More control is needed over the investment of collateral funds.

One of the much vaunted advantages of cat bonds has been their full collateralisation. In traditional reinsurance, no collateral is offered to the cedant. In contrast, when a cat bond is issued, the investors’ money is held as collateral. This collateral is released to the bond’s sponsor (the cedant) in the case that the trigger event (storm, earthquake and so on) occurs. If the bond is not triggered, then the money is returned to investors on maturity of the bond. All good for cat bonds, you may well think.

Now, it turns out, to many people’s surprise, that the money held as collateral for some cat bonds has been invested not, as might be expected, in low risk securities such as treasuries, but in subprime-related debt. This has only come to light because Lehman Brothers filed for Chapter 11 protection on 14 September and was unable to continue in its role as total return swap (TRS) counterparty on four cat bonds. (A TRS is a way of guaranteeing the bond: the guarantees, in the case of these four cats, are now likely to be worthless.)

The four bonds, the total value of which was three quarters of a billion dollars, are now in default. They are: Newton Re Series 2008-1 (sponsor Catlin), Willow Re Series 2007-1 (sponsor Allstate), Ajax Re Series (sponsor Aspen Re), and Carillon Series 1 (sponsor Munich Re).

Details of what the collateral funds were invested in have not been revealed, but it is understood to include, in at least some cases, mortgage-related collateralised debt obligations (CDOs). Again, it has not been revealed at what level these investments now stand, but it is understood that, in some cases, they stand considerably below par.

Therefore, if a trigger event were to occur, the full amount of money invested would not be available to pay sponsors. Equally, if there is no trigger event and the bonds mature, the bond investors will not, as things stand currently, get their principal back in full – even though the event they were insuring against never happened. While there is no suggestion of any wrongdoing, this is clearly not what investors expected.

Cat bonds need to be reformed. In particular, much greater transparency is necessary if the sector is to continue to flourish as it has done over the past few years. Currently, if an investor seeks to buy a cat bond in the secondary market, there is no way for that investor to find out what the underlying assets are invested in, whether treasuries, CDOs or CDO variants. That must change.

Michael Eakins, executive director, insurance financing group, at Goldman Sachs, suggests transparency could be increased by using online data rooms. The online data room would be kept live throughout the term of the bond and any information required to be shared with investors would be posted there. He also suggests that the rules governing investment of assets underpinning the TRS for cat bonds should be strengthened: certain structured asset classes should be excluded. In addition, there should be frequent marking to market, with collateral being posted below threshold levels and potentially independent third-party review of the asset valuation.

Cat bonds are a great financial invention. It would be a shame if the collapse of Lehman Brothers led to any sullying of their reputation. Rapid reform should ensure it does not.

Key Points

• One of the advantages cat bonds have over traditional reinsurance is full collateralisation.

• However, there has been insufficient transparency over what the underlying assets are invested in.

• Problems have emerged because of the collapse of Lehman, which guaranteed four cat bonds.

• The way forward involves more transparency and stronger rules.