Top cats

Cat bonds, which cover the risk of natural disasters, have become big business offshore. Anthony Smyth and Philip Paschalides report on Irish and Cayman dominance in the sector

The recent earthquakes and tsunami in Japan, together with other major natural catastrophes in both Australia and New Zealand, have caused large-scale devastation and tragic loss of life in those regions.

From an economic perspective, massive losses have been generated by these events. A portion of those economic losses will be met by the global insurance industry, which will put a dent in the balance sheets of the insurers and reinsurers that have underwritten the risks. With a finite amount of capital in the insurance and reinsurance world – and therefore a limited capacity to underwrite new risks – and with Solvency II heralding important regulatory changes affecting capital requirements, insurers will be looking to alternative channels to raise capital to cover catastrophic risks.

One such alternative to holding risk on an insurer’s balance sheet (or ceding to a ­reinsurer) is to spread the risk to the capital markets through the issuance of catastrophe bonds, also known as ’cat bonds’.

Cover version

The benefits of cat bonds are twofold. First, they can provide an attractive return to investors so long as the insured event does not occur, and second they provide cover to the sponsor by allowing risk to be offloaded from the insurer or reinsurer’s balance sheet and passed to investors.

Since 2001 the market for cat bonds has grown substantially, reaching $12bn (£7.5bn) in 2010. Since the global financial crisis investors have sought yield that is uncorrelated to the credit markets – in cat bonds they have found it.

There are now specialist investment funds that invest exclusively in cat bonds, and after recent changes to hurricane risk ­models, prices in the secondary cat bond market quickly rebounded – evidence of ongoing investor appetite. Since the tragedies in Asia industry sages have ­predicted that this market may double in the next two or three years. As the levels of bond issuance increase, two jurisdictions have emerged in this highly specialised market as the locations of choice for cat bond-issuing vehicles – Ireland and theCayman Islands.

Ireland has traditionally been favoured by many Europe-domiciled insurance ­corporations for insurance-linked securitisation transactions to provide cover against both European and Japanese windstorm and hurricane risks. The attraction of ­Ireland owes much to initiatives taken by the Irish government and industry in ­introducing innovative legal and tax changes to ensure the country can react to market and product changes and maintain its competitive position.

Special interest

Of particular significance to cat bond issuance vehicles is Ireland’s relatively ­flexible legal and regulatory environment, which permits cat bond issuances to be undertaken by both regulated and ­unregulated entities. These can either be special purpose reinsurance vehicles (SPRVs) or special purpose vehicles (SPVs).

SPVs are used in cases where underlying risk is transferred by synthetic means, using a derivative, rather than through a reinsurance arrangement, where SPRVs are used.
Making Ireland attractive in this sector are Ireland’s favourable tax regime for SPRVs and unregulated SPVs, which permits cat bond issuances to be undertaken on a tax-neutral basis; its early implementation of the EU’s Reinsurance Directive, which established a bespoke regulatory regime for SPRVs and enhanced Ireland’s suitability as a location for a variety of insurance-linked transactions; and its lack of minimum ­capital funding requirements for SPRVs.

As a traditional home for captive ­insurance companies and the domicile of choice for capital markets transactions in the Americas, it was inevitable that Cayman would develop into the premium cat bond jurisdiction in the Americas when the insurance and capital markets converged, to the point of eclipsing Bermuda – perhaps the more obvious contender for this business.

Cayman has housed the majority of cat bond deals in the Americas to date, providing cover for risks as diverse as hurricane, earthquake, windstorm and wildfire exposure, as well as accommodating structures addressing more esoteric areas such as medical benefits claims risk and longevity risk.

Cayman’s prominence is due to the same combination of attractive factors that makes it ideal for other structured debt capital markets transactions – tax-neutrality, a proven record, creditor-friendly insolvency law, a sensible and pragmatic regulator and an experienced, sophisticated and ­professional workforce.

The advantages are only set to increase following last year’s modernisation of ­insurance law, which created a new category for cat bond issuers, specifically recognising the highly structured nature of insurance-linked securities such as cat bonds and the expectations of those who participate in them, whether as investors or sponsors.

When the new law comes into force later this year the regulatory framework can only enhance Cayman’s offering and ­support the growth of this exciting and dynamic market.

Anthony Smyth and Philip Paschalides are partners in the structured products and capital markets group of Walkers Global in the Dublin and Cayman Islands offices respectively