A suggestion for an ILS and cat bond collateral safety mechanism

Recently, two outstanding catastrophe bonds have seen impairments to the value of the collateral assets held in trust, which would eventually be used for loss payments or be returned to the cat bonds investors, putting investors at risk of a small loss of principal.

A suggestion has been made for a safety mechanism to prevent this from happening again and to protect investors from losses to their investments created by a decline in value of the cat bond or ILS transaction collateral assets.

The recent issue, which affected the collateral investments of two of reinsurer Munich Re’s Queen Street cat bonds, first Queen Street III followed by Queen Street II, occurred due to rigorous investment guidelines which meant that the two underlying collateral trust funds had to liquidate their assets, resulting in a loss of mark-to-market value in the collateral.

The U.S. debt ceiling crisis impacted the value of some of the collateral investments, taking the per-unit value of the funds to below $1. In European funds, when this happens, the sale of assets is forced on the funds when the value drops below the dollar mark. In the U.S. such funds generally receive some support from asset managers to prevent the price dropping so much, so we haven’t seen a flurry of other deals suffer the same issue as so many cat bonds are managed from U.S. collateral accounts.

For the Queen Street cat bonds no such provision was in place and so the funds were liquidated causing a loss of value in the collateral accounts and perhaps a loss of principal to investors, if the funds are not replenished. This could result in a downgrade on both of the cat bonds and a minimal loss to investors in the deal.

A suggestion from Zurich, Switzerland based ILS investment manager Plenum Investments makes a lot of sense in such a situation. The ILS manager suggested recently that it should perhaps fall to the reinsured to make up the collateral in cases where it has seen a loss in the value of its investments.

Plenum said; “As portfolio managers we would like to see further improvement of these structures such as automatic mechanisms to compensate investors for losses arising from the sale of the collateral assets.”

It would require a small amount of legal editing to cat bond offering documents to build this in as a required part of the strucure. Some kind of caveat may be required, perhaps regarding the amount of collateral reduction, as there could be cases where collateral is eroded due to a completely unforeseen event for which the reinsured could not be held liable.

The case of the two Queen Street cat bonds collateral reduction is an unusual one and it demonstrates that nothing is truly uncorrelated from the wider financial markets and economy. It is the first time anything like this has been seen in the cat bond market and it would have been hard to predict the probability of such an occurrence.

It would not be expected to happen again, now issuers and those managing collateral are aware of this possibility, but suggestions like the one from Plenum show that the ILS market continually seeks to innovate and reduce credit risks for investors, which is one of the many positives associated with the ILS asset class.