The High Cost of Cat Bond Safety

The cost of issuing a catastrophe bond has become more expensive as higher quality collateral is being used to alleviate investor credit fears.

“High quality has effect on cost,” says Don Thorpe, an analyst with Fitch Ratings in Chicago. “The question is whether investors will accept a lower yield or expect sponsors to pay the higher spread.”

Two new catastrophe bond structures have closed and one is currently being marketed.

Today, Chubb Corp. closed the $150 million East Lane III structure, which will protect it from hurricane losses in its Florida residential personal lines business. Last month, Scor closed a $250 million Atlas V vehicle that will protect the French reinsurer from windstorm and earthquake losses in the U.S. and Puerto Rico.

Still being shopped on the market is the $200 million Mystic Re II, a cat bond that backs Liberty Mutual’s U.S. hurricane and earthquake exposure.

All three structures are being heralded as the return of the catastrophe bond market after the sector was pummeled by collateral credit losses following the collapse of Lehman Brothers.

Lehman was the counterparty to many of the total return swaps imbedded in the sector’s collateral programs. The firm’s September bankruptcy caused significant losses and widespread investor fear about catastrophe bonds’ exposure to credit risk.

In order to allay credit risk concerns, the new cat bond issuers have made several changes including matching the duration of the collateral to the bond, using high quality paper such as U.S. Treasuries and providing daily mark-to-market.

“Essentially, the issuers need to keep the asset quality high and the duration short on the collateral,” Thorp says. “Given the current credit environment, it’s going to be like this for the time being.”

But holding quality collateral and marking it daily means paying a higher price, which will either be paid by investors through lower yields or by sponsors that are willing absorb the spread to close the deal.

The cost is not insignificant given what was being paid on collateral programs prior to the Lehman bankruptcy. Spreads on total return swaps that were five to ten basis points last year have reached 50 to 60 basis points today.

What is “too much” to pay for a catastrophe bond depends on whether that price is significantly higher than the alternative — fully collateralized reinsurance.

“From what I understand, traditional reinsurance is in a hardening market,” says Gary Martucci, a credit analyst with Standard & Poor’s in New York. “And we are coming into the renewal season for Florida wind and some of the money from hedge funds may not be there [to add capacity].”

Fitch’s Thorp suggests that as the credit crises eases, the mix of the collateral accounts may change, which in turn could eventually lower prices. But other changes — such as matching asset and liability durations — will likely remain.

“You won’t see these huge mismatches — 30- or 40-year assets to pay off a three-year liability that were included in some previous issues,” Thorp says.

Martucci adds that even while the moves by cat bond issuers to bump up the quality of collateral is welcome, it does not change S&P’s approach to rating new structures.

“The credit rating is tied to the rating of the total return swap counterparty,” Martucci says. “Whether they would have put all treasuries that were all perfectly cash-flow matched to the underlying liability, we are still doing it the same way.”

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