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“It Could be You” (but not necessarily in a good way)

Andrew Stafford QC (London) and Jonathan D. Cogan (New York)

Kobre & Kim

“It could be you” is the catch phrase of the UK’s best known lottery game.  It may turn out to be applicable to Catastrophe Bonds (“CAT bonds”)unless insurers and investors are sophisticated and wary and have an appetite for pursuing or defending litigation.

CAT bonds are a form of Insurance Linked Security (“ILS”) and play an increasingly important role for insurers hedging against risks they are underwriting. They areessentially an alternative to re-insurance. In the United Kingdom, the Treasury has been encouraging the idea that London should become a hub for the fast-expanding market, currently estimated to be worth US $22 billion.  In May 2015, a task force was set up to investigate the establishment of London as a hub to compete with offshore centres such as Bermuda and Cayman.   In recent weeks, China reintroduced the first CAT bond covering Chinese earthquake perils.  Yields are generallyattractive, modelling implies catastrophic events are rare, and the bonds have so far generated little litigation.  This article explores some of the risks CAT bonds carry and what the future might look like.

When catastrophe strikes in the form of, say, an earthquake, flood or hurricane, an insurer faces huge claim demands.  Traditionally, the insurer would hedge this by means of re-insurance.  CAT bonds offer access to other funding as a means to hedge against the risk.  Package a whole series of catastrophe policies and sell derivative bonds paying an attractive yield and you have a CAT bond.

An insurer issues or sponsors the issue of a bond, often through a third party special purpose vehicle (“SPV”).  The investor hands over capital (the Principal) to the SPV.  The SPV may invest the Principal (usually AAA rated stock) and make regular payments to the investor, sometimes pegged to a market standard, such as LIBOR, during the period of the Bond.  Some Bonds may be traded on a secondary market.  At maturity, the Principal is returned to the investor – assuming that events have not intervened….

In the event of a catastrophe (in “real world” terms) third parties can determine whether it is a catastrophe for the purposes of the Bond and, if so, what the effect is on the Principal.  Some or all of the Principal may be sacrificed to the insurer at the investor’s loss.   This may wipe out the SPV’s material reserves, and may wipe out the bonds.

For the insurer, the attraction of issuing CAT bonds is the generation of capital reserves and diversifying risk.  Perils spanning different geographies, risk profile and type may be bundled together in a single product.  In place of anannually renewable and re-calculated premium, insurers can secure a hedge at a single price over a longer period of time.  The bond attracts buyers from beyond the traditional arena of re-insurers – selling bonds gives insurers access to a different source of capital.  There is also the perception that moving away from traditional re-insurance also means moving away from the downside of long-standing relationships – the pay-back cycle in which re-insurance premiums rise following an extreme insured event. For the bondholder, there is attraction of an annual return on investment,the likelihood of repayment on maturity, and the capacity to trade the bonds. Moreover, when interest rates are at historic lows, the annual yield on CAT bonds is especially alluring to prospective purchasers.

The success of CAT bonds depends in part upon the sophistication with which insurers calculate the risk of a trigger event and how this then translates into a commercially attractive issue price. It also depends upon the capacity of the prospective buyer to evaluate the risk.  There are two features which are worth noting.  The first is the modelling which underlies a CAT bond.  Insurers run highly complex programmes which enable them to reach a conclusion as to the probability of a trigger event over a particular period of time.  Unlike re-insurers which may be well-placed to subject modelling to close scrutiny, an investor from outside the insurance industry may lack the wherewithal to undertake a similar due diligence exercise.  Secondly, as with for example mortgage-backed securities, the process of bundling and packaging a series of policies inside the wrapper of a bond renders more opaque the substance of the underlying risk which the investor is buying.  Some commentators have expressed the view that CAT bonds will eventually generate a catastrophe of their own as a consequence of these features, a prediction which has itself been denied by some of the architects of bonds.

The consequences of a trigger event include the total wipe-out of the bond, with the loss obviously falling on the bond-holders.  In these circumstances, bond-holders have a powerful incentive to find ways to evade this unpleasantness. There are five options will likely present themselves in these circumstances.  The first option is litigating the terms of the bond, seeking to establish that the catastrophe falls outside the scope of the contractual trigger, or that the contractual trigger has not been validly pulled.  Second, it may be possible to litigate on the basis that the way in which the bond was presented offends relevant prospectus rules.  Third, the bond-holder could argue in litigation that the bond has been mis-sold (a variation on the second).  Fourth, the bonds could be sold as distressed debt to so-called vulture funds, leaving those with most appetite for litigation to take up the cudgels.  Fifth, the bond-holders could also sue third parties which have played a role in the issue and operation of the bond.

These options echo responses to the default or near wipe-out of other securitised debt of recent vintage. CAT bonds themselves have so far been litigated very rarely.  One example of CAT bond litigation is the Mariah Re case which was recently before the Second Circuit Court of Appeal in the United States.

Mariah Re Ltd. (“Mariah”) was a SPV established to provide reinsurance to American Family Mutual Insurance Company (“American Family”).  ISO Services, Inc. and AIR Worldwide Corporation signed agreements with Mariah obligating them to report on severe weather events and calculate the amount, if any, Mariah would need to pay to American Family.   Mariah was wiped out.  The contention was that ISO Services, Inc. and AIR Worldwide Corporation had acted in breach of their contracts, as a consequence of which Mariah Re had paid to American Family far more than was contractually due.  In addition to suing ISO Services, Inc. and AIR Worldwide Corporation, proceedings were also pursued against American Family on the basis of breaches by it of its reinsurance contract with Mariah Re, and for unjust enrichment.  Mariah (by then in liquidation) was used as the vehicle to sue third parties – the external severe weather reporter, the calculation agent, and the insurer which received the pay-out from Mariah.

Mariah is a perfect example of the dynamic inherent to CAT bonds.  The wipe-out event incentivised the SPV to litigate.  The cost-benefit analysis of litigation was obvious in view of the wipe-out.  When weighing up whether to invest in CAT bonds, potential investors will take into account the potential avenues for recourse.  Those involved in the issue and operation of bonds (including third party contractors) will note that when a catastrophe strikes, there will be no shelter from being drawn into litigation.  With this kind of scenario in mind, it points to one conclusion – stormy weather ahead.