As a direct effect of the ongoing pandemic, we now see an impact in a growing but little-known area of the capital markets: catastrophe bonds.
The spread of Covid-19 in developing countries recently triggered a payout of over $100 million from one such catastrophe bond offering sponsored by the World Bank—known as a “pandemic bond”—wiping out the investment of noteholders in its riskier tranche.
The continuing effects of Covid-19 may similarly cause principal losses for other types of catastrophe bonds as well—and lead to litigation among deal participants struggling to avoid or manage the fallout.
The Pandemic Bond Payout
In 2017, the World Bank issued first-of-their-kind pandemic bonds to raise funds that could be deployed in the event of a pandemic affecting specific developing countries. The countries would receive those funds only if a covered disease reached certain benchmarks in terms of growth and spread, as calculated by a third-party agent pursuant to data provided by the World Health Organization.
As long as the benchmarks were not met, investors would receive interest payments along with the return of principal after approximately three years.
As of this April, however, Covid-19 had satisfied the WHO’s benchmarks, and the funds raised by the bond offering had thus been paid out to the affected countries. As a result, investors will lose $132.5 million in principal—the maximum possible payout for a coronavirus.
Catastrophe Bonds: Background
The World Bank’s pandemic bonds follow the model of insurance-linked, or “catastrophe,” bonds. Catastrophe bonds are typically used by insurers, reinsurers, or state agencies with insurance or reinsurance obligations to sell some of their exposure to losses from cataclysmic events (like hurricanes and storms) within a certain band (e.g., above $100 million up to $300 million).
The sponsor sets up a special-purpose vehicle (the SPV) to issue the notes. These two entities enter into a reinsurance contract, whereby the sponsor pays the SPV premiums and the SPV agrees to pay the sponsor from the proceeds of the sale of the bonds in the event of specified triggers (e.g., if the sponsor’s losses from a covered event exceed a certain threshold).
Catastrophe bonds appeal to some investors because they offer high interest rates, and their riskiness is not correlated with market risk.
Beyond Pandemic Bonds
In the coming months, we expect principal losses may spread beyond pandemic bonds to other forms of catastrophe bonds. Some bonds present more straightforward risks of loss—i.e., those tied to the ratio of medical costs to premium revenues, or to life-insurance products. But other catastrophe bonds that insure against losses other than property damage may also experience principal losses.
For example, given the economic downturn caused by Covid-19, securities linked to mortgage-insurance products (which protect against the risk of missing mortgage payments due to, e.g., job loss or disability) may experience significant losses.
As evinced in recent years, most notably by the collapse of the mortgage-backed securities (MBS) market, when security-level losses materialize, litigation is inevitable. Though any dispute will focus on the particular intricacies of the individual catastrophe bond, we expect litigation in the industry to focus on the process for determining that the conditions to trigger payments from the SPV have been met and the extent of principal lost.
Noteholders, for example, may seek to prevent the disbursement of funds to the sponsor by claiming that the relevant benchmarks have not been met, or that the relevant parties failed to follow the appropriate processes in reaching the determination that triggers have been met. Conversely, sponsors may seek declaratory judgments that the benchmarks were in fact reached based on the criteria disclosed in prospectus materials.
As another example, some SPVs enter into contracts with third-party agencies to determine whether a covered event has occurred. While the offering documents may preclude noteholders from suing those third-party agencies directly, investors may seek to hold the SPV responsible for unreasonably relying on those third parties if their conclusions are idiosyncratic or outliers.
However, noteholders pursuing this theory should take care to examine how much discretion the relevant contracts provide those third parties in declaring a covered loss; at least one court has dismissed claims challenging how third-party firms had ascertained the extent of a trigger event due in part to broad discretion afforded one of the firms under its agreement with the SPV. In Mariah Re Ltd. v. Am. Family Mut. Ins. Co., 52 F. Supp. 3d 601 (S.D.N.Y. 2014).
As the pandemic stretches on, more catastrophe bonds are increasingly likely to hit their triggers—and litigation is likely to ensue. Participants in these transactions would be wise to evaluate novel arguments that may be asserted by or against them in the event of a dramatic loss of principal.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Joshua Kipnees is a partner in the litigation group at Patterson Belknap Webb & Tyler LLP, where he focuses his practice on false advertising and complex commercial litigation, including matters relating to asset-backed securities transactions and successor liability.
Jeffrey Hughes is an associate in Patterson Belknap’s litigation department.