The Credit Crisis and Insurance-Linked Securities: No Catastrophe for Catastrophe Bonds

Abstract

The cyclical disconnect between demand and supply for reinsurance protection from natural catastrophe risks led insurers to look for solutions outside of the traditional insurance markets. A solution was found in the capital markets in the late 1990s with the development of the first risklinked securities in the form of catastrophe bonds or “cat bonds.” The cat bond provides a mechanism to transfer natural catastrophe risk to the capital markets from insurers using securitization technology. The cat bond market permits typical capital market investors to take exposure to one or more specified natural catastrophic events for attractive risk premiums directly without being regulated as insurance companies. The credit crisis has focused new energy and attention on cat bonds as investments that permit diversification away from credit and interest-rate risk. The credit crisis has also substantiated many of the theoretical advantages of the asset class in such a scenario, and focused new attention on ways to enhance these advantages by further insulating the collateral underlying the repayment of the bonds from credit-related risks. This has resulted in an improvement both in the quality of that collateral and in the terms of the total return swaps that cover losses in the collateral and provide for the payment of interest to be made on the bonds in a timely manner.

TOPICS: Security analysis and valuation, legal and regulatory issues for structured finance, legal/regulatory/public policy