Where there is uncertainty, there are always bets—the question is who wins. From horse racing to the price of gold, people have always speculated on uncertainty. FINRA is issuing this alert to inform investors about event-linked securities—financial instruments that allow investors to speculate on a variety of events, including catastrophes such as hurricanes, earthquakes, and pandemics.

The market for event-linked securities has grown substantially since they were first developed in the mid-1990s. At present, these products are not offered directly to individual investors. But various funds, including mutual funds and closed-end funds, have purchased or are authorized to purchase them on behalf of individual investors. While not widespread, holdings of event-linked securities in these funds—especially high income funds—are also not unusual.

Event-linked securities currently offer higher interest rates than similarly rated corporate bonds. But, if a triggering catastrophic event occurs, holders can lose most or all of their principal and unpaid interest payments. This is precisely what happened to funds that owned bonds linked to U.S. hurricane risk when Hurricane Katrina struck.

We are issuing this Alert to describe how event-linked securities work and to help investors determine whether and to what extent the funds they hold invest in event-linked securities.

What Are Event-Linked Securities?

One common type of event-linked securities, which will illustrate many of their characteristics, are "catastrophe bonds"—"cat bonds" for short. If a "sponsor," such as an insurance company or reinsurance company (a company that insures insurance companies), wants to transfer some or all of the risk it assumes in insuring a catastrophe, it can set up a separate legal structure—commonly known as a special purpose vehicle (SPV). Foreign governments and private companies also have sponsored cat bonds as a hedge against natural disasters.

The SPV issues cat bonds and typically invests the proceeds from the bond issuance in low-risk securities (the collateral). The earnings on these low-risk securities, as well as insurance premiums paid to the sponsor, are used to make periodic, variable rate interest payments to investors. The interest rate typically is based on the London Interbank Offered Rate (LIBOR) plus a promised margin, or "spread," above that.

To assure that investors will receive their promised interest and principal payment amounts, in case the returns generated by the collateral and the premiums are not enough, the SPV may enter into a "swap" contract with another financial institution, called a "counterparty." Typically the counterparty agrees to pay the SPV interest payments based on LIBOR, in exchange for the earnings on the collateral. The counterparty may enter this agreement as a hedge on other bets that it has made through other parts of its business.

As long as the natural disaster covered by the bond—whether a windstorm in Europe or an earthquake in California—does not occur during the time investors own the bond, investors will receive their interest payments and, when the bond matures, their principal back from the collateral. Most cat bonds generally mature in three years, although terms range from one to five years, depending on the bond.

If the event does occur, however, the sponsor's right to the collateral is "triggered." This means the sponsor receives the collateral, instead of investors receiving it when the bond matures, causing investors to lose most—or all—of their principal and unpaid interest payments. You may hear this described as a "credit cliff." When this happens, the SPV might also have the right to extend the maturity of the bonds to verify that the trigger did occur or to process and audit insurance claims. Depending on the bond, the extension can last anywhere from three months to two years or more. In some cases, cat bonds cover multiple events to reduce the chances that investors will lose all of their principal.

Because cat bond holders face potentially huge losses, cat bonds are typically rated BB, or "non-investment grade" by credit rating agencies such as Fitch, Moody's and S&P. Non-investment grade bonds are also known as "high yield" or "junk" bonds. These ratings agencies, as well as sponsors and underwriters of cat bonds, rely heavily on a handful of firms that specialize in modeling natural disasters. These "risk modeling" firms employ meteorologists, seismologists, statisticians, and other experts who use large databases of historical or simulated data to estimate the probabilities and potential financial damage of natural disasters.

Again, for most individual investors, the question is whether you are exposed indirectly to these risks by virtue of owning shares in funds that invest in cat bonds.

Trigger Happy

Each cat bond has its own triggering event(s), which is(are) spelled out in the bond's offering documents. These documents typically are only available to purchasers or potential purchasers, however, because cat bonds are not subject to the SEC's registration and disclosure requirements. A number of different types of triggers have developed, some of which are listed below. Bear in mind that the question of whether a triggering event occurred—or the true meaning of a triggering event—can be complex and could wind up being litigated and require a ruling from a court. This in turn may add additional uncertainty to the way these securities perform. For example, there were property insurance lawsuits following 9/11 that centered on whether the attacks on the World Trade Center counted as one occurrence or two.

Reasons Given for Holding Them

Some of the reasons given for investing in cat bonds are their high yields and their lack of correlation with other asset classes in the financial markets.

• High Yields: Cat bonds currently pay much higher interest rates than similarly rated traditional corporate bonds, whose investors are not exposed to modeling risk (see below). Some even argue that investors are overcompensated for the risk they assume by buying cat bonds.
• Diversification: Cat bonds are also pitched to fund managers as a good way to diversify a portfolio because their performance is not related to that of other asset classes in the financial markets. The thinking is that even if stocks and bonds are in a bear market, the value of cat bonds shouldn't be affected. Bear in mind, though, that the effect of natural disasters on financial markets is not well-studied or foreseeable, and that past performance is no guarantee of future returns.

Also remember that cat bonds provide diversification benefits only if they are a limited portion of a portfolio that is otherwise invested in marketable securities and other assets, and if the cat bonds are not all linked to the same event. For instance, a mutual fund will gain limited diversification benefits from buying five bonds that all cover earthquakes in California.

Know When to Walk Away

As with any financial instrument, cat bonds also present risks.

• The Credit Cliff: A cat bond can cause the investor rapidly to lose most or all of his or her principal and any unpaid interest if a triggering event occurs. The high yield will not make investors whole if the triggering event actually occurs.
• Modeling Risk: Prices, yields and ratings of cat bonds rely almost exclusively on complex computer modeling techniques, which in turn are extremely sensitive to the data used in the models. The quality and quantity of data vary depending on the catastrophe. For example, there is more data available on earthquakes than on pandemics, which can be based only on the Spanish flu epidemic of 1918 in terms of real data. As one sales brochure warns, "There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy."
  
  As another example, the unusual frequency of hurricanes between 2001 and 2005, as well as the amount of damage that they caused, defied then-existing computer models. This caused Northeast and Gulf Coast hurricane models to be significantly revised. Investors should remember how much is riding on these models, and how they are essentially untested.
  
  Another sales brochure states that cat bond investors should have access to expertise in probability modeling, weather forecasting, seismology and other technical factors to evaluate the value of an event-linked bond. Therefore, fund managers should consider whether they can devote adequate resources to accessing or developing expertise in evaluating cat bonds. Individual investors thinking about buying funds that invest in cat bonds should consider whether those fund managers have the necessary resources and expertise.
  
  Regardless of the amount of data available and the revisions to computer models that take place, the eternal investing adage applies: past performance does not guarantee future returns.
• Liquidity Risk: Secondary trading for cat bonds is very limited, so in a pinch an investor may not be able to sell. In addition, the secondary transactions that do occur are privately negotiated, so pricing information is not generally available to the public.
  
  Remember also that the maturity of some cat bonds can be extended during the worst possible time—when a trigger may have occurred. This can cause the bonds' value to plummet, making them even harder to sell.
• Unregistered Investments: Most cat bonds are issued in what are called Rule 144A offerings, which are available only to large institutional investors and are not subject to the SEC's registration and disclosure requirements. As a result, many of the normal investor protections that are common to most traditional registered investments are missing. For example, issuers of cat bonds are not required to file a registration statement or periodic reports with the SEC, unlike issuers of registered bonds. While general prohibitions against securities fraud apply to Rule 144A offerings, the lack of public disclosure may make it difficult for both individuals and fund managers to obtain and evaluate the information used to price and structure cat bonds.
• Counterparty Credit Risk: As mentioned above, cat bond issuers commonly enter into swap agreements with third parties that guarantee interest and principal payments to investors, as long as the triggering event does not occur. If the third party suffers financial distress, for example, and is unable to back these payments, investors would not receive the interest and principal amounts promised.

Other Event-Linked Securities

Some cat bonds are straightforward in offering only one class of securities. Other issuances can offer several classes, or "tranches," which vary in payment terms, coupon rates and credit ratings. These terms are generally dictated by the bonds' offering documents.

To complicate matters further, some cat bonds have been packaged into securities known as collateralized debt obligations (CDOs). These CDOs contain cat bonds sponsored by a number of insurers. This can minimize the risk to the investor of complete loss of principal—or it can multiply losses if the cat bonds in the CDO are not properly diversified. In addition, while most cat bonds have a maturity of three years, CDOs can have much longer terms.

You may also hear about "sidecars" in the event-linked securities world. These are like "mini" insurance or reinsurance companies that allow institutional investors to participate directly in the profits and risks of certain catastrophe policies written by an insurer or reinsurer. Sidecars are similar to the SPVs that issue cat bonds, but often are privately negotiated and issue both equity and debt.

Derivative instruments are also part of the event-linked landscape. These instruments allow one party (the protection buyer) to pay a fixed premium in exchange for an agreement by the other party (the protection seller) to pay a lump sum if a specified catastrophe event occurs—typically based on a Parametric or Industry Loss Index. These contracts are traded privately among dealers and institutional investors in the over-the-counter market. Again, while individual investors generally cannot participate in these particular types of derivative contracts directly, they could own them indirectly through mutual funds or other financial instruments that invest in these contracts.

How to Protect Yourself

Since individual retail investors generally cannot invest directly in event-linked securities, you will want to find out whether any funds you own invest in cat bonds or other similar event-linked instruments. Check your fund's prospectus and statement of additional information (SAI) to see whether your fund is authorized to invest in event-linked securities—including CDOs and derivatives—and if so, how much. You can typically find this information under the headings "Investment Objectives" or "Investment Policies."

When you read these documents, consider whether the fund manager has adequate resources and expertise to evaluate the risks of event-linked securities and whether they are a sound investment. Does the fund manager have an educational background or work experience, such as in the insurance industry, that would allow him/her to understand the quantitative and forecasting methods used in building computer models for event-linked securities? If not, does the fund manager employ a third party consultant who does? In your prospectus or SAI, look under the heading "Management of the Fund." If you need more information, you may have to research other sources, for example on the Internet.

To learn what securities your fund owns, and how much, you can look up the fund's holdings in its annual report or semi-annual report to shareholders. It is important that a fund's event-linked securities are diversified in terms of type of risk and geographic location, and that they comprise a limited part of the portfolio.

http://www.sec.gov/edgar/searchedgar/prospectus.htm