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originator to the SPV would in turn be paid to investors as coupon on their investment in the CAT bonds. In the event that the specified catastrophe occurs, funds in the collateral trust would be paid to the originator, thus reducing or eliminating the amount in trust available to be returned to investors at bond maturity.

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54. One of the first securitizations of catastrophic risks was originated by USAA in 1997. The format employed by USAA -- commonly referred to as the Residential Re transaction, the registered name of the SPE employed by USAA has become a model for most CAT bond transactions since. A description of the transaction follows. Since then, U.S. quake risks in California and the Midwest, U.S. wind exposures, Japanese quake and typhoon exposures, French windstorms -- all have been the subject of successful CAT bond issues. As an alternative to the issuance of CAT bonds, some recent transactions have extended the concept to the use options on CAT bonds. The Allianz transaction, described below is an example of such a transaction.

An illustration: The Residential Re transaction. In 1997, USAA originated a securitization of $477 million in CAT bonds, representing 80% of $500 million of its aggregate losses from an East Coast hurricane in excess of $1 billion in one year. One tranche, $164 million in AAA rated notes, was principal

points. The other tranche, $333 million in BB rated notes, placed both principal and interest at risk at LIBOR plus 576 basis points. The cost of the transaction to USAA was the equivalent of a 6% rate-on-line plus transaction fees of another $10 million or so. The transaction is more fully described in the following figure:

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Such flexibility can be extremely valuable given the high volatility of retrocessional alternatives. Other insurers and reinsurers have

The components of a CAT bond

engaged in similar "optionable" deals (e.g., Yasuda in 1998 and SOREMA in 1999).

55. The specific components of the transactions are looked at further24:

The contract between the originator and the SPV: The issue of whether a reinsurance contract or a financial contract is appropriate was discussed in paragraph 51. Under the terms of the contract, the originator pays a premium - in the case of a reinsurance contract, the premium is the equivalent to the rate-on-line for a typical reinsurance construct - to the SPV.

The SPV and the investors: The SPV sets up a collateral trust. Funding for the collateral trust comes from the investors in the CAT bonds issued by the SPV. These bonds offer an interest coupon equal

to:

(i)

LIBOR plus or minus the swap spread25; plus

(ii) The premium or rate-on-line paid into the SPV by the

originator.

The return of principal to investors under the terms of the notes is usually dependent on the amount of CAT-related obligations owed by the SPV under its contract with the originator. A number of transactions have provided for the repayment of all or part of the principal (with or without interest) even after an SPV has paid out all of its funds to the originator for claims stemming from qualifying event. Not infrequently, such principal repayments are tied to a future commencement date, with payouts ranging over a period of time.

The swap contract: The proceeds from the investors, now placed in the collateral trust, are then invested in high credit quality assets. The specific types of assets that qualify are generally the subject of

24 For a more detailed discussion regarding the various components and participants, see Lehman Brothers, California Earthquake Authority: Review and application of capital market products. May 2001. 25 The swap spread results from swapping the interest payments on the assets in the collateral trust with

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negotiation between the originator, the placement agent, and the rating agencies. There is inevitably a difference between the market interest rate on these assets over the time of the bond and the spread required by investors when the bond is closed. In order to ensure that investors are paid a market interest rate, a counterparty is engaged to swap the investment earnings on the collateral to LIBOR plus or minus the swap spread. The amount of the spread above or below LIBOR depends on the type of swap, the identity of the counterparty, and the credit quality and investment yield earned on the assets.

56. There are at least two types of swap arrangements that are in use in these types of transactions. The originator generally makes the choice, depending on his risk preferences.

(i)

A basis swap converts the interest earned on the collateral investments to a LIBOR or EUBOR basis, but the originator retains the credit risk of the underlying assets as well as the risk of assets being liquidated at a value below par (known as "collateral liquidation/spread risk”).

(ii) A total return swap also converts the interest earned to a LIBOR or EUBOR basis, but the swap counterparty assumes the credit risk and the liquidation/spread risk of the underlying assets. In essence, the swap counterparty guarantees both the LIBOR or EUBOR based interest rate and the full return of principal. Thus, principal default would occur only if both the counterparty and the collateral defaulted.

Other transformer vehicles: Protected cells

57. Instead of an SPV, an originator can use a protected cell structure to accomplish insurance-linked securitization. Though statutory in nature, a protected cell does not give rise to a separate corporate entity. Hence there are no capital requirements. Instead, an existing insurer or reinsurer contributes assets to a protected cell within its existing corporate structure and, by law, the cell segregates these assets from the remaining general assets of the company. The assets within the cell are only available to creditors of the protected cell. Other creditors must

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assert their claims against the remaining general assets of the firm, but not against the assets within the protected cell.

58. In the United States, the protected cell is regulated separately for solvency and can only operate with the prior approval of a plan of operation by the insurance regulator. Because there is no separate corporate entity however, the protected cell is thought to overcome the tax drawbacks of a domestic securitization. The entire tax status and bankruptcy-remoteness of protected cells remains untested and uncertain in the United States however.

59. Other jurisdictions have also adopted the protected cell approach. Guernsey was in fact the first jurisdiction to permit protected cell companies. In Guernsey, a captive insurer can effect a securitization through the use of a protected cell for instance. Royal Bank of Scotland, for example, has applied a protected cell approach both to the conversion of insurance into ISDA ("International Swaps and Derivatives Association") products and to a synthetic securitization of a portfolio of derivative products26.