Catastrophe bonds (also known as cat bonds) are risk-linked securities that

transfer a specified set of risks from a sponsor to investors. They are often
structured as floating rate corporate bonds whose principal is forgiven if specified
trigger conditions are met. They are typically used by insurers as an alternative
to traditional catastrophe reinsurance.

For example, if an insurer has built up a portfolio of risks by insuring properties in

Florida, then it might wish to pass some of this risk on so that it can remain
solvent after a large hurricane. It could simply purchase traditional catastrophe
reinsurance, which would pass the risk on to reinsurers. Or it could sponsor a cat
bond, which would pass the risk on to investors. In consultation with an
investment bank, it would create a special purpose entity that would issue the
cat bond. Investors would buy the bond, which might pay them a coupon of
LIBOR plus a spread, generally (but not always) between 3 and 20%. If no
hurricane hit Florida, then the investors would make a healthy return on their
investment. But if a hurricane were to hit Florida and trigger the cat bond, then
the principal initially paid by the investors would be forgiven, and instead used by
the sponsor to pay its claims to policyholders.[1]

Michael Moriarty, Deputy Superintendant of the New York State Insurance

Department, has been at the forefront of state regulatory efforts to have U.S.
regulators encourage the development of insurance securitizations through cat
bonds in the United States instead of off-shore, through encouraging two
different methods — protected cells and special purpose reinsurance vehicles.[2]

In August 2007 Michael Lewis, the author of Liar's Poker and Moneyball, wrote an
article about catastrophe bonds that appeared in The New York Times Magazine,
entitled "In Nature's Casino."[3]

Contents
[hide]

• 1 History
• 2 Investors
• 3 Ratings
• 4 Structure
• 5 Trigger types
• 6 Market participants
• 7 Patents
• 8 References
• 9 External links

• 10 See also

[edit] History
The notion of securitizing catastrophe risks became prominent in the aftermath
of Hurricane Andrew, notably in work published by Richard Sandor, Ken Froot,
and a group of professors at the Wharton School who were seeking vehicles to
bring more risk-bearing capacity to the catastrophe reinsurance market. The first
experimental transactions were completed in the mid-1990s by AIG, Hannover
Re, St. Paul Re, and USAA. The market grew to $1-2 billion of issuance per year
for the 1998-2001 period, and over $2 billion per year following 9-11. Issuance
doubled again to a run rate of approximately $4 billion on an annual basis in
2006 following Hurricane Katrina, and was accompanied by the development of
Reinsurance Sidecars. Issuance continued to increase through 2007 despite the
passing of the post-Katrina "hard market," as a number of insurers sought
diversification of coverage through the market, including State Farm, Allstate,
Liberty Mutual, Chubb, and Travelers, along with long-time issuer USAA. Total
issuance exceeded $4 billion in the second quarter of 2007 alone.

[edit] Investors
Investors choose to invest in catastrophe bonds because their return is largely
uncorrelated with the return on other investments in fixed income or in equities,
so cat bonds help investors achieve diversification. Investors also buy these
securities because they generally pay higher interest rates (in terms of spreads
over funding rates) than comparably rated corporate instruments, as long as they
are not triggered.
Key categories of investors who participate in this market include hedge funds,
specialized catastrophe-oriented funds, and asset managers. Life insurers,
reinsurers, banks, pension funds, and other investors have also participated in
offerings.
A number of specialized catastrophe-oriented funds play a significant role in the
sector, including Clariden Leu Ltd., Credit Suisse Asset Management, Fermat
Capital Management, Nephila, Stark, Securis, Coriolis, Banque AIG, Solidum,
Pentelia Capital Management, Goldman Sachs Asset Management, Secquaero
Advisors, and others. Several mutual fund managers also invest in catastrophe
bonds, among them OppenheimerFunds, Pioneer Investments, and PIMCO.

[edit] Ratings
Cat bonds are often rated by an agency such as Standard & Poor's, Moody's, or
Fitch Ratings. A typical corporate bond is rated based on its probability of default
due to the issuer going into bankruptcy. A catastrophe bond is rated based on its
probability of default due to an earthquake or hurricane triggering loss of
principal. This probability is determined with the use of catastrophe models. Most
catastrophe bonds are rated below investment grade (BB and B category
ratings), and the various rating agencies have recently moved toward a view that
securities must require multiple events before occurrence of a loss in order to be
rated investment grade.

[edit] Structure
Most catastrophe bonds are issued by special purpose reinsurance companies
domicilied in the Cayman Islands, Bermuda, or Ireland. These companies typically
write one or more reinsurance policies to protect buyers (most commonly,
insurers or reinsurers) called "cedants." This contract may be structured as a
derivative in cases in which it is "triggered" by one or more indices or event
parameters (see below), rather than losses of the cedant.
Some bonds cover the risk that multiple losses will occur. The first second event
bond (Atlas Re) was issued in 1999. The first third event bond (Atlas II) was
issued in 2001. Subsequently, bonds triggered by fourth through ninth losses
have been issued, including Avalon, Bay Haven, and Fremantle, each of which
apply tranching technology to baskets of underlying events. The first actively
managed pool of bonds and other contracts ("Catastrophe CDO") called Gamut
was issued in 2007, with Nephila as the asset manager.

[edit] Trigger types

The sponsor and investment bank who structure the cat bond must choose how
the principal impairment is triggered. Cat bonds can be categorized into four
basic trigger types. The trigger types listed first are more correlated to the actual
losses of the insurer sponsoring the cat bond. The trigger types listed farther
down the list are not as highly correlated to the insurer's actual losses, so the cat
bond has to be structured carefully and properly calibrated, but investors would
not have to worry about the insurer's claims adjustment practices.
Indemnity: triggered by the issuer's actual losses, so the sponsor is indemnified,
as if they had purchased traditional catastrophe reinsurance. If the layer
specified in the cat bond is $100 million excess of $500 million, and the total
claims add up to more than $500 million, then the bond is triggered.
Modeled loss: instead of dealing with the company's actual claims, an exposure
portfolio is constructed for use with catastrophe modeling software, and then
when there is a large event, the event parameters are run against the exposure
database in the cat model. If the modeled losses are above a specified threshold,
the bond is triggered.
Indexed to industry loss: instead of adding up the insurer's claims, the cat
bond is triggered when the insurance industry loss from a certain peril reaches a
specified threshold, say $30 billion. The cat bond will specify who determines the
industry loss; typically it is a recognized agency like PCS. "Modified index" linked
securities customize the index to a company's own book of business by weighting
the index results for various territories and lines of business.
Parametric: instead of being based on any claims (the insurer's actual claims,
the modeled claims, or the industry's claims), the trigger is indexed to the natural
hazard caused by nature. So the parameter would be the windspeed (for a
hurricane bond), the ground acceleration (for an earthquake bond), or whatever
is appropriate for the peril. Data for this parameter is collected at multiple
reporting stations and then entered into specified formulae. For example, if a
typhoon generates windspeeds greater than X meters per second at 50 of the
150 weather observation stations of the Japanese Meteorological Agency, the cat
bond is triggered.
[edit] Market participants
Examples of cat bond sponsors include insurers, reinsurers, corporations, and
government agencies. Over time, frequent issuers have included USAA, Hartford,
Swiss Re, Munich Re, Liberty Mutual, SCOR, Hannover Re, Allianz, and Tokio
Marine & Fire.
To date, all direct catastrophe bond investors have been institutional investors,
since all broadly distributed transactions have been distributed in that form.[4]
These have included specialized catastrophe bond funds, hedge funds,
investment advisors (money managers), life insurers, reinsurers, pension funds,
and others. Individual investors have generally purchased such securities through
specialized funds.
Examples of investment banks and other dealers that are active in the issuance
of catastrophe bonds are ABN AMRO, Aon Capital Markets, Deutsche Bank, BNP
Paribas, Goldman Sachs, Merrill Lynch, MMC Securities Corp., Lehman Brothers,
Swiss Re Capital Markets, and Willis Capital Markets. Some of these groups also
make secondary markets in these bonds.
Most bond offering documents include an expert modeling analysis, with the bulk
of these being prepare by AIR, EQEcat, and Risk Management Solutions.[5]
Applied Research Associates and Milliman [6] also provide research and technical
support.[7]
Numerous law firms have been active in this space, notably Cadwalader,
Wickersham & Taft LLP,[8] Cleary, Gottlieb, Steen & Hamilton,[9] Dewey &
LeBoeuf,[10] and Sidley Austin.[11]

[edit] Patents
There are a number of issued US patents and pending US patent applications
related to catastrophe bonds.[1] These are examples of insurance patents.
Insurance patents are a recent trend since the 1998 State Street Bank decision
affirmed that business method patents were allowed by United States patent law.
There are approximately 150 new patent applications filed each year on new
insurance products and processes. [2]

Catastrophe bonds were being talked about as far back as the early 1990s, but it was not
until 1995 that they came into the limelight. In 1995, a series of devastating natural disasters in
the United States pushed American insurers to reassess their hedging strategies against even
greater catastrophes that could cripple them with claims. In November 1996, Morgan Stanley
agreed to underwrite the first public issue of insurance-related securities-catastrophe bonds, or
CAT bonds for short. The client was the California Earthquake Authority (CEA), created by the
state to insure California homeowners forsaken by insurance companies after the Northridge
earthquake. The plan was to market bonds to big institutional investors with a novel feature:
Bondholders would earn a huge 10%, but if any earthquake were to cause more than $7 billion in
losses to the CEA, bondholders could lose their principal. That the deal did not occur is another
story altogether, but it did mark the launch of a new class of bonds on the street.

The first disaster-linked bonds to be actually issued in the US were then called "Act of God
bonds." A landmark issue came in 1997 with Residential Reinsurance's US$477 million hurricane-
linked bond to fund catastrophe reinsurance. The issue managed by Goldman Sachs, Merrill
Lynch and Lehman Brothers would be triggered by a hurricane happening within a year that will
lead to claims exceeding US$1 billion.

The success of this issue opened doors for similar securities from other insurance and
reinsurance companies in the United States. In November 1997, Goldman Sachs and Swiss Re
New Markets launched the first such securitization in Asia with 10-year US$120 million Japanese
earthquake-linked bonds for Tokio Marine and Fire Insurance. The deal was the first to use a
parametric structure to determine loss on the face value of the bonds.

The emergence of catastrophe-linked securities heralded the convergence of insurance

and capital markets. Later on, some issuers embedded derivatives like options in cat bonds. In
April last year, Swiss Re introduced an earthquake swap transaction to back US$30 million
reinsurance cover for Mitsui Marine and Fire against earthquakes in Tokyo

CAT bonds are designed to protect insurance companies from events like massive
hurricanes and earthquakes, which happen rarely but cause enormous damage. The bonds pay
interest and return principal the way other debt securities do -- as long as the issuer doesn't get
whacked by a catastrophe that causes losses above an agreed-upon limit. For example, a
San Antonio-based insurer floated a CAT bond issue with the loss threshold being $1 billion. As
long as a hurricane didn’t hit their client for more, investors would enjoy their junk bond like
yields of about 11%, and get their principal back. However, in the event of the losses exceeding
$1 billion, the bondholders would lose their principal as well as the interest. The bonds were a big
hit on the street and were majorly oversubscribed.

CAT bonds are an example of the new class of options on the street, linked to nature.
They are extremely high risk and high return, with not only insurance companies but also big
corporates hedging catastrophe risk by issuing CAT bonds. CAT bonds have come as a reprieve
for companies working in high-risk areas like Oriental Land, the owner of the Tokyo Disneyland.
Faced with the prospect of insuring a potential fatality (Tokyo is an earthquake prone area)
insurance companies, in trying to manage their risk and returns, prescribe massive premiums on
such insurance policies. Reinsurers balk at the idea of reinsuring such high-risk insurance
policies. However, with the presence of the CAT on the street, companies are resting easy. For
them, CAT bonds are an easy and safe option to raise money because if a calamity strikes, they
don’t have to pay anything back.

CAT bonds do not come cheap, and are currently considered more expensive than
insurance policies, with only the maximum risk segment ascribing to the idea. A proper
management of such an issue can lead to the insured party not having to pay a penny, and be
insured at the same time. A case of such a structuring option is that of Oriental land, the
company which manages the Tokyo Disneyland. Their back to back issues of US$ 200 million of
CAT bonds, along with the SPVs and structuring options created caused ripples on the street.
Oriental Land: How to manage your CAT risk!

Building a massive entertainment complex close to the sea, including hotels,

shopping malls, entertainment complexes and a whole Disneyland is quite a daunting task,
especially with the fear of earthquakes looming over all the time. The last major earthquake
to strike this region caused an estimated US$ 145 billion of damage. For Oriental, aiming at
building the best Disneyland in the world, insurance cover would not be sufficient to recoup
losses if something like this happened, besides insurance being costly and coming for only
one year at a time.

Since 1983, when the Tokyo Disneyland became operation, Oriental did not seek
earthquake insurance of any kind, having had problems with insurance companies and faith
in its construction of buildings. What Oriental was interested in was a cost-efficient, longer-
term earthquake cover that extended beyond mere property damage to also cover the
equally ruinous after effects of a disaster such as a decrease in Disneyland visitors. Till the
advent of the CAT, such an option was unviable and needless to say, not available.

In May 1999, Oriental Land successfully raised a total of US$200 million in the first-
ever deal of earthquake risk securitization by a corporate. Led by Goldman Sachs, the CAT is
in two parts: a US$ 100-million, five-year note issue for the earthquake cover and a further
US$ 100-million, standby post-earthquake fund facility. Both bonds have been issued
through Cayman-registered special purpose vehicles.

Unlike the existing earthquake insurance policy, the cover is not pegged simply to
physical damage. Rather, it is structured according to the magnitude, location and depth of
the earthquake. The company had other objectives too. It wanted to make sure that the cost
of rebuilding the facility is contained and it does not lose too many visitors to the
aftereffects. For example, it did not want to pay a hefty premium for the cover and preferred
to pay only minimal interest on the post-earthquake contingent portion.

The Structuring

For the structuring of the deal, Oriental entered into financial contracts with
two SPVs (special purpose vehicles); both of them based in Cayman Islands (for tax
benefits). The first SPV called Concentric limited would pay Oriental as much as US$ 100
million in case of an earthquake happening within five years, whether or not there would be
any physical damages. Once the triggering earthquake happened, Oriental Land would be
compensated with the appropriate amount, depending on the earthquake magnitude, depth
and location as measured by the Japan Meteorological Agency.

In turn, Concentric would raise US$ 100 million in five year floating notes at 310 over
six month LIBOR (translating to approximately 6.5%). Concentric engaged Goldman Sachs
Mitsui Marine Derivative Products to collateralize its obligation to Oriental. Goldman would
invest the proceeds of the issue in US government securities, A-1 or triple A class paper. The
aim of this agreement was an interest rate swap whereby GSMMDP would ensure that the
interest yield on the portfolio would convert to LIBOR flat the interest being accrued on the
papers and ensure that Concentric receives the full amount to pay to Oriental Land on the
trigger date. The losses, if any were to be compensated by GSMMDP who would get a flat
fee for the services. Noteholders, on their part would lose entire or a part of the principle
depending on the magnitude and location of the earthquake’s epicenter. (Oriental and
Goldman sought the help of a US based firm called EqeCat for modeling the earthquake risk
for creating the levels).

The second SPV, called Circle Maihama would extend Oriental a post earthquake
reconstruction fund facility of US$ 100 million to be raised through issue of 5-year notes at
75 bp over six month LIBOR (approximately 4.2%). Circle Maihama entered into a similar
interest swap with GSMMDP. On the trigger date, GSMMDP would liquidate the portfolio and
allow Circle to subscribe to US$ 100 million worth of Oriental Land bonds at 25 bp over
LIBOR, with Oriental enjoying an interest moratorium of three years. Once issued, the notes
would also be extended for three years with the noteholders getting 5 bp over LIBOR in
these three years.

In the end, the deal gave Oriental Land the best of both worlds. They got the needed
earthquake cover without having to pay back the principal and an available line of credit for
reconstruction without having to pay a hefty premium.

The Pricing of CAT Bonds – a Bird’s eye view

In a very basic manner, the pricing of the CAT depends on the probability of the event (called a
stochastic event) being insured. An earthquake cover, say in California would more likely carry a
larger cover than in Washington. This however, could be reversed for some other event.
Alongwith the probability estimates are computed for the amount of loss the company might face
on the bonds. Other factors like value of the property being insured, the quality of construction
etc. is input. What results, in a basic manner is the exceeding probability curve. By analyzing the
curve for the particular business, an estimate can be made of the expected loss to the
transaction, which is usually expressed, as a percentage of the limit of coverage. This, in turn
gets multiplied by the investor’s and the rating agency’s perception about the possibility of the
event occurring. This results in the expected yield on the CAT and forms the basis for the rate of
return.
The writing’s on the wall

Over US$ 4 Billion of CAT bonds have been issued in the market since inception, with the
number growing. Currently, CAT bond issue is an expensive proposition due to the complexity of
the deal, often involving an investment banker to work closely with consultants like EqeCat for
modeling the risk. However, they have presented a serious threat to the reinsurance industry.
Reinsurers were at a high till 9/11, their coffers full of money, undercutting each other for a
share of the business. However, post 9/11 and the fact of paying off massive sums in life and
real estate insurance policies, the Cat looks ready to take the street… and it maybe here to stay.