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Catastrophe Bonds !

Catastrophe Bonds
Frequently Asked Questions

Q: What are catastrophe bonds?
A: Catastrophe bonds - or in short CAT bonds – are securities whose
reimbursement value may be diminished as a consequence of a natural
catastrophe event.


Q: What is the purpose of CAT bonds?

A: CAT bond transactions are sponsored by corporations which are seeking to buy
additional financial protection against natural catastrophe events in addition to the
cover they can obtain in the insurance and reinsurance marketplace.
The vast majority of the sponsors so far have been insurance companies and
reinsurance companies. However, CAT bonds may also be sponsored by
companies belonging to other industries.

Q: Why should an investor have an interest in CAT bonds?
A: Natural catastrophe risks offer an excellent means of diversification, as they are
marginally correlated to financial risks.
The typical way for investors to carry natural catastrophe risks is to hold equity in
property insurance companies. One drawback of this scheme is that the
catastrophe risk is not dissociable from other risks like management risk, reserve
deficiency risk, or investment risk.
Investing in CAT bonds represents a more structured and documented way of
assuming natural catastrophe risks exposure than investing in the equity of
insurance companies.


Q: How big is the CAT bond market?
A: The market has been growing regularly for the last five years and currently
exceeds $2 billion.

Q: What is the structure of a CAT bond transaction?
A: CAT bonds are issued by Special Purpose Vehicles (SPVs). The SPV is a passive
and independent intermediary structure standing between the catastrophe bond
holders and the sponsor.
Immediately after issuing CAT bonds to investors, the SPV enters into a cover
agreement with the sponsor, through which the SPV provides the sponsor with a
protection against natural catastrophe events.
The SPV puts the proceeds received from the CAT bond issuance into a trust
account. The SPV uses this fund as collateral in order to secure its obligation
under the cover agreement.


Q: What happens when a natural catastrophe event occurs?
A: The cover agreement defines the conditions under which the sponsor is entitled
to receive an indemnity from the SPV. If an indemnity is due, the SPV uses the
funds available in the trust account to indemnify the sponsor. Any payment of
indemnity to the sponsor translates to an equivalent reduction of the
reimbursement value of the CAT bond for the investor.


Q: How is the indemnity, hence the reduction of reimbursement value,
calculated?

A: The calculation can be based on the monetary amount of loss incurred by the
sponsor as a result of the natural catastrophe event, after application of a
franchise. Alternatively, the calculation can be based on an index reflecting the
market loss generated by the natural catastrophe event. For some other CAT
bonds, the calculation is based on certain physical parameters of the natural
catastrophe event. The calculation process is supervised by an independent
auditor.

Q: Why are CAT bonds not issued directly by sponsors?
A: Catastrophe bonds may be issued directly from the sponsor’s balance sheet,
but this creates more inconveniences than advantages. Particularly since using a
separate structure like the SPV turns out to be more secure for investors for it
immunizes them against the sponsor’s credit risk.


Q: How is the natural catastrophe risk in a CAT bond quantified?
A: The natural catastrophe risk is comprehensively analyzed and documented by
an independent risk modeling agency. The analysis relies on sophisticated models
which are widely recognized and used in the insurance industry.


Q: Do CAT bonds have ratings?
A: The majority of CAT bonds are rated by one or more agencies. Rating categories
for CAT bonds are the same as that for other types of bonds.
Most CAT bonds are rated in the “BB” category which indicate that the risk of
incurring a reimbursement value reduction is assessed to be in the 1% region.


Q: What levels of return do CAT bonds produce?
A: Most CAT bonds pay quarterly variable interest rates indexed on LIBOR.

Spreads offered by CAT bonds are significantly wider than those offered by other
asset classes in a given category of rating.
For example, “BB” CAT bond are currently issued with spreads ranging from 450
to 650 bps, representing attractive multiples of their estimated expected loss.
The Sharpe ratio, which measures the amount of expected margin by unit of risk,
is commonly well above 0.4 for CAT bonds.

Q: How long is the maturity of a CAT bond?
A: Most CAT bonds have a scheduled reimbursement date which is 12, 24 or 36
months from the issuance date. The scheduled reimbursement date is the actual
reimbursement date, if no eligible natural catastrophe event occurred during the
risk period.
There is commonly a provision specifying that the reimbursement date might be
extended a couple of months after the scheduled reimbursement date, if a loss
occurs and requires some extra time in order to be evaluated.

Q: What kind of secondary market exists?
A: A secondary market does exist and is being developed by a couple of market
makers.
In the absence of a natural catastrophe event, most CAT bonds can easily be
traded around their par value for amounts of up to five million dollars.
Depth decreases when a natural catastrophe event has occurred or is about to
occur, although, transactions can still take place at a discount, as was witnessed
in September 1999 when Hurricane Floyd was threatening the East Coast.


Q: How have CAT bonds performed historically?
A: To date, CAT bonds have performed very well, despite some significant natural
catastrophe events. The few CAT bonds which have matured to date have been
redeemed in full without any loss to the investors.


Q: Who should invest in CAT bonds?
A: The CAT bond market is restricted to qualified institutional buyers as defined in
rule 144A of the Securities Act.
Investing in CAT bonds implies a certain level of risk and must only be considered
as part of a global strategy of diversification.
CAT bonds produce a low level of risk correlation with other classes of assets and
can, therefore, dramatically help improve the expected return/risk pattern of an
investment portfolio.

Q: Why should an investor contact SOREMA?
The CAT bond market requires insurance and reinsurance expertise in order to
make sure that deals are properly structured and that prices are acceptable.
SOREMA has significant experience in the field of natural catastrophe risks and
has always been among leaders in using modern risk modeling techniques.
Furthermore, SOREMA was one of the early participants in the CAT bond market
both as a sponsor and as an investor.

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(Last update : Tue, 26 Jun 2001)