22 August 2013

Risk.net: Cat bond 'lite' structures raise contamination risk and insolvency fears

Experts are divided on the use of segregated accounts companies (SAC) in so-called catastrophe bond 'lite' transactions, with some suggesting they introduce an increased element of risk compared with more traditional structures.

In a typical cat bond issue, catastrophe risk is transferred from the cedant to the capital markets via a fully collateralised special purpose vehicle (SPV) completely separated from the operations of the ceding (re)insurer. The process is standardised under Rule 144a of the US Securities and Exchange Commission.

In contrast, cat bond lite transactions aim to strip away the structuring, legal, and distribution costs of a Rule 144a issue to provide cedants with faster and more cost-effective access to the capital markets. Some providers use their own proprietary SPV programmes as intermediaries in these transactions, while others are experimenting with SACs.

In the latter case, segregated accounts (or cells) are used to isolate different groups of assets and liabilities from each other and the SAC's general account. However, all the cells and holding company are viewed as a single legal entity under law.

Some lawyers claim the SAC's legal status means catastrophe bonds issued using an SAC are vulnerable to certain risks not shared by SPV structures.

Some cat bond investors also have concerns about the SAC structure. One chief executive at a European insurance-linked securities investment firm says the cell structure may break down in some circumstance and not protect individual investors' assets - for example, if a court freezes the SAC's assets.

In such an event, investors holding bonds in cells not subject to legal action could still find their coupon and principal payments frozen by the courts.

Contamination risk could also occur if a cedant observes a collateral deficiency in their allotted cell and demands additional collateral as recompense from neighbouring cells.

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