The death of the total return swap in the cat bond market is almost upon us

Collateral arrangements in catastrophe bond deals, not a subject we touch on particularly often, but something worth revisiting now that the long forecast death of the total return swap as collateral solution is almost upon us. When we last covered the total return swaps demise back in December 2011, it accounted for approximately 12% of outstanding cat bonds. By the end of 2012 that number had been reduced significantly.

The last time a total return swap was used in the issuance of an insurance-linked security or catastrophe bond deal, at least a major public transaction that we covered in our Deal Directory, was back in 2009. Four ILS structures used a total return swap arrangement for collateral provision during 2009 and from that year on they have all but disappeared with no cat bonds issued since that year using one for collateral.

The reason for the total return swaps demise is of course linked to the collapse of Lehman Brothers. Total return swaps make use of a counterparty acting as guarantor for the securitization collateral, often an investment bank guaranteeing the return of principal at the end of a deals term. This theory came unstuck during the 2008 financial markets crisis when Lehman Brothers collapsed leaving a number of cat bonds exposed to default as the guarantor had effectively disappeared.

After that the market put its trust in other collateral solutions, with Treasury money market fund’s proving the most popular, followed by various types of structured notes and tri-party repurchase agreements. TMMF’s remain the most popular choice of collateral solution, accounting for 71% of outstanding cat bond capacity at the end of 2012, followed by structured notes at 20% and tri-party repo’s at 8%. Structured notes have seen some growth in usage since our article in 2011 but tri-party repo’s percentage of the cat bond market has declined a little.

As for total return swaps, at the end of 2012 they accounted for just 1% of the outstanding cat bond market, according to data from Swiss Re’s recent insurance-linked securities market report. The only remaining outstanding cat bonds which used a total return swap were the stricken Nelson Re deal and the Globecat cat bond at the end of the year. The Globecat transaction has now matured, on the 1st February, meaning that the only cat bond with a total return swap in place as a collateral solution is the extended, and still under arbitration, Nelson Re deal.

So the total return swap is almost no more. The Nelson Re deal is under extension while arbitration is undertaken and was due to have been revisited on the 6th December but we have not heard whether any agreement has been reached. Once that deal is finally settled and allowed to mature the total return swap will be no more in the catastrophe bond market.

Outstanding cat bond collateral solutions - Source: Swiss Re Capital Markets

Read our other articles on Swiss Re’s recent report:

– 2012 a unique year for the insurance-linked securities market

– Increasing numbers of pension funds and asset managers participating in ILS

– Over 50% of catastrophe bond volume issued in 2012 used indemnity triggers