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Big disaster, complex issues could hurt stellar catastrophe bond loss rate

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Losses on catastrophe bonds have been rare, and disputes over bond payouts even rarer. That could change, though, as the market grows and bond structures become riskier and more complex.

Of hundreds of cat bond deals to date, natural disasters have triggered fewer than six and only two have produced litigation or arbitration, market sources say.

“Disputes arising out of that are pretty sparse,” said Huhnsik Chung, a partner a law firm Locke Lord L.L.P. in New York.

Still, cat bond deals themselves have become more complicated, with more indemnity triggers and other features that have not been tested by losses, experts say.

“That complexity in itself raises the potential risk” of disputes, said Michael Madigan, a partner at Sidley & Austin L.L.P. in New York.

Trigger mechanisms — already the focus of one cat bond lawsuit — are a likely source of future disagreements, along with alleged failures to disclose information in offering documents or in descriptions of a ceding insurer's business, bond experts say.

“The bottom line is we don't have much of a track record on how bonds will behave in a big event, especially a big event that triggers several bonds,” Mr. Madigan said.

Cat bond issuance set a record last year with the completion of 39 deals totaling $8.3 billion, according to Swiss Re Capital Markets. Since 1996, cat bonds and insurance-linked securities have attracted a cumulative $65.6 billion in capital, according to alternative reinsurance website Artemis.bm.

However, cat bond losses to date total well under $1 billion. Major losses include:

? Muteki Ltd., sponsored by Japanese agricultural insurance cooperative Zenkyoren Ltd., which paid a $300 million total loss after the March 2011 Tohoku, Japan, earthquake and tsunami.

? Mariah Re Ltd., sponsored by American Family Mutual Insurance Co. of Madison, Wisconsin, which suffered total losses on two $100 million bond issues after severe weather struck the Midwest in 2011.

? Kamp Re 2005 Ltd., sponsored by Zurich American Insurance Corp., which paid $144 million of its $190 million in principal on losses from Hurricane Katrina.

? Avalon Re Ltd., sponsored by Bermuda-based Oil Casualty Insurance Ltd., which lost $12.7 million of the $135 million in principal on a junior tranche of notes after the 2007 explosion of a Consolidated Edison Inc. steam pipe in New York.

Other cat bonds have suffered losses unrelated to natural disasters.

Crystal Credit Ltd., for example, paid on notes covering credit insurance losses of sponsor Swiss Re Ltd. Four other cat bond vehicles suffered minor investment losses on swaps with counterparty Lehman Bros. after Lehman collapsed in 2008.

Disputes over cat bonds have been rare.

The biggest involved Mariah Re, now in liquidation in the Cayman Islands. The company's liquidators filed suit in U.S. District Court in New York in 2013 to recover $100 million paid to American Family under one of two Mariah bonds.

The Mariah bond had an industry loss trigger based on Midwest storm losses reported by the Property Claims Services unit of Insurance Services Office Ltd. and evaluated by cat modeler AIR Worldwide Corp. The extent of Mariah's liability depended on whether AIR treated losses as metropolitan area property damage, which carried higher values, or nonmetropolitan damage, according to court records.

ISO and AIR, both units of Verisk Analytics Inc. of Jersey City, New Jersey, also were named in the suit.

Mariah's liquidators, acting on behalf of investors, alleged that ISO improperly updated its original catastrophe bulletin to include more site-specific information on the 2011 storms in Kansas, and that AIR wrongly reclassified the losses as metropolitan property damage, leading to a total loss on the bond.

U.S. District Judge Richard J. Sullivan threw out Mariah's breach of contract suit last September, saying investors “gambled and lost on the weather.”

Mariah is appealing the ruling to the 2nd U.S. Circuit Court of Appeals in New York.

A second dispute pitted Switzerland-based Glacier Reinsurance A.G., now in runoff, against cat bond vehicle Nelson Re Ltd. over Glacier's losses from Hurricane Ike in 2008, which cut a path of destruction through several Caribbean nations and nearly a dozen U.S. states. Glacier demanded arbitration to resolve which of its policies should be covered by a Nelson Re note providing $67.5 million for Glacier losses exceeding $145 million. Glacier withdrew its arbitration claims in 2013, though, and bondholders recovered 100% of their principal.

The growing complexity of more recent bond deals could lead to more disputes, experts say.

Most cat bonds now are written with indemnity triggers rather than industry loss or parametric triggers, according to Swiss Re. This means bond investors need to understand more about a ceding company's own business, and cedents have to describe it fully and accurately, sources say.

“The onus on disclosure is growing massively,” said Kiran Soar, a partner and head of reinsurance at Ince & Co. in London.

Some bonds now include a variable coupon feature, said Bill Dubinsky, head of ILS at Willis Capital Markets & Advisory in New York. If the cedent's business changes and affects its expected loss levels, the coupon rate on a cat bond may rise or fall annually to reflect it, potentially affecting the value of the bond, he said. If the mechanics of these spread adjustments aren't disclosed in accordance with the underlying documents and information supporting them provided in a timely way, disputes could follow, he said.

Bonds with indemnity triggers also may provide for advance payments to cedents based on established case reserves, with mechanisms for a cedent to collect more from bond investors or repay the advance depending on how the reserves develop, Mr. Madigan said.

“You have to make sure all these different features are working together in a synchronized way,” he said. “It just takes more time and effort for everyone involved.”

Should the benign catastrophe experience of the past several years change, that also could lead to more disputes.

The number of issued and outstanding bonds is at an all-time high, and the bonds themselves are riskier and exposed to higher average levels of expected losses than previous years as investors have become comfortable with the risks, Mr. Dubinsky said.

A major hurricane or earthquake now could trigger a large number of bond losses, he said.

“That's really up to Mother Nature,” said Gary Martucci, a director at Standard & Poor's Corp. in New York. “It's really which way the wind blows.”