31 March 2014
Although Hurricane Sandy had been downgraded to a tropical storm by the time it hit New York City in October 2012, the storm surge it brought devastated the coast. Among the worst hit were the city's swamped subways: Water devastated power stations and switching equipment. The Metropolitan Transportation Authority suffered billions of dollars in losses.
Last April, when it came time to renew the MTA's insurance policies, many longtime insurers were no longer willing to cover the agency's risks. Others doubled or tripled the premiums, or reduced coverage.
The MTA needed an alternative source of coverage, and fast: Its traditional policies expired in May, just a month before the hurricane season. On a referral from an investment banker, the MTA's general counsel, James Henley, reached out to Stephen Rooney, cohead of Mayer Brown's global insurance practice. Henley had heard about so-called catastrophe bonds, an insurance-linked security where capital markets investors take on the financial risks related to a catastrophic event, instead of insurers or reinsurers. Henley wanted to know whether an entity as large as the MTA could design such a bond offering for itself.
Rooney, who has worked on more than two dozen such bond offerings in the past two decades, told Henley that he thought it could be done. Pioneered by The Goldman Sachs Group Inc. and others in the mid-nineties in the wake of Hurricane Andrew and the Northridge earthquake, "cat bonds" have recently become popular again. By last year investors, drawn by the promise of relatively high returns and the securities' utter lack of correlation with world markets, were holding a record $20 billion worth of them.
But the bonds carry unusual risks: If the event spelled out in their covenants is triggered—by, for example, a 7.0 earthquake or a specified dollar threshold of losses—the policyholder can claim up to the full value of the bonds. Investors require that the bonds describe an objective, measurable environmental "trigger" for when the insured entity has the right to claim bond principal. Defining that trigger transparently is critically important to attracting investors. To that end, insurers enlist risk modeling firms to crunch historic data related to specific perils, ultimately charting each peril's probability.
The MTA offering faced multiple challenges. No one had ever written a cat bond related just to the peril of storm surge, and no risk modeling firm had ever developed a risk analysis for it. Rooney's team, working with two underwriters, found a modeling firm willing to do the analysis. The trigger was based on the height of a storm surge; to measure it, investors and the MTA would rely on tidal gauges throughout the city originally installed by the U.S. Oceanic and Atmospheric Service and by the U.S. Geological Service.
Another concern was the structure of the bonds themselves. In the wake of the Dodd-Frank Wall Street Reform and Consumer Protection Act, credit default swaps and default insurance derivatives were being regulated vigilantly. To avoid an additional layer of regulation by the Commodity Futures Trading Commission, regulators would need to consider the bonds as insurance, not as a derivative. "We had to create something that would be clearly insurance and outside the Dodd-Frank regulatory realm," Rooney says. With the help of tax partner George Craven, Rooney was able to structure the transaction so that the Internal Revenue Service would recognize it as a type of insurance, even though the MTA was far from a typical insurer.
The offering proved to be a big success with investors. After the preliminary offering of $125 million was oversubscribed, the MTA expanded the transaction to $200 million. It closed July 30.
Rooney "was very smart, very creative" in putting together the inaugural storm surge bond, says the MTA's Henley. Access to capital markets has increased insurance coverage available to the MTA at a historically low price. Adds Henley: "This gives a public institution like ours a way of leveraging all the capital in capital markets, so that if there is a coverage shortfall, we can meet our needs."
Reprinted with permission from the March 31, 2014 edition of The American Lawyer © 2014 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.