Monday, February 02, 2009

Cat bonds correlate with everything else

One of the appeals for Catastrophe bonds was their "non-correlative" properties and structure of probable ("expected") returns.

Since the weather is not governed by market swings or the games men play, contracts based on outcomes from same would provide attractive properties for players seeking independence of returns.

Turns out, in recessions, everything correlates. The below article has some confusing language regarding the contract structure, but the gist of the problem is that counter-party risk trumps acts of G0d. (Option guys would say the gamma of risk is no-where near constant)

By Neil Unmack and Oliver Suess

Feb. 2 (Bloomberg) -- A catastrophe bond sold by Allstate Corp. faces “imminent” default, according to Standard & Poor’s, because of losses caused by the collapse of Lehman Brothers Holdings Inc., only the second such security to fail in a decade.

New York-based S&P downgraded $250 million of debt sold by Allstate’s Willow Re Ltd. to D, the lowest grade, from CC, according to a Jan. 30 statement. Northbrook, Illinois-based Allstate sold the bonds in 2007 to protect against losses caused by U.S. hurricanes.

“The issuer has notified Standard & Poor’s that it will not have sufficient funds to make the scheduled interest payment,” S&P analyst Gary Martucci in New York wrote in the statement.

Insurers started using so-called cat bonds in the 1990s to transfer the risk of claims that could threaten their solvency. Bond investors in Zurich Financial Services AG’s Kamp Re 2005 Ltd. lost money when property damages caused by Hurricane Katrina in 2005 exceeded the threshold that entitled Zurich to keep investor funds.

Allstate Chief Executive Officer Tom Wilson is cutting 1,000 jobs and reviewing products sold by the life insurance business after injecting $1 billion of capital into the unit in October and removing its president in December. Moody’s Investors Service downgraded the largest publicly traded U.S. auto and home insurer, last week to A3 from A2, citing “significant investment losses, weak earnings, and reduced capitalization.”

Returns Guaranteed

Willow Re is one of four catastrophe bonds that used contracts sold by Lehman Brothers to guarantee returns on collateral backing the notes and to make interest payments. Lehman’s collapse in September nullified the guarantees, leaving the securities open to market value losses on the collateral.

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