Demand for new catastrophe bonds has been hit by fears they may be more vulnerable to credit risk than previously thought, after the collapse of Lehman Brothers exposed a flaw in the bonds' structure.

The bonds, which transfer insurance companies' financial losses from natural disasters to investment funds, remain among the few assets to have made money in 2008.

But their reputation as a shelter from other types of financial market risk has been damaged by the downgrading of four catastrophe bonds guaranteed by a unit of Lehman Brothers following the U.S. investment bank's Sept. 15 bankruptcy filing.

Credit rating agency Standard & Poor's identified exposure to Lehman as the "weak link" triggering the downgrades, but also cited shortfalls in the collateral backing the bonds, which included some structured debt. The four bonds -- issued by Ajax Re, Carillon, Newton Re and Willow Re -- are quoted at heavily discounted levels.

"The (insurance-linked securities) market was founded on the idea that it was a pure insurance play, invulnerable to nasty things like credit risk," said Lane Financial LLC, a broker-dealer specialising in risk transfer between the insurance and capital markets, in a research note. "It has not lived up to its own rhetoric."

Investors now want revisions to the structure of such bonds -- in particular, tougher rules on how the collateral backing them is managed. Market players say concern about credit risk is among factors dragging on the primary market, which has seen no new supply since August. About $2.7 billion of catastrophe bonds have been issued this year, down from $7.3 billion in 2007.

"For cat bonds, the premium is supposed to (reflect) insurance risk, not credit risk," said Christophe Fritsch, Head of Insurance-Linked Securities at AXA Investment Managers.

"Investors have to focus particularly on the financial strength of the swap counterparty since it guarantees the cat bond interest and principal, as long it does not go bankrupt."

COLLATERAL

Catastrophe bonds pay investors a high rate of interest, but they risk losing part or all of their principal if a specified natural disaster -- often a hurricane or earthquake -- occurs.

Collateral is held against the bonds to ensure that interest and principal payments can be made or the sponsoring insurer's claims met should a disaster happen. A total return swap (TRS) agreed between the issuer and a counterparty which undertakes to compensate for any decline in the value of the collateral is meant to offer further protection.

But when Lehman collapsed, investors and insurers on both sides of four bonds for which it was TRS counterparty were left with direct exposure to the collateral pool. S&P later slashed ratings on the bonds to levels that imply high risk of default.

In a recent note, the rating agency said Lehman's failure had shaken the market, slowing issuance and prompting participants to seek "revised TRS structures that are acceptable from both a commercial and risk perspective".

But it warned: "We have yet to see a catastrophe bond structure that, in our view, has effectively removed counterparty and market value risk".

SOLUTIONS

Proposed solutions focus mainly on the quality and type of assets that can be used as collateral. This could include a ban on structured products or a requirement that collateral be liquid, with no duration mismatch to the cat bond itself.

Some investors also want the TRS counterparty to commit to make up immediately any loss in the collateral account, with assets marked to market on a weekly or daily basis -- possibly by an independent valuation agent. Others want to be able to monitor the collateral pool online.

Barney Schauble, a partner at Bermuda-based hedge fund Nephila Capital, which specialises in insurance risk, said the simplest way to eradicate credit risk was to use U.S. Treasuries as collateral. "Obviously, investors like more yield if they can get it, but as they have learned, more yield comes with additional exposure," he said.

Many privately placed reinsurance transactions already use Treasuries as collateral, he noted. "From an issuer's standpoint, if you are using (a catastrophe bond) to buy protection, you want to make sure that protection is there," Schauble said. "So they are very happy for for collateral to be in Treasuries."

AXA IM's Fritsch said greater disclosure might allow investors to decide for themselves in future what degree of credit risk they are prepared to accept, and at what price.

"At AXA IM we manage a lot of credit and so it should be easy for us to analyse the collateral ourselves, but in the past when we have asked for this information the swap counterparty has not always provided it," he said.

Fritsch described the Lehman situation as "very unfortunate" but said it would ultimately benefit the market by improving transparency and accountability for future issuance.

Lane Financial noted that swap arrangements had already been tightened up on transactions issued in 2007 and 2008, but said ideally the market should standardise principal protection.

"Competitive pressures being what they are this may not happen," its note said. "But either way, standard or not, one thing that must happen is that there must be full disclosure so that interested parties can have full facts before them."

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Copyright 2008 Reuters,