Like CDOs, only better

Date: Tuesday, June 9, 2009
Author: Business Spectator.com

A novel insurance product designed to provide protection against one-in-100 year cyclones and other catastrophic natural events is being touted as a safety net for the next global financial crisis.

It is ironic that the innovative insurance product is structured in a similar way to collateralised debt obligations, which proved to be the toxic killers of the European and US banking systems in 2007 and 2008.

The idea, put forward by American economics professor Barry Eichengreen, is to use 'catastrophe bonds' or cat bonds as a capital insurance mechanism to protect the world's banks against systemic risk.

Rather than holding capital at all points in time to protect against major shocks, against which an additional bit of capital would be an inadequate buffer, Eichengreen says banks could sell cat bonds.

The return paid on the bonds would be like paying an insurance premium whose cost is equivalent to a bit of additional capital in the good times, in return for a large payout in the event that systemic risk materialises.

Cat bonds have been used in the insurance industry since the mid-1990s to securitise some of the higher-level risks that were too expensive for reinsurance.

The simplest definition of a cat bond is a security that provides reinsurance protection to the issuing company, usually an insurance or reinsurance company, in the case of a catastrophic event such as a hurricane or earthquake. They pay a margin over Libor and this can vary from 10 per cent for a less risky region to 20 or 30 per cent for places like Florida.

A cat bond collects funds from investors and deposits them in a trust account for possible reinsurance claim. If a catastrophic event does not occur, the investors have their principal and interest refunded. If an event occurs, investors would lose all or part of their principal.

Eichengreen says cat bonds are attractive to investors because they offer returns that are uncorrelated with those on other financial assets. This was one reason why the market for cat bonds had held up relatively well despite the severity of the credit crisis.

However, Eichengreen admits that the benefits of diversification would be less likely if cat bonds were used for capital insurance.

He said: “Returns to investors will decline in the event of systemic risk, which is precisely when the returns on their other investments will decline. It is not obvious, therefore, that financial cat bonds will be attractive to hedge funds, pension funds, sovereign wealth funds and sophisticated private investors.

The solution was to get the International Monetary Fund to provide a systemic risk facility that could underwrite systemic risk insurance for member countries in a similar fashion to the way in which the World Bank had provided the Caribbean Catastrophic Risk Insurance Facility.

Eichengreen's idea, which was floated in a paper released last month by the IMF, comes at a time when institutional investors are flocking to cat bonds.

Barney Schauble of the Bermuda-based alternative investment manager, Nephila Capital, told Business Spectator institutions were attracted to insurance-linked securities because the returns are not correlated with other asset classes.

Schauble says the recent $US35 million mandate Nephila won from AMP Capital Investors was part of a resurgence of interest that involved flows to Nephila of hundreds of millions of dollars.

A noteworthy aspect of the AMP decision was that it was based on advice from the investment consulting division of Mercer, one of the most powerful global gatekeepers in pension fund investing.

Nephila, which has also won mandates from MLC and one other large Australian institution, is one of the few hedge funds in the world to have provided returns that were close to “zero beta”.

Beta measures the correlation between the price movements of two different indices. A beta below one means the assets do not move in tandem.

Schauble says there are only about $US10 billion in cat bonds in the world. He agrees with Eichengreen that the biggest challenge for financial cat bonds would be finding the counterparty to cover the potential obligations.

He said the idea of a reinsurance bank to cover the “fat tail” risks of the banking industry was not that different to what the insurance industry had been doing for hundreds of years through companies such as Cologne Re.