For whom cat risk tolls

Once the preserve of just a handful of players, the niche market for catastrophe derivatives is growing in popularity. The privately negotiated market is flourishing as structured deals emerge and hedge fund activity picks up. By Navroz Patel

Casual observers of the catastrophe risk transfer market might be forgiven for thinking catastrophe bonds are the be-all and end-all when it comes to non-traditional sources of reinsurance. They're wrong.

Privately negotiated natural catastrophe derivatives and industry-loss warranties (ILWs), de facto catastrophe index options structured as reinsurance contracts, are viewed by many as an equally important instrument in encouraging the convergence of insurance and financial risks.

"There is a growing recognition among insurers that a certain percentage of protection should come from an alternative source, namely the capital markets," says Ed Torres, co-head of capital markets at Benfield Advisory in New York. Benfield Advisory is the corporate finance and advisory business of Benfield, a London-based reinsurer. "Reinsurers that previously used ILWs a little are now using them much more extensively."

As catastrophe risk models have gained greater credibility and acceptance, hedge funds have also grown increasingly comfortable with ILWs, says Torres: "There's a level of transparency in the pricing of cat risk that has created a lot of trading activity in derivatives-based ILWs."

Others agree. "During the past year or so, we have witnessed more of a trading mentality among buyers and writers of ILWs," says Paul Schulz, president of Aon Capital Markets, part of Chicago-based insurance and risk management specialist Aon. "The fact that, unlike cat bonds and traditional reinsurance, ILWs can be put together very quickly is of obvious appeal to hedge funds."

In fact, hedge funds are becoming a larger part of the reinsurance market generally, says Albert Selius, head of trading for asset-backed securities and insurance-linked securities at Swiss Re in New York. "Just look at some of the major multi-strategy funds that have opened up reinsurers in recent years. Many participate greatly in the market in derivatives format."

Managers set to enter reinsurance include Citadel Investment Group (Risk July 2007, pages 34-36)¹ and DE Shaw, Risk's current Hedge Fund of the Year (Risk January 2007, pages 56-57).² Bermuda-based property catastrophe market specialist DE Shaw Re launched earlier this year, with Darren Redhead, previously a senior underwriter with a Lloyd's syndicate, named as the new reinsurer's chief underwriting officer at the end of May.

Private equity funds have also been flexing their financial muscle. Initially launched in July 2006 with $500 million, Bermuda-based Aeolus Re announced in January that its capital base had increased to more than $1 billion via an investment from a group of investors including Warburg Pincus, an existing investor, and Merrill Lynch Global Private Equity. Aeolus Re is active in the ILW market.

Interest in the multi-billion-dollar catastrophe derivatives market began to truly build in the early 1990s. Contemporary estimates of the size of the market vary widely, from as low as $5 billion to more than twice that number. Industry analysts estimate that Swiss Re, one of the most active traders of ILWs and cat derivatives, traded between $1 billion and $2 billion of product during the first three quarters of 2007. Taking into account Swiss Re's activity in the ILW and cat derivatives market relative to its peers, the total size of the market is likely to be in the $7 billion-12 billion range, says Selius. Contracts are typically $5 million-10 million in size, with a one-year tenor.

ILWs are priced off industry-wide-type losses. In the US, this is often the Property Claim Services (PCS) index, an indicator of catastrophe-related property losses produced by ISO, a New Jersey-based insurance data specialist.

Although many use the term ILW interchangeably with 'catastrophe derivatives' or 'catastrophe swaps', ILWs are technically reinsurance products. To be classed as reinsurance, actual losses must be demonstrated. As such, an ILW contract will specify an industry-wide loss amount, often running into tens of billions of dollars, but will additionally stipulate another relatively small amount of actual losses (say, $10,000) that must be demonstrated for the contact to be triggered.

However, there has been a lack of standardisation in ILW contracts. This is now starting to change. "Firms are now putting dedicated staff on to the catastrophe derivatives product as activity grows, and standardisation of documentation for ILWs in derivatives format is coming," says Selius. "Removing opaqueness and uncertainty over what is and isn't included in trades will increase comfort among users that they are not being picked off in any way."

Indeed, Risk has learnt that Swiss Re, alongside several other dealers, has been in discussions with the International Swaps and Derivatives Association, with the aim of publishing draft standardised documentation that can be finalised after a comment period. Proprietary documentation for catastrophe derivatives offered by Swiss Re and Deutsche Bank are quite similar and are likely to form the basis of future Isda documentation.

Collateral is often required for ILW transactions - but the decision over whether the trade should be collateralised depends on the nature of the counterparty, says Swiss Re's Selius. For instance, a hedge fund manager can present a quite different counterparty risk proposition to one posed by a highly rated reinsurer. There are often other differences in the way risk is transferred too. "For reinsurers wanting to achieve reinsurance accounting, we are able to take the risk in reinsurance form then separately enter into a derivatives contract with a hedge fund or other counterparty to transform some of that risk," explains Selius.

Catastrophe risk traders say some major hedge funds balk at the suggestion they must collateralise catastrophe swap trades. The sound of endemic counterparty credit risk concerns in the over-the-counter market customarily causes derivatives exchange product development managers to prick up their ears, and this has indeed been the case with catastrophe derivatives.

Contracts have been listed on several exchanges, although volumes to date have been lacklustre. This year, there have been renewed efforts to get the market off the ground, with the Chicago Mercantile Exchange and New York Mercantile Exchange (Nymex) listing US catastrophe risk futures contracts in March, referenced to the US-based reinsurer Carvill's proprietary hurricane index and the PCS index, respectively. There has also been a collaborative effort by Deutsche Bank and the London-based Climate Exchange to launch catastrophe event-linked futures on the Chicago Climate Futures Exchange.

However, there are doubts about the flexibility of exchange-traded contracts. Benfield's Torres, for one, believes that, while the launch of exchange-traded catastrophe derivatives is indicative of the growing interest in ILW-type products, an exchange may not be the optimal market venue for this product. "ILWs require a degree of customisation not currently attainable on exchange-traded contracts," he says. "As an example, none of the trades Benfield has intermediated would conform to the specifications of the exchange-traded contracts. Still, exchange-traded markets can take time to develop."

Even some of those that have used the exchange-traded market in the past have reservations. "We have traded two options on Nymex futures, but that's it so far," says Swiss Re's Selius. New York-based interdealer broker GFI brokered the first cat derivatives transaction based on Nymex's new US cat futures contract in August. The two counterparties involved in the option trade were Swiss Re and Bermuda-based reinsurer Ascendant. "From our perspective, there are some obvious problems with the futures contract, which is why we elected to trade the option," says Selius. "Unlike with ILWs, there's no limit on potential losses for the protection seller, and the contract includes wildfires and riots."

The inclusion of wildfires and riots - perils that arguably have their roots in the vagaries of human behaviour - are especially contentious. "How can we model that, and consequently, how can I get sign-off from our risk manager to trade these futures?" says one multi-strategy hedge fund trader.

There is, however, some optimism about the long-term development prospects for futures contracts. Exchange-traded catastrophe and weather derivatives are likely to play an increasing role in insurance risk management in coming years, says Dane Douetil, London-based chief executive of Brit Insurance: "Real-time pricing of catastrophe risk could be of great benefit to the industry."

In fact, Swiss Re is currently working with numerous bourses to develop exchange-traded catastrophe derivatives markets, says Selius. "We don't know which will take off, if any. But if one does, we want to be there, so we will stay involved, remaining hopeful that the exchanges will build liquidity," he explains.

Proponents of catastrophe futures say the sceptics from the OTC market are being disingenuous in their critique of the exchange-traded market. "It's not as if liquidity in the ILW market is so great either," says one executive involved in the development of cat futures.

Indeed, there are currently significantly more protection sellers than buyers in the ILW market, concedes Swiss Re's Selius: "Appetite for cat risk is strong, so buyers of protection are demanding low prices, while protection sellers want higher prices. Liquidity has suffered." Most activity is focused on US wind and earthquakes, with trading of Europe wind picking up too, he adds.

Nonetheless, the lack of PCS-like indexes in Europe and Asia has hampered the global development of cat derivatives, say analysts. Earlier this year, Swiss Re began advocating the establishment of an independent agency to aggregate European claims data and produce an efficient market-loss index that would facilitate significant growth in the market for cat bonds and ILWs referencing European perils. It is widely anticipated the agency will be created before the end of 2008.

In the interim, at least one major catastrophe risk modelling firms is to launch parametric industry loss indexes for European and Japanese perils, Risk has learnt. Rather than being based on actual losses, a parametric index's value is dependent on the severity of the peril in question.

As well as development in the indexes, the construction of standardised documentation and the influx of hedge fund and private equity money into this space, there's also been plenty of innovation in structuring, with the appearance of a class of deals that has been long talked about: synthetic catastrophe collateralised debt obligations (CDOs).

Brit Insurance is one of only a handful of firms to have so far launched a synthetic CDO, and Douetil says the rationale for launching such a deal needs to be understood in a broader context. Increasing scrutiny by rating agencies means the total quantum of economic capital is increasingly being determined externally for European insurers. "We are very focused on return on net-tangible assets and run our own internal capital model, but there's less flexibility over the total quantum of capital required for a given amount of risk," he explains. "There is, however, flexibility in the composition of capital and that's where we've concentrated our efforts to become innovative and efficient."

As a result of these changes, insurance companies are increasingly asking themselves how they can optimise capital, with many questioning the amount of ordinary equity and subordinated debt that is issued, as well as how they can best use reinsurance and other forms of quasi-capital such as standby liquidity facilities and catastrophe instruments from the capital markets.

Brit Insurance responded to these questions by pioneering the use of long-term tier-two subordinated debt in 2004 and 2005 as an alternative to equity or short-term bank finance. Other medium-sized UK-based insurers soon followed suit. Then, in December 2006, Brit created an off-balance-sheet cash-collateralised catastrophic property reinsurance vehicle in Bermuda, capitalised by Brit and other institutional investors. Brit took a 19.6% lead interest in the new retrocessional player (called Norton Re) via a holding company structure. The vehicle had $101.7 million of capital at inception. "The deal has enabled us to take highly volatile catastrophe business off our balance sheet using a different form of capital base - namely the hedge fund industry," says Douetil. Separately, Brit has also begun to build a reinsurance presence in Gibraltar.

But Brit's biggest innovation involves derivatives-based ILWs and a huge swap within a synthetic CDO-type structure that has helped herald the beginning of the application of credit derivatives structuring techniques to the sphere of catastrophe risk.

Designed by New York-based reinsurance intermediary Guy Carpenter and ABN Amro (which created a similar deal called Bayhaven in 2006), Brit's Fremantle transaction was launched in June this year. In essence, Fremantle is a three-year static synthetic catastrophe CDO based on a portfolio of catastrophe derivatives referencing six major natural catastrophe risk types, including 10 specific perils: UK windstorm, Europe windstorm, Japan typhoon, Japan earthquake, California earthquake, new Madrid earthquake, Florida hurricane, Gulf hurricane, East Coast hurricane, and so-called by-passing hurricane (one that does not make landfall in the US or Mexico).

The Fremantle deal was the result of around two years of research and dialogue and, in effect, reinsures Brit for six specified losses in excess of an initial three losses. So, in CDO-theoretic terms, Brit retains the equity tranche exposure associated with the first three losses.

"Amortising the price of the deal over its three-year term, the pricing would compare very favourably with traditional ILWs, which, in any case, are typically only offered at a tenor of 12 months," says Douetil.

Fremantle issued a total of $200 million notes, rated by Moody's Investors Service and Fitch Ratings. The deal comprised: $60 million of AAA/Aa1 notes paying three-month Libor plus 90 basis points; a $60 million BBB+/A3 tranche offering three-month Libor plus 200bp; and $80 million of BB-/Ba2 notes paying three-month Libor plus 700bp.

As with all CDO-type deals, the rating, tranching and subordination of the notes are designed to appeal to a diverse cross-section - potentially attracting new investors into the catastrophe risk market.

Brit was also able to source three-year reinsurance - something that is typically not available in the traditional retrocessional market. "It's also cash-collateralised, which reduces counterparty credit risk," says Douetil. "And, importantly, by writing the cover as a swap between Brit and Fremantle, it can be recorded as an asset on our balance sheet."

This means that from Brit's perspective, once a loss occurs, the value of the swap increases as Brit is closer to receiving a payment should a fourth loss ultimately occur. "With traditional reinsurance, you would collect at the fourth loss then recognise that gain. Under the swap with Fremantle, the value increases from when an initial loss occurs, so assets and liabilities are better matched," Douetil explains.

Yet another innovative feature of the deal is a call option embedded into the structure. "It's entirely up to us to decide whether we want to cancel the deal at 12, 15 and 18 months, for a price," says Douetil. In this way, dependent on the pricing of catastrophe risk, and assuming no actual losses are experienced, Brit has the choice to pay a cancellation fee and reissue or source reinsurance elsewhere. "It has also created a reference pricing point for us in the market. There's no reason why we couldn't do private deals where someone pays us in excess of two losses, for instance." Douetil declined to comment on whether or not Brit has, or is considering, any such further transactions.

Many leading credit derivatives desks are convinced there is serious money to be made from applying credit derivatives structuring expertise to catastrophic risk transfer. And a number of institutional investors are also keen to get their hands on a highly rated credit-type instrument whose value is uncorrelated with that of mortgages, corporate credit or stocks. While some analysts have predicted the end of the CDO market since the turmoil in August and September, it seems the CDO isn't quite dead after all.

1 www.risk.net/public/showPage.html?page=456862

2 www.risk.net/public/showPage.html?page=359542.