FOURTH QUARTER 2013 | ISSUE 1
U
nder the Insurance Law of the Cayman Islands, a Class C License is required for the carrying on
of insurance business involving the provision of reinsurance arrangements in respect of which the
insurance obligations of the Class C Insurer are limited in recourse to and collateralised by the Class
C Insurer’s funding sources or the proceeds of such funding sources which include the issuance of bonds or
other instruments, contracts for differences and other such funding mechanisms approved by [the Cayman
Islands Monetary] Authority. This classification is aimed at issuers of catastrophe bonds (cat bonds) and other
insurance linked securities (ILS) who raise finance to support reinsurance transactions. 2013 marks 16 years
of cat bond issuance since the original architecture for today’s cat bond model was utilised by Residential
Reinsurance Limited, a Cayman domiciled reinsurer, to raise $477 million in one-year bonds which facilitated
an equivalent measure of single hurricane reinsurance protection to USA. This was swiftly followed by SR
Earthquake Fund, Ltd., another Cayman domiciled reinsurer, for which Swiss Re placed $137 million in bonds
to provide California earthquake reinsurance. Cayman has been the leading domicile for cat bonds ever since.
Innovation has always been the
watchword of alternative risk financing.
In the last two decades, no sector has
seen more innovation than the financing
of catastrophe risks, and in particular the
direct link between the capital markets
and the insurance market in the form of
catastrophe bonds (“cat bonds”).
The first cat bonds to come to market
in 1996/97 created an amount of
speculation that it is difficult to envisage
today: Would they be understood and
accepted by investors? Who would those
investors be? How would they price?
Was there sufficient transparency?
Would the default mechanisms work?
Was this a temporary source of
reinsurance capacity? They are now,
however, a well-established source of
reinsurance capacity and an established
asset class for investors. While events
of default have been few, they have
served to prove the viability of these
transactions to ceding insurers. As
an asset class, they have proven
attractive to both generalist and
specialist investors.
Founded on Innovation
Since the inception of the first bond,
we have seen numerous innovations
in transaction structures. By way of
example, while cat bonds are offered
only to accredited, mainly institutional
investors, many such investors are not
permitted to invest in bonds where
the principal is fully at risk.
What is a
Cat Bond?
Cat bonds are notes issued
by a special purpose
reinsurer. They provide
for normal redemption at
the end of a pre-determined
period, but in the event of a
catastrophe that falls within
defined limits, ie geographic
limits, type of loss and size
of insured loss, the holders
of the bonds contribute.
This contribution may be
in the form of forfeiture
and/or delay of some or all
of the notes principal and
interest. The defined limits
of default are determined
by a reinsurance contract
between the issuer and an
insurance company, for
which the maximum limit
of coverage equals the
note proceeds.
In response to this, cat bond issuers
break transactions into tranches,
offering different classes of bonds to
investors with different risk appetites
and parameters. These included floating
rate and fixed rate bonds.
Similarly, the early transactions
included interest-only swaps, with
independent counter-parties. Later,
total return swaps were used. Following
the 2008 collapse of Lehman, who
were swap counter-party to four live c