Link: Inside the MTA’s catastrophe bond offering

When the MTA announced its move to purchase catastrophe bonds as a hedge against future storm surges, it raised a few eyebrows among both the reinsurance world and transit advocates. The catastrophe bond market is a highly specialized one, and the MTA had become the first major public entity to wade into it. Now, as details emerge the bond issuance appears to offer investments a big payoff and provides the MTA protection against unlikely events. It is, essentially, a private insurance.

In the first in-depth piece to examine the catastrophe bond sale, Tessa Stuart of The Village Voice looks at the big bet and the big payoff. As she frames it, after Sandy when the MTA had to turn to insurance to cover billions of dollars of damage, it was clear that the agency’s premiums would be unaffordable moving forward. And so to test the market, the MTA turned to catastrophe bonds. She writes:

That’s how the fate of the subway system ended up in the hands of just 20 investors. If a hurricane were to descend on New York tomorrow, repairs to the subway system would be paid for with money put up by those investors, who bought shares of a so-called catastrophe bond the MTA sold this past summer. It’s not philanthropy; it’s an investment. The same 20 bankrollers stand to make millions, provided another Sandy doesn’t hit tomorrow or anytime in the next three years.

Before Sandy, the MTA owned an insurance policy worth $1 billion. After the storm, says the agency’s director of risk and insurance management, Laureen Coyne, “It was impossible to get that kind of coverage.” Even half a billion dollars’ worth would have cost twice as much. The MTA was particularly concerned about its protection in the event of another flood…

Without a lot of options, the MTA dove headfirst into the small, strange catastrophe bond market, where an estimated 100 investors worldwide do $16 billion worth of deals…In order to sell the bond, the MTA’s in-house insurer, First Mutual Transportation, enlisted a law firm to create an offshore entity dubbed MetroCat Re, located—for “various legal and tax reasons,” Coyne says—in Bermuda. All the money involved in the bond arrangement goes through MetroCat Re.

Essentially, the bond is a simple high-stakes bet: If a catastrophic hurricane causes a Sandy-magnitude storm surge on or before August 5, 2016, investors lose every cent they ponied up. No hurricane, and they get all of their money back, plus a return that will top 13.5 percent.

The MTA put the bond up for sale in July, expecting to sell $125 million in shares, but the interest was overwhelming. The agency ultimately sold more than $200 million to just 20 investors. (Ostrovskaya describes the buyers not as individuals, but “pretty much specific catastrophe bond funds that specialize in this type of investment.”)

The surge protection supplements the $500 million in insurance the MTA has purchased to cover perils such as wind and fire. That policy costs the MTA $46 million a year.

It’s easy to see why the catastrophe bond was popular—it’s an incredibly lucrative proposition. A $10 million share could pay off more than $1.35 million in just three years. The money comes straight from the MTA, which makes quarterly payments into a trust, in much the same way that it would pay an insurance premium. At the end of three years, if disaster hasn’t struck, the investors cash out.

Stuart’s piece goes on to explain how a storm surge high enough to trigger the bond conditions is rather unlikely, but I think that’s besides the point. The only way the MTA could insure against future losses was through these bonds. All told, the various investors could make a combined $27 million — a total similar to what the MTA is paying for insurance — and the agency gets more coverage than it can from insurance companies right now. It’s an intriguing situation, and it’s the one time we’re hoping the MTA has to shell out the money in the end rather than suffer through another catastrophic storm.