default because of a missed premium payment, but the sponsor chose to make everyone whole at maturity,” he says. “These are a new type — I’ve think we got the gamut covered now.”
