After a turbulent 2011 for the Insurance market Stephen James, Simon Raftopoulos and Samuel Banks, Appleby examine the Cat Bonds market in the Cayman Islands.
Despite a quiet hurricane season thus far in 2012, wildfires in the western United States and devastation to crops due to widespread drought throughout the world have left insurers struggling with massive economic losses, depleted reserves and a strained capacity to underwrite risk. The introduction of new measures such as Solvency II in Europe and other jurisdictions such as Bermuda further increases capital requirements, leaving insurers looking for alternative ways of raising capital to cover catastrophic risks. As a result, financial instruments such as catastrophe bonds are again drawing the attention of both insurers and investors alike as a means of increasing insurance capacity whilst providing enhanced returns in an environment of historically-low interest rates.
What are Cat Bonds?
Catastrophe bonds, or ‘cat bonds’, are a type of financial instrument that enable insurers to transfer risks from specified disasters to investors. According to Goldman Sachs, in excess of US$3.4 billion worth of cat bonds have already been issued in 2012, more than double the US$1.6 billion from same period last year.
The popularity of cat bonds derive from the fact that traditional insurance and reinsurance methods have, at times, proven inadequate for dealing with the scale of damages resulting from natural disasters such as windstorms, floods and earthquakes. The concentration and extent of losses that can accompany catastrophic events has led insurers to take advantage of the capital markets as a means of offsetting exposure and widening the pool of parties prepared to undertake low probability, high-impact insurance risk.
As insurers and reinsurers are limited by the capital they hold and are accordingly constrained in their capacity to underwrite new risks, the issuance of cat bonds by insurers (or ‘sponsors’) to investors provides benefits to both parties. Through the issuance of cat bonds, sponsors are able to move risk from their balance sheets and increase their insurance capacity, generally at a lower cost of capital than purchasing reinsurance, the alternative form of risk transfer.
Structure of Cat Bonds
The establishment of a cat bond structure generally involves an insurer or reinsurer (acting as the sponsor) establishing a bankruptcy-remote special purpose vehicle (‘SPV’) which is usually licensed to conduct insurance business by the relevant authority. The SPV then reinsures specific risks of the sponsor in exchange for the sponsor paying premiums to the SPV. The SPV raises capital by issuing the cat bonds to investors in the capital markets and the proceeds 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. Cat bonds are typically issued to investors at par with an interest rate at levels commensurate with the risk that they may lose part or their entire principal on the occurrence of one or a number of defined catastrophic events. Cat bonds are usually rated below investment grade, such rating being influenced primarily by structural, regulatory and legal perils, but also by specific perils to which the transaction is exposed and results of the peril model used by the rating agency to rate the bonds. If the specified catastrophe does not occur, the investors receive their principal back at the end of the term with interest paid during the life of the bond. However, if the specified catastrophe occurs, then the bond principal is diverted to pay the sponsor that is reinsured in the transaction and the entirety of the investors’ funds could be lost.
Investors in Cat Bonds
Due to the high levels of risk and the potentially high returns, cat bond investors are typically large institutions including pension and hedge funds, insurers, reinsurers and banks. These investors are increasingly attracted to cat bonds because of their solid returns, historically-low default rates and reliability compared with recent swings in equity, "junk"-bond and commodity prices. Pricing of, and default on, these bonds are relatively uncorrelated with underlying credit or interest rate risk, making them increasingly attractive for pension funds or large investors seeking to diversify their returns.
Why the Cayman Islands?
Historically, the Cayman Islands has proven itself as the domicile of choice for capital markets transactions and captive insurers. Due largely to its tax-neutral position, stable government, sensible regulations and well-developed common law legal system, the Cayman Islands have seen early success in the cat bond market. The Cayman Islands boast over US$31 billion worth of cat bonds issuances, a figure that represents more than 73 per cent of the total market. In addition, the Cayman Islands Stock Exchange (CSX) has recently announced that it reached its 100th cat bond programme and series listing, with a total face value of around US$8.5 billion. This success is hailed by the CSX’s chairman, Anthony Travers, as “an example of how to generate positive economic results through innovation-appropriate regulation and an in-depth understanding of the international financial marketplace.” Although other jurisdictions such as Bermuda and Ireland have eroded some of its market position, the Cayman Islands still boast the largest number of cat bond issuances to date. In an effort to further secure the Cayman Islands’ dominance in the cat bond market, the Cayman Islands’ government recently introduced a number of incentives to bolster the reinsurance market and to attract reinsurers, including concessions to work permits and permanent residency. The rationale is that if large insurers come to the Cayman Islands to buy reinsurance, it will cause them to think about cat bonds in the jurisdiction as well.
The Cayman Islands government’s introduction of a new Insurance Law (the “New Law”), which is expected to come into force by the end of Q3 2012, provides, amongst other things, for two new classes of insurance licence. The first is for issuers of insurance linked securities such as cat bonds (Class C) and the other for reinsurers (Class D).
The New Law recognises the structured nature of insurance-linked securities such as cat bonds and an understanding of how they function in practice. Perhaps more importantly, the New Law appears to recognise that all participants (both sponsor and investor) in cat bond transactions are sophisticated parties and understand what to expect from such transactions. For example, the description of the Class C insurer in the New Laws specifically references such essential concepts as limited recourse and funding through the issuance of bonds or other instruments or arrangements. The greater certainty and predictability resulting from the New Law is anticipated to enhance the jurisdiction’s reputation as a platform for cat bond issuances and as a reinsurance centre and to streamline the process of structuring cat bond transactions, thereby further solidifying the Cayman Islands’ dominance in the cat bond market.
As the insurance industry demands alternative means of increasing risk underwriting capacity at reduced costs and investors look for diversified financial instruments with attractive returns, the cat bond industry will continue to grow and develop. With a wealth of experienced professionals, modernised and streamlined insurance legislation and the enhanced capabilities of service providers, the Cayman Islands are extremely well-placed to continue its dominance as the jurisdiction of choice for new cat bond issuances.
Stephen James Partner
Simon Raftopoulos Partner
Samuel Banks Associate
Appleby Bermuda, British Virgin Islands, Cayman Islands, Guernsey, Hong Kong, Isle of Man, Jersey, Mauritius, Seychelles and Shanghai.