Cat bond market still seeking collateral solution
LONDON (Reuters) - Insurers are still seeking a universal solution to weaknesses in catastrophe bonds exposed by Lehman Brothers' collapse, though structural improvements have helped push sales past $1 billion (606 million pounds) this year.
This year's nine catastrophe bonds have employed innovative structures to neutralise credit risk, but disagreement over whether such securities must continue to offer a Libor-based return is hampering the search for a new industry standard.
Catastrophe bonds, used by insurers since the 1990s to manage their exposure to natural disasters, have traditionally used London Interbank Offered Rates -- a standardised set of indicative money market rates -- as a benchmark for returns.
Some investors want that to remain so, but others argue that Libor increases correlation with other financial instruments and undermines catastrophe bonds' appeal as a diversifying asset.
"It's the Libor piece of the puzzle that's complicated," said Erik Manning, a director within Deutsche Bank's Structured Products and Alternative Risks Group.
"Libor is not a risk-free rate, although perhaps at the peak of the boom people treated it as such, and it's tricky to find credit-neutral structures that will deliver a Libor return."
Catastrophe bonds transfer insurers' losses from hurricanes or earthquakes to investors, who receive a high rate of interest but risk losing their principal if a disaster occurs.
They were among the few assets to withstand last year's meltdown in global markets, but their reputation was damaged when four bonds guaranteed by a unit of Lehman were downgraded following its insolvency, and issuance halted for six months.
French reinsurer Scor (SCOR.PA) reopened the market with a $200 million transaction in February, since when about $1.4 billion of new bonds have been sold.
Scor's deal, and subsequent transactions by U.S. insurers Liberty Mutual, Chubb Corp (CB.N) and Assurant (AIZ.N), were structured like older catastrophe bonds, with a counterparty employed via a total return swap (TRS.L) to manage the underlying collateral and make up any shortfall.
COUNTERPARTY ROLE
The counterparty role was taken by Lehman in the four bonds that were downgraded by credit rating agency Standard & Poor's, which cited deficits in their collateral accounts. Two of the bonds are now in default.
"The collateral management process was relatively low profile until the Lehman debacle, which made it a point of focus for issuers and investors," said Mark Gibson of the Capital Markets Structuring group at BNP Paribas, which has proposed a new repo-based collateral mechanism.
"In hindsight, it was a flawed decision to save 5 or 10 basis points (in running costs) for several ratings' worth of counterparty credit quality, given the collateral provision element was meant to be about securing low credit risk."
Bonds using a counterparty this year have set strict rules for monitoring collateral, which has mostly been invested in debt issued under the U.S. government's bank rescue package and guaranteed by the Federal Deposit Insurance Corporation FDIC.L. Continued...
