The recent financial downturn has shown that cat bonds are not free from credit risk as highly rated counterparties have been subjected to rapid downgrades, and qualified assets have endured sharp and often inexplicable markdowns, according to Don Thorpe, senior director and global head of Fitch's insurance-linked securities group.

"The recent credit crisis has challenged the notion of near zero correlation between cat bonds and other assets in the financial markets," says Thorpe. "That being said, the cat bond structures now coming to market feature several structural improvements in the area of invested assets and swap counterparties.'

These new structures include asset portfolios that are invested in more liquid securities whose durations are better matched to the bonds' maturities, and greater disclosure of the assets owned and more frequent 'topping up' of any market value declines by the applicable swap counterparties.

The catastrophe bond market has also reopened with the marketing of a handful of transactions including Scor's Atlas V bond in recent weeks.

This is an important aspect of the structure where Fitch believes the interests of both the transaction sponsors and the note holders are aligned.

"If a structure suffers a loss due to a combination of investment losses and the failure of a swap counterparty to perform, then that loss will be passed on to note holders in the form of missed interest or principle payments," says Thorpe. "At the same time, the sponsor will be paying for insurance (or reinsurance) protection that may not be fully available to it in the event of a catastrophe because of the investment losses."

Although the credit quality of the assets held in trust and the swap counterparty are generally not limiting factors in its ratings of cat bonds, Fitch nonetheless views these changes positively even though these changes likely will not result in higher ratings.

In particular, Fitch believes a daily posting by the swap counterparty of collateral for any mark-to-market shortfalls strongly mitigates the risk of investment losses.

Cat bonds have conventionally been regarded as being a pure insurance play with credit risk being virtually eliminated through structural features such as a highly-rated total return swap (TRS) counterparty and qualified investment guidelines.

However, activity in the cat bond market stalled following the failure of Lehman Brothers in the fall of 2008. Lehman Brothers had been the TRS counterparty on four cat bonds. At least one of those bonds, Willow Re, has subsequently failed to make its full interest payments when due. In addition, certain transactions have been negatively impacted by losses in the qualified investment portfolio resulting from asset value markdowns.