Cayman Islands: Cayman Cat Bonds

Last Updated: 3 February 2011
Article by Paul Scrivener

Paul Scrivener, head of the insurance group at Cayman Islands law firm, Solomon Harris, takes a look at the catastrophe bonds industry and the role played by the Cayman Islands.

No doubt it raised a few eyebrows in Bermuda when it was announced in July last year that new figures revealed that the Cayman Islands had become the leading offshore jurisdiction for listed catastrophe bonds ("cat bonds"). Even Bermuda's main newspaper, The Royal Gazette, was forced to acknowledge that Bermuda had a lot of catching up to do to match its offshore rival in the competition for cat bond business. The July figures showed that there were 74 cat bonds listed on the Cayman Islands Stock Exchange with a value of over US$7.7 billion whereas, in contrast, Bermuda's own statistics showed 10 listed bonds having an aggregate value of US$1.17 billion. For those involved in Cayman's structured finance and captive insurance industries there was much less surprise as the figures simply bore testimony to the jurisdictions continuing ability to adapt and embrace innovative financial products.

In an article in QFinance, Anthony Harrington describes cat bonds in a particularly graphic way when he says, "Catastrophe bonds are either complete lunacy or an outstanding triumph of statistics and probability theory over common sense, depending on your point of view". This comment speaks to two particular features of a cat bond – the high risk taken by investors with a view to achieving a significant investment return and the importance of the modelling undertaken by the specialist catastrophe modelling houses to assess the likelihood of a particular catastrophe occurring.

Cat bonds may be thought of as the place where insurance and the capital markets truly come together. They provide additional capacity in the insurance market and offer an alternative to traditional reinsurance and retrocession contracts. They allow the insurance industry access to the deep pockets of the capital markets and reduce insurance costs to end users. AM Best describes a cat bond as, "A structured debt instrument that transfers risks associated with low frequency/high severity events to investors". The key feature of a cat bond, which contrasts with traditional reinsurance, is that risk in relation to the particular peril is transferred to investors rather than reinsurers. A cat bond enables insurers or reinsurers to spread risk so as to avoid their balance sheets being substantially impaired where huge losses arise from natural disasters. In that sense, a cat bond is a form of insurance securitisation. The nature of the bond is a high yield debt instrument which is linked to an insurance risk and, as the name would suggest, the insurance risk is typically a catastrophic risk arising from a natural disaster such as a hurricane, earthquake or flood. Historically, cat bonds have been used principally to cover the risk of US hurricanes, US earthquakes, Japanese typhoons and earthquakes and European hurricanes. However, whilst cat bonds have been traditionally limited to the world of natural disasters, they need not be so as evidenced by the issue by FIFA of cat bonds worth US$260 million against cancellation of the 2002 World Cup in South Korea/Japan.

Cat bonds first came into vogue in the aftermath of devastating Hurricane Andrew which hit South Florida in 1992, the most costly Atlantic hurricane in US history (US$26.5 billion), until surpassed by Hurricane Katrina in 2005. Cat bonds emerged from the search for a vehicle that would bring more risk-bearing capacity to the catastrophe reinsurance market or, to put it another way, how could reinsurers spread the burden and protect their balance sheets when faced with truly catastrophic claims? The first cat bonds emerged in the mid to late 1990's with sponsors such as AIG, Hannover Re and St Paul Re and continued to develop over the coming years with 9/11 and Hurricane Katrina not surprisingly stimulating further growth in the sector. More than US$30 billion of securities have been issued and 2010 was a particularly strong year for new issues.

How are cat bonds typically structured and how do they work? The structure has much in common with the traditional securitisation model used with asset-backed securities. The Cayman Islands has always been strong in the asset backed securities market, particularly, CDO's, and therefore it is perhaps no surprise that the Cayman Islands would become a participant in insurance securitisations, with the first Cayman cat bond listed on the Cayman Islands Stock Exchange in 2007.

The traditional structure involves an insurance company or a reinsurance company (the "Sponsor") establishing a special purpose vehicle ("SPV") as a bankruptcy remote entity. As with a CDO, the SPV will typically be set up in a tax neutral offshore jurisdiction such as the Cayman Islands. The Sponsor pays premiums to the SPV with the SPV acting as a reinsurer of the Sponsor and the SPV raises its capital by the issuance of the cat bond to investors in the capital markets. The usual model in the Cayman Islands is for the funds provided by the investors to be deposited into a collateral account and invested in investment-grade securities such as money market funds. The funds in the collateral account are available to satisfy the catastrophic losses reinsured by the SPV. The cat bond obviously carries a coupon – usually a floating rate coupon - which is serviced from the premiums paid by the Sponsor to the SPV and from the investment income earned on the funds in the collateral account.

Because of the high risk for the investor in the bond the coupon needs to be attractive and would typically be anywhere between 3 per cent and 20 per cent over LIBOR. One particular advantage of the SPV being domiciled in a jurisdiction such as the Cayman Islands is that there is no withholding tax on the payment of the coupon. The typical term of a cat bond is three to five years. If the catastrophe covered by the bond does not occur, the investors receive their principal back at the end of the term and, of course, their interest during the term of the bond. In these circumstances, the return on investment should be very healthy. However, if the catastrophe arises – the major hurricane hits Florida or there is a land-falling typhoon in Japan – and the bond is triggered, the entirety of the investors' funds could be wiped out. Investment in cat bonds is therefore not for the faint of heart!

Whether or not the bond is triggered and losses have to be met can be a complicated issue and there are various trigger types. Some triggers are closely correlated to the sponsor's actual losses and therefore operate more like traditional reinsurance whereas others are not correlated in this way and the payment made under the bond to the sponsor may bear little resemblance to the actual losses thereby providing a windfall for the sponsor. An example of the latter would be a bond which pays out to the sponsor based on a set wind speed at a specified number of weather stations but the actual loss exposure of the sponsor arises in locations away from the weather stations specified.

Whilst traditionally cat bonds have been issued to cover the risk of a particular loss, they have also been structured to cover the risk that multiple losses will occur, with the first second event bond having been issued as long ago as 1999 and the first third event bond having been issued in 2001.

Cat bonds are frequently rated by the traditional rating agencies but whereas a typical corporate bond is rated based on the likelihood of issuer default, a cat bond is rated based on the likelihood of the catastrophe arising and the principal being impaired as a result.

Who invests in a cat bond? Not surprisingly, bearing in mind the high risk/high reward associated with cat bonds, the investors are typically institutionally-based and tend to comprise hedge funds, insurers, reinsurers, banks and pension funds. There is no doubt that the global financial crisis had a marked impact on cat bonds as hedge funds, in particular, bailed out because of the need to go into cash. The investors who remained had concerns about the transparency of the underlying collateral arrangements particularly in the light of collapse of Lehman in 2008. Lehman had acted as counterparty on a number of cat bonds. However, the lessons learned from Lehman have led to an improvement and simplification of the collateral arrangements, typically, through the use of US Treasuries and AAA rated securities. Consequently, investors have returned, attracted not only by the higher coupon compared to corporate bonds but by the diversification and lack of correlation to traditional assets classes that cat bonds can provide.

As 2011 gets underway, the cat bond industry remains vibrant and Cayman appears to be in a very strong position to retain its position as the leading offshore domicile in this market. Its ambitions in this regard are not least reflected in the recently revised Insurance Law which for the first time establishes a separate licensed category for cat bond SPVs and no doubt the fact that in September last year Cayman was, for the second year running, named by UK banking and finance magazine, The Banker, the number one specialized financial centre, globally, will do the jurisdiction no harm.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions