Dealing with danger

The collapse of Lehman Brothers sent waves of many different kinds through the capital markets. One of the less obvious was in the market for natural catastrophe bonds, or cat bonds, where it alerted investors to a need for more secure collateral. In structuring a new issue for reinsurer Hannover Re - using special purpose vehicle (SPV) Eurus II - the BNP Paribas cat bond team has come up with an inventive repo-based solution.

With outstanding issues worth some $11bn - down from its 2007 peak of $15bn - the cat bond market isn't exactly huge but it is of growing interest to investors in search of alternative returns. It began to evolve in the 1990s as a source of additional capacity in the reinsurance market.

Cat bonds transfer risk from an insurer, reinsurer or corporate - the sponsor - to debt investors. The layer of liability is invariably remote from the risk, in that it only kicks in after losses of considerable magnitude. A typical structure uses an SPV, which takes on the risk and then sells bonds to investors.

All things being equal, the premiums are passed on to investors in the form of a coupon at a spread to Libor or Euribor, unless a loss is triggered. 'Catastrophe', by its nature, is characterised by low frequency but high severity so, in the unlikely event of a significant loss, the investors will lose some or all of their capital.

Insurers like cat bonds because they allow them to diversify away from traditional reinsurance, and because it gives them multi-year cover (as opposed to one-year reinsurance transactions) at a predetermined price.

Investors like the bonds because their returns are uncorrelated with more conventional assets and, in the absence of loss, they offer attractive spreads. The market received a boost after Hurricane Katrina in 2005, when a lot of traditional capacity withdrew from the market, and annual issuance grew strongly to 2007, when it hit a record $7.7bn.

In 2008, the annus horribilis, non-correlation did not prevent it slumping to $2.7bn. Some hedge funds, which had been prominent players in this market, became distressed sellers and depressed pricing. The situation was aggravated by the downgrade of four cat bonds exposed to Lehman Brothers which, as total return swap counterparty, was effectively holding the investors' capital.

Confidence returns

This year has seen confidence returning and issuance has regained some momentum, touching $1.8bn by the end of July. Sponsors have recognised the need to strengthen the collateral and it was on this particular issue that the BNP Paribas team was able to come up with an innovative twist.

Hannover Re, a cat bond pioneer, was looking for additional protection against severe European windstorm risk and asked BNP Paribas, as lead structurer, sole bookrunner and joint lead manager, to devise a structure that would appeal to investors while restraining costs to the sponsor.

The team was aware that, in the current climate, investors had become more demanding. "When markets are lax and soft, the rules get lax and soft," says Mark Gibson, head of non-life insurance solutions, capital markets structuring at BNP Paribas. "There were deals done in 2007 that one couldn't do at the moment, because investors have realised that they are able to tighten the terms and conditions."

Important decisions

One important choice that had to be made was the nature of the trigger. An indemnity trigger is activated by the issuer's actual losses. So if the cover is for $100m with an excess of $400m, the bond is triggered once claims exceed $400m. Non-indemnity triggers may be based on other mechanisms, such as modelled loss, insured industry loss or physical parameters such as earthquake magnitude or wind speed.

While indemnity triggers might seem to be the simplest solution, it is not that straightforward. "Indemnity is do-able, but the issue is data quality," explains Mr Gibson. "With reinsurer sponsors, investors are at least two steps away from the original data, making it harder to assess the risk and establish losses. It's all about transparency."

Since cat bonds provide capacity in parallel to traditional reinsurance, pricing is sensitive to prevailing conditions in that market. Right now, the comparative economics of reinsurance versus indemnity-triggered cat bonds may favour the former. Nonetheless, about 30% of this year's issuance uses an indemnity trigger, according to Rishi Naik, head of BNP Paribas's insurance-linked securities trading and syndication team.

In the Eurus II issue, a parametric trigger based on a wind speed index was used, using readings from more than 200 European reporting stations. Two features were incorporated to appeal to investors. One is that the maximum wind speed that can be considered is 43 metres per second, meaning that freak wind speeds reported at a low number of stations cannot negatively affect the index value. The other is a toolkit that allows investors to calculate the impact of a windstorm themselves, using wind speeds from public sources.

At the heart of the Eurus II deal's innovation, however, was the collateral solution. While the sponsor is effectively using its premiums to pay the spread, the issuing vehicle needs to deploy the cash received so that it can generate Libor (or Euribor) while remaining secure. After Lehman, the conventional practice of using top grade bonds with a total return swap counterparty, usually the underwriting bank, was regarded with suspicion. "By the end of 2008, the question of 'what is the collateral in these deals?' was the subject of enormous focus," says Joshua Luks, a fixed income specialist in the alternative funding group at BNP Paribas.

BNP Paribas's answer was to combine corporate and sovereign bonds with a triparty repurchase (repo) mechanism - a "new structural benchmark" for the cat bond market, it says. This allows Eurus II to deposit the cash and get back securities that act as collateral. BNP Paribas sells an eligible pool of repo assets to Eurus II with an obligation to buy them back on a quarterly basis, and pays the SPV 3 million Euribor plus the repo spread.

Only investment grade bonds or better are eligible as collateral, and the obligations are always over-collateralised. If the collateral's market value drops on any particular day, additional assets are automatically transferred to maintain the required ratio.

BNP Paribas points to its own strength as a counterparty and its sizeable presence in the repo market, and maintains that the mechanism is significantly superior to previous structures in terms of transparency. "We report to the investors every day, with daily pricing and margining by an independent third party - Euroclear," explains Kapil Damani, a member of the capital markets structuring team at BNP Paribas.

From kick-off in early June, the issue was ready to be announced by the second week of July. That was fast work, given the new features involved, but the sponsor wanted the cover in place before the storm season got under way in September, with the August holidays in between.

At launch, the issuer was hoping to raise €75m with a three-year bond. But as the marketing process developed, investor demand prompted a doubling up to €150m, priced at 675 basis points over Euribor. That was the tightest pricing of any benchmark 2009 cat bond to date.

"The collateral structure makes the issue more economic, and so more attractive to the sponsor," says Mr Gibson, "but the investors are not suffering as a result."

Not only does the new structure balance the interests of investors and sponsor but, BNP Paribas believes, it is a scaleable solution with possibilities for other types of transactions. "It will be useful in other cat bond deals, says Mr Luks. "But it also sets a precedent for any other collateral situation - involving commodities, for example, or equities."