Keep it private

A peek into the world of private catastrophe bonds

Private

The catastrophe bond market reached record levels in 2013. Packaging reinsurance risk in bond format has been extremely successful in moving peak insurance risk – in particular US hurricane risk – away from the relatively small balance sheets of reinsurers and placing it in the far larger capital markets. As a small part of a broad based stocks and bonds portfolio, these instruments have diversifying properties that have been attracting investors with lower return thresholds.

Catastrophe bonds broaden the supply of reinsurance capacity to many institutions that would otherwise be excluded from the market. An important feature of catastrophe bonds that distinguishes them from other types of reinsurance is the existence of a secondary market. This enables investors to trade out of their positions and provides the possibility of mark to market pricing. One or both of these properties are prerequisites for many investors.

But the cat bond product is not without its detractors. Reinsurance buyers are used to being able to negotiate very large deals in a few weeks that rely on a single, short contract and the strength of market custom. Samir Shah, AIG’s reinsurance buyer, recently pointed out that the documentation for one of their cat bond issues was longer than the group’s entire annual report. The time and expense of sponsoring public cat bonds is frequently sighted as a reason for maintaining a traditional reinsurance programme rather than transferring risk to the capital markets.

A relatively recent innovation is the increased use of a different legal structure to create ‘private’ cat bonds. Proponents of private cat bonds (otherwise known as cat bond light or 4(2) or regulation D) contend that they combine the best features of a fully-fledged public issue and collateralised reinsurance. They are less expensive, less time consuming and more flexible than cat bonds and at the same time more liquid and more widely distributed than collateralised reinsurance.

The US Securities Act of 1933 imposes a general requirement to register securities with the SEC. In practice this requirement is impractical to comply with and the public and private structures rely on two different exceptions to this rule. These ‘safe harbours’ are known as 144A (public bonds) and 4(2) (private bonds).

The documentation for 144A bonds is designed to be self-contained. All of the information needed to enable a trade between two parties will be recorded. Investors have no recourse to the sponsoring insurance company to ask for further information. By contrast, investors in private bonds sign confidentiality agreements with the sponsor and secondary market trades occur within the universe of investors who have an equivalent relationship with the sponsor.

Early transactions included tiny, one year bonds that used a zero coupon structure – for example, the $4.25m bond that Swiss fund Solidum issued and successfully traded in 2010, and the $11.95m Oak Leaf deal that Towers (now JLT) brought to the market the following year. JLT’s ILS team have specialised in the 4(2) structure and have been behind a number of deals including the $100m, three year Skyline that was placed this January.

Michael Popkin who is co-head of ILS at JLT explained that “for all of the cedents that we work with it is the first time to the capital markets. This structure allows our clients to access a broader range of investors than would be possible with collateralised reinsurance at a competitive all-in cost.”

Cost savings come from radically simpler documentation and the absence of numerous service providers that are necessary to complete a full-blown 144A offering. Much of the onus for performing due diligence is shifted from the lawyers to the investor. As Andre Perez, CEO of Horseshoe, put it “they’re not doing your thinking for you – you have to do your own thinking”.

It seems unlikely that the private cat bond will slow the growth of the public cat bond market. For larger offerings the savings in frictional costs are outweighed by the ability to access a deeper investor base that facilitates more efficient price discovery and is able to provide hundreds of millions of dollars of capacity.

But private cat bonds do provide good answers to certain risk management questions. The flexibility of the structure means that we are likely to see them being used in some of the more innovative transactions of the next few years and succeeding in bringing new sources of insurance risk to investors.

 

Posted: Monday, March 17th, 2014