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CAT BONDS – LITIGATION PERSPECTIVES

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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.

Investing

Northern Trust: Outsourcing Accelerates Through Pandemic as Investment Managers Seek to Improve Margins, Enhance Business Resilience, and Future-Proof Operations

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Northern Trust: Outsourcing Accelerates Through Pandemic as Investment Managers Seek to Improve Margins, Enhance Business Resilience, and Future-Proof Operations 1

White Paper Sees Increase in Managers Outsourcing Middle and Front Office Functions to Achieve Optimal Business Structures

According to a white paper published today by Northern Trust (Nasdaq: NTRS), investment managers of all sizes and strategies have been prompted to undertake a comprehensive review of their operating models as a result of the Covid-19 pandemic which has accelerated existing trends that are compounding cost pressures. This has led increasing numbers of managers to outsource in-house dealing and other functions, such as foreign exchange and transition management, hitherto seen as core.

While cost savings remain a core driver, and indeed are one outcome of outsourcing, costs are no longer the only focus. Far from being solely a defensive reaction to increased pressure on margins, the white paper (‘From Niche to Norm’) describes outsourcing as part of the target operating model, or moving toward the ‘Optimal State’ for many investment managers, and  explains how the focus “has expanded to the variety of other potential benefits offered – enhanced capabilities, improved governance and operational resilience.”

Gary Paulin, global head of Integrated Trading Solutions at Northern Trust Capital Markets said: “The pandemic has challenged a range of operational assumptions. Working from home has, for example, questioned the need for a portfolio manager to be in close proximity with the dealing desk. Previously considered essential, the pandemic has effectively forced firms to ‘outsource‘ their trading desks to remote working setups and the effectiveness of this process has disproved the requirement for proximity, in turn, easing the path to third-party outsourcing. Many investment managers are actively considering outsourcing to a hyper-scale, expert provider as a potential, cost efficient solution – one that maintains service quality and, hopefully, improves it whilst adding resiliency.”

Northern Trust’s white paper compares outsourced trading to software-as-a-service stating: “instead of carrying the cost and complexity of running an in-house solution, firms move to an outsourced one, free up capital to invest in strategic growth and move costs from a fixed to a variable basis in line with the direction of travel for revenues.” 

Guy Gibson, global head of Institutional Brokerage at Northern Trust Capital Markets said: “The opportunity to deploy capital to build new fund structures, develop new offerings, focus on distribution and enhance in-house research has been taken up by several of our clients to the benefit of their investment approach, and to the benefit of their investors.  Additionally, in the last two months alone, many firms have recognized that outsourcing to a well-capitalized, global platform has enabled them to take advantage of cost-contained growth opportunities in new markets.”

A further development, which has echoes of the journey the technology industry has already undertaken, is the move towards ‘whole office’ solutions, which represent the next potential wave in outsourcing.

According to Paulin; “recently we have observed a growing number of managers wanting to outsource to a single, hyper-scale professional service provider who can do everything, everywhere. This aligns with Northern Trust’s strategy to deliver platform solutions for the whole office, serving our clients’ needs across the entire investment lifecycle.”

The white paper can be downloaded here.

Integrated Trading Solutions is Northern Trust’s outsourced trading capability that combines worldwide locations and trading expertise in equities and fixed income and derivatives with access to global markets, high-quality liquidity and an integrated middle and back office service as well as other services, such as FX. It helps asset owners and asset managers to meaningfully lower costs, reduce risk, manage regulatory compliance and enhance transparency and operational efficiency.

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How are investors traversing the UK’s transition out of lockdown?

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How are investors traversing the UK’s transition out of lockdown? 2

By Giles Coghlan, Chief Currency Analyst, HYCM

Just when we thought we had overcome the initial health challenges posed by COVID-19, the UK Government has once again introduced lockdown measures in certain regions to curb a rise in new cases. This is happening at a time when the government is trying to bring about the country’s post-pandemic recovery and prevent a prolonged economic downturn.

This is the reality of the “new normal” – a constant battle to both contain the spread of the virus but also avoid extended economic stagnation.

Of course, no matter how many policies are introduced to spur on investment, traders and investors are likely to act with caution for the foreseeable future. There are simply too many unknowns to content with at the moment.

To try and measure investor sentiment towards different asset classes at present, HYCM recently commissioned research to uncover which assets investors are planning to invest in over the coming 12 months. After surveying over 900 UK-based investors, our figures show just how COVID-19 has affected different investor portfolios. I have analysed the key findings below.

Cash retreat

At present, it seems that by far the most common asset class for investors is cash savings, with 78% of investors identifying as having some form of savings in a bank account. Other popular assets were stocks and shares (48%) and property (38%). While not surprising, when viewed in the context of investor’s future plans for investment, it becomes evident that security, above all else, is what investors are currently seeking.

A third of those surveyed (32%) said that they intended to put more of their wealth into their savings account, the most common strategy by far among those surveyed. This was followed by stocks and shares (21%), property (17%), and fixed interest securities (17%).

When asked about what impact COVID-19 has had on their portfolios throughout 2020, 43% stated that their portfolio had decreased in value as a consequence of the pandemic. This has evidently had an effect on investors’ mindsets, with 73% stating that they were not planning on making any major investment decisions for the rest of the year.

Looking at the road ahead

So, it seems that many investors are adopting a wait-and-see approach; hoping that the promise of a V-shaped recovery comes to fruition. The issue, however, is that this exact type of hesitancy when it comes to investing may well slow the pace of economic recovery. Financial markets need stimulus in order to help facilitate a post-pandemic economic resurgence, but if said financial stimulation only arrives once the recovery has already begun, the economy risks extended stagnation.

It seems, then, that there are two possible set outcomes on the path ahead. The first is a steady decline in COVID-19 cases, then an economic downturn as the markets correct themselves, followed by a return to relative economic stability. The second potential outcome is a second spike of COVID-19 cases which incurs a second nationwide lockdown – delaying an economic revival for the foreseeable future. At present, the former of these two scenarios is seemingly playing out with economic growth and GDP steadily increasing; but recent COVID-19 case upticks show that it’s still too soon to be certain of either scenario.

A cautious approach, therefore, will evidently remain the most common investment strategy looking ahead. But investors must remember that, even in the most uncertain times, there are always opportunities for returns on investment. Merely transforming a varied portfolio into cash savings risks a long-term decline in value.

High Risk Investment Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. For more information please refer to HYCM’s Risk Disclosure.

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Hatton Gardens 5 top tips for investing in Diamonds

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Hatton Gardens 5 top tips for investing in Diamonds 3

By Ben Stinson, Head of eCommerce at Diamonds Factory

Investing in diamonds can be extremely rewarding, but only if you know what to look for. For investors who lack experience, finding your diamond in the rough can be quite daunting.

For even the most beginner of diamond investors, the essentials are fairly obvious. For instance, you need to ask yourself will the diamond hold its value over time? What’s the overall condition of the stone and the jewellery? Is there history behind the item in question?

Although common sense plays a big part in investing, people often need insider tips and tricks to go from beginner to expert. Tony French, the in-house Diamond Consultant, at Diamonds Factory shares his professional knowledge on the 5 most important things to look for when investing in diamonds.

1: Using cut, weight and colour to determine value

Firstly, consider the shape, colour, and weight of your diamond, as this can play a pivotal role in guaranteeing growth in the value of your item. Granted, investing trends change with time, but a round cut of your diamond will almost always be the most sought after. The cut of your diamond is incredibly important, as it can influence the sparkle and therefore, the overall value. It’s a similar story for the intensity of some colours, such as Pink, Red, Blue, Green etc. Concerning weight, the heavier (bigger) stones will generally increase in value by a bigger percentage. Collectively these factors also contribute to the supply and demand aspect, which will determine their high price, and will ensure your item is re-sellable.

2: Provenance

Looking for significant value? Well, aim to own jewellery or diamonds that come from an important public figure. If you’re lucky enough to own a piece that has significant history, or was owned by a celebrity or person of interest, it’s an absolute must to have concrete evidence of this. Immediately, this proof will increase an item’s overall value, and there’s a good chance the stardom of your item might drum up interest amongst diehard fans, increasing the value even further…

Equally, it’s possible to proactively bring provenance to unique diamonds of yours. For instance, you can offer to loan bespoke, or unusual pieces for film, theatre, or TV performances – then it can be advertised as worn by xyz.

3: Find the source

Ben Stinson

Ben Stinson

Establishing your diamond’s source is one of the most important things you can do when investing in diamonds. If you’re starting out, try to purchase diamonds that have NOT been owned by too many people, as the overall value of the diamond will reflect multiple ownership. Alternatively, I’d always recommend buying from suppliers like ourselves or other suppliers and retailers, who buy directly from the people who have had them certified.

Primarily, this will allow you to have a greater degree of transparency, which is crucial when buying such a valuable item. Next, you should immediately see an increase in value of your diamonds, as identifying a source will allow traceability and therefore, market context.

4: Certification

Linked closely with my previous point, is the requirement to ensure that your diamonds are certified by a credible lab, and you have the evidence to prove so (a written document with specific grading details about your diamonds) – this will remove any doubts of impropriety.

It’s essential to remember that not all labs are the same, and many labs are better than others. Both the AGS (American Gem Society) and GIA (Gemological Institute of America) have great reputations and are world renowned. I’d recommend doing your own research into the labs, and when you’ve found the pieces that you’d like to invest in, then make an informed decision based upon your findings. Ultimately, proving certification will make your stones easier to insure, and deep down, you can have peace of mind knowing you have got what you have paid for.

Don’t forget to keep this paperwork in a safe location as well – you’d be surprised how many people we’ve met who have lost, or forget where they’ve placed it.

5:  Patience is a virtue…

If the market is strong, it might be tempting to look for an immediate sale once you’ve purchased a high value item. However, I suggest holding onto your diamonds for some time before even thinking about selling. More often than not, an item is more likely to increase in value over a few years than a few days – try and wait a little longer!

Equally, I would encourage having your diamonds, or jewellery professionally valued regularly. If you don’t have the knowledge to make a rough judgement on how much your pieces are worth, a consultant or expert can provide both a valuation, and contextualise that amount in the wider market. From there, you should be empowered with the knowledge to decide whether to keep or sell.

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