Swiss Re Insurance-Linked Fund Management

PCS - Emerging Risks, New Opportunities

New-found flexibility helps catastrophe bond market grow


The catastrophe bond market is continuing to grow in 2013. Strong inflows of new investor capital and an increasing interest among insurers and reinsurers to sponsor cat bonds are two factors that have helped. But this year one of the key factors that has assisted in the markets growth is a new-found flexibility in the terms of some recent cat bond deals.

Flexibility is something that has been called for within the cat bond market for a number of years. As the market has grown, and deal terms have become more complex but at the same time more standardised, sponsors have been looking for ways to flexibly and easily expand the cover a new cat bond issuance offers them.

Cat bonds tend to have a term of anywhere from one to five years, with the majority still coming in at a three-year term. This means that whatever cover they provide a sponsor is locked in according to the terms of the underlying deal structure for that period. Being able to lock in an element of flexibility into the deal has huge attraction for sponsors and recent additions to deal structures are surely going to help to encourage other sponsors to come forward and try out the market.

For potential new sponsors, the closer a catastrophe bonds terms and structure can be to the terms it receives from its existing reinsurers the more likely it is to try out the cat bond market as an alternative. It doesn’t all come down to price for most sponsors, the way the cover fits with its other sources of reinsurance and meets its needs in terms of structure are vital to address and the cat bond market is taking steps to meet these needs.

By building flexibility into transactions, while trying to mirror reinsurance contract terms and features that cedents appreciate where possible, the cat bond market will itself help to drive additional, incremental issuance from new and existing sponsors. Therefore anything that can be added to cat bonds in terms of flexibility is a positive for the broader market and helps to ensure ongoing growth.

An article published by Business Insurance recently discusses some of the features hitting the cat bond market which have helped to increase flexibility in deal terms and structures.

The first is the relatively recent trend to structure catastrophe bonds so that they cover all ‘named storms’ rather than just hurricanes. In the past cat bonds have specified that tropical storms must be Category 1 hurricanes, or that they must have wind-speeds above a certain level or some other definition. By simply stating that only a ‘named storm’ can qualify it covers tropical storms, those storms that develop into hurricanes and also any that move to post-tropical status (very important).

This simple change to deal terms has allowed insurers to cover their wind and hurricane risk in one layer of their reinsurance program, a much more attractive prospect for any smaller primary insurers tentatively looking at the cat bond market as a potential source of reinsurance cover.

A second feature is the variable reset, which we’ve seen in a few transactions this year. This feature allows a sponsor to elect to adjust key factors of the cat bond, at an annual reset, such as the attachment point, as a result of which the attachment probability would change and so would the interest spread paid to investors.

This is a really interesting new cat bond feature, as seen in Travelers recent Long Point Re III Ltd. (Series 2013-1) transaction. It means that the layer of protection a cat bond offers can be moved up and down the cedents tower, so the cat bond becomes a much more flexible source of cover. This means that if another layer of the tower becomes eroded a cedent could use the cat bond to reinstate that cover, or simply to provide additional protection where it feels it is needed.

AIG’s recent Tradewynd Re cat bond is another example of a market becoming more accepting of different risks and features. This deal includes coverage for named storms in the Gulf of Mexico and some of the underlying book of business is energy risk based making this the first cat bond to cover some offshore energy risks we believe. This cat bond also features a flexible reset feature allowing the attachment to be moved.

Also, the Turkish Catastrophe Insurance Pool’s first direct catastrophe bond issuance, Bosphorus 1 Re Ltd., and the fact that it grew to $400m in size thanks to broad investor support is another sign of a market maturing and becoming more familiar and willing to accept diversifying risks.

As investors get increasingly comfortable with catastrophe risk as an asset class and the catastrophe bond structure we expect the rate of innovation within the market to increase. Most markets see increased innovation as the market becomes more popular or mainstream, and the cat bond market will likely be no different.

The structuring firms we speak with are constantly trying to add new features into cat bond structures and often it is a case of finding the right sponsor for the feature, rather than the feature for a sponsor. As innovation rates increase in catastrophe bond structuring, this new-found flexibility will increase and we expect issuance, and the size of the market, will increase alongside it.

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