Cat Bonds
Paul Scrivener, head of the insurance group at Cayman Islands law firm, Solomon Harris, provides an insight into Cayman’s role in the global cat bond sector. Catastrophe bonds, or cat bonds for short, first emerged in the aftermath of devastating Hurricane Andrew which hit South Florida in 1992. Reinsurers wanted to spread the risk burden and protect their balance sheets when faced with truly catastrophic claims. By late 2010 more than US$30 billion of securities had been issued. The Cayman Islands has become the leading jurisdiction for catastrophe bonds with the numbers of listed bonds now dwarfing Bermuda despite Bermuda’s long-established reinsurance industry. In July 2010 there were 74 cat bonds listed on the Cayman Islands Stock Exchange with a value of over US$7.7 billion. In comparison, Bermuda had 10 listed bonds with an aggregate value of US$1.17 billion (US$1.814 billion by April 2011). Cat bonds allow the insurance industry access to the capital markets and reduce insurance costs to end users. AM Best describes a cat bond as, “A structured debt instrument that transfers risks associated with low frequency/high severity events to investors”. The key feature of a cat bond is that risk is transferred from reinsurers to investors. In this way, reinsurers avoid their balance sheets being substantially impaired where huge losses arise from natural disasters. The nature of the bond is a high yield debt instrument which is linked to an insurance risk, typically a catastrophic risk arising from a natural disaster such as a hurricane, earthquake or flood. Historically, cat bonds have been used principally to cover the risk of US hurricanes and earthquakes, Japanese typhoons and earthquakes and European storms. The structuring of a cat bond is not dissimilar to the structuring of asset-backed securities, a sector in which the Cayman Islands has always been particularly strong. The first Cayman cat bond was listed on the Cayman Islands Stock Exchange in 2007. An insurance company or a reinsurance company (the “Sponsor”) establishes a Cayman Islands special purpose vehicle (“SPV”) as a bankruptcy remote entity. The Sponsor pays premiums to the SPV with the SPV acting as a reinsurer of the Sponsor and the SPV raises its capital by the issuance of the cat bond to investors in the capital markets. The funds provided by the investors are deposited into a collateral account and invested in investment-grade securities such as US treasuries. The funds in the collateral account are available to satisfy any catastrophic losses that might arise. The cat bond carries a floating rate coupon which is serviced from the premiums paid by the Sponsor to the SPV and from the investment income earned on the funds in the collateral account. Depending on a number of factors, but in particular whether the bond is parametric-based or indemnity-based (please see below), the yield can be between 3 per cent and 20 per cent over LIBOR. One particular advantage of the SPV being domiciled in a jurisdiction such as the Cayman Islands is that there is no withholding tax on the payment of the coupon. The typical term of a cat bond is three to five years. If the catastrophe does not occur, the investors receive their principal back at the end of the term and, of course, their interest during the term of the bond. However, if the catastrophe arises – a major hurricane hits the US East Coast or there is an earthquake in California – and the bond is triggered, the entirety of the investors’ funds could be wiped out. Whether or not the bond is triggered can be a complicated issue and there are various trigger types. Some triggers are closely correlated to the sponsor’s actual losses (indemnity-based) and therefore operate more like traditional reinsurance whereas others are not correlated in this way and the payment made under the bond to the sponsor may bear little resemblance to the actual losses (parametric-based). The recent events in Japan demonstrate how parametric-based cat bonds work. Despite the enormous economic impact of the earthquake and the tsunami, it is believed that only a handful of bonds with Japanese earthquake exposure will have been triggered. This is because most Japanese earthquake cat bonds were limited geographically to the Tokyo area and were therefore not triggered by the unfortunate events in the north east of the country. Investors in cat bonds are typically institutionally-based and tend to comprise hedge funds, insurers, reinsurers, banks and pension funds. They are particularly attractive to sophisticated investors because investment performance is entirely uncorrelated to the performance of traditional asset classes. Cat bonds did suffer during the global financial crisis as hedge funds, in particular, bailed out because of the need to go into cash. The collapse of Lehman in 2008 was also damaging to some extent but, fortunately, only to a handful of cat bonds. Lehman had acted as counterparty for these cat bonds and as a result of Lehman’s difficulties it emerged that the collateral held was seriously impaired. The lessons learned have led to an improvement and simplification of the collateral arrangements, typically, through the use of US treasuries and AAA rated securities. There is considerable investor appetite for cat bonds at the present time and it seems likely that this is set to continue with cat bonds now typically trading at a lower price than before the Japanese earthquake. This level of investor interest is certainly good news for reinsurers since the events in Japan, Australia and New Zealand have certainly reduced capital available in the international property catastrophe reinsurance market. Cat bonds are frequently rated by the traditional rating agencies but whereas a typical corporate bond is rated based on the likelihood of issuer default, a cat bond is rated based on the likelihood of the catastrophe arising and the principal being impaired as a result. As the cat bond industry continues to develop Cayman appears to be in a very strong position to remain the leading offshore domicile in this market. Cayman is certainly setting out its stall to do so having recently revised it Insurance Law to establish for the first time a separate licensed category for cat bond SPVs. The future looks bright for this highly specialist sector of Cayman’s insurance industry. Paul Scrivener may be reached at This e-mail address is being protected from spambots. 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