Monday, August 26, 2013

Cat Bonds and Contamination Risk

By Tim Dulaney, PhD and Tim Husson, PhD

Many pension funds have struggled to achieve sufficient return on their investments in the current low interest rate environment.  Some have begun investing in insurance-linked securities, particularly catastrophe ('cat') bonds.  You can find our primer on insurance-linked securities here; essentially, insurance companies issue cat bonds to transfer the risk of catastrophic losses to investors, meaning cat bond investors suffer losses in the event of a major disaster.

While such risk might be considered unsuitable for a pension fund, recently issued cat bonds also have another potentially risky feature that could lead to widespread losses under certain circumstances.  These cat bonds are called 'cat bond-lite' structures.

Traditional cat bonds are created through a special purpose vehicle (SPV), a separate legal entity often domiciled in the Cayman Islands or other legally favorable offshore location.  SPVs are also used by CDOs and other complex structured securities as a way of separating the assets linked to the security from the rest of the issuer's assets.  That way, if the deal goes awry, only the assets in the SPV are at risk, limiting insolvency risk to some extent.  However, setting up an SPV might be relatively expensive.

In a cat bond-lite transaction, the cat bond's assets are held by segregated account companies (SAC), which may issue many cat bonds on behalf of many issuing insurance companies.1  While in some circumstances this may be sufficient separation to avoid any contamination or insolvency issues, some legal experts are concerned that cat bond-lite structures may increase systemic risk in the insurance-linked securities market:
There might be some marginal cost increases [for using an SPV over an SAC] but they really are on the edges. Whenever I've looked at it I've concluded [an SAC] was introducing vulnerabilities for something that doesn't really have that many advantages.
What this means for pension funds is that cat bond-lite transactions expose pension funds to not only the risk of loss stemming from particular major disasters, but also to insolvency risk of cat bond-lite SACs.  While many of the legal ramifications of cat bond-lite structures remain untested, the controversy does shed some new light on the growing market for cat bonds and insurance-linked securities.

1 The first cat bond-lite transaction occurred in the summer of 2010.

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