The global financial turmoil should not trouble the cat bond market.

The financial crisis, which spread like wildfire because of the securitisation and repackaging of debt based on subprime mortgages, shows no sign of abating. Will cat bonds, themselves a form of securitisation, suffer in the backlash?

In fact, cat bonds have proved resilient and a relatively safe haven in the financial storm. There are very few sections of structured finance that have remained open to new issues (among the few are US auto loans, student loans and credit cards). But cat bonds have remained open and 2008 could be the second-highest year in history for new issuance.

The use of capital markets as a tool for insurance companies has grown massively since its inception more than a decade ago. Although cat bond activity has slowed in 2008, a longer perspective reveals that cat bond activity is still high.

There are reasons for the boom in cat bonds over the past few years. After hurricane Katrina (the most expensive natural disaster ever to strike the US), there was a surge in demand for reinsurance and not enough capacity. Traditional reinsurance, when it was available, was highly priced. Cat bonds filled a need and brought, in addition, the advantages of full collateralisation and the important idea of insurers being able to access the world’s capital markets.

Equally, there are reasons for cat bonds’ recent comparative slowdown in 2008. Today, there is sufficient capacity in the reinsurance market and prices for reinsurance are cheaper. With cat bonds still positioned as providing surplus capacity, it is no wonder that cat new issues have slowed.

As for the effects of the credit crunch, the uncorrelated nature of cat bonds has made them relatively free of contagion. Cat bonds cover hurricane or earthquake risks: the wind and the earth do not care what the capital markets are doing.

But the cat bond sector had one strike against it. On 19 September, a few days after Lehman Brothers filed for protection under Chapter 11 of the US Bankruptcy Code, ratings agency

AM Best placed the debt ratings of a number of Lehman-related cat bonds under review with negative implications. This was because Lehman is the swap counterparty on each of these bonds and there is some doubt as to whether Lehman will be able to meet its obligation under the swap agreement. The affected cats are: Newton Re, whose sponsor was Catlin, Willow Re (sponsor Allstate) and Ajax Re (sponsor Aspen Re).

The impact of the early termination of the swap agreement is unclear at the time of writing. It is possible that the swap counterparty could be replaced.

A sign of health in the insurance linked securities sector is that secondary market trading volume has increased. Trading in already issued bonds is more than $3bn (£1.6bn) in the year to date. This figure is higher than the total number of new issues in 2008 to date. Trading exceeds issuance for the first time ever.

Part of the reason for the increased trading volume is the exit of some hedge funds from the sector, with trading volume up because they are selling their cat positions, often to cover losses in other sectors. This is actually a sign of health in the sector, whose investor base has been supported by the formation of several new specialist funds, and by new capital inflows.

Cat bonds offer a form of uncorrelated risk that should prove attractive for investors seeking a safe haven in a financial storm.

Key points

• Cat bond new issuance has slowed in 2008.

• Secondary trading volumes are high.

• The investor base is growing with new funds formed.

• The uncorrelated nature of cat bonds means they have largely avoided the subprime contagion.