Are ILS investors repeating the mistake of ‘Lehman’?

Jul 2015

Prior to 2008 the standard Cat Bond collateral structure was using a total return swap (“TRS”) with the structuring investment bank. The investment bank invested the collateral into securities of their choice, subject to certain constraints, and swapped the interest rate into LIBOR and guaranteed repayment. Over time and little by little the collateral security requirements were weakened, as with all structured finance products, and the investment banks had greater scope. A cynic may say that the investment banks were given cheap rolling finance from the TRS product. Lehman was one of these banks, providing a TRS for 4 cat bonds. When Lehman failed investors had to rely on the underlying collateral, which was found to be highly rated, long duration CDOs and in one case a ‘regulation triple-X’ cat bond whose underlying risk was a poor performing portfolio of CDO and other investments. Given all the underlying investments were trading at a discount, these 4 cat bonds all lost value, some considerably. Due to inadequate structuring, the cat bond market, which purported to investors to be free of econometric risk, suffered losses as a result of Lehman failing.

Today we are seeing signs of a similar and even more dangerous structural weakness seeping quietly into the market...