Regulation, Risk and Retail: What Rules Govern Cat Bond ETFs?

In this month’s first blog post, we explored how investor access to cat bonds continues to expand beyond the nearly-exclusive reach of institutions and wealthy investors. That was thanks in part to a number of regulations that made them more accessible.

As investors increasingly look beyond traditional asset classes for true portfolio diversification, we believe that understanding the regulatory framework behind these products is just as important as understanding their returns.

In this blog post we intend to show why it’s important for investors to unpack the regulatory and structural environments that cat bonds exist within today to better understand the landscape in which they operate. 

Cat bonds were rendered virtually untouchable by so-called “retail” investors for years, largely thanks to the Rule 144A of the Securities Act of 1933, which limits the resale of certain restricted securities to certain Qualified Institutional Buyers (QIBs). Some of the most common examples of QIBs include certain institutions managing at least $100 million in securities, broker dealers, and other entities like pension funds and insurance funds.

Since cat bonds are held in offshore Special Purpose Vehicles (SPVs) and the notes issued by those SPVs are sold into the US capital markets under Rule 144A, they are allowed to be held within funds registered by the Investment Company Act of 1940 (“40 Act”).

Most ETFs, like mutual funds, are 40 Act funds and thus have the ability to own the debt securities issued by the cat bond SPVs.  ETFs must adhere to additional regulatory requirements around diversification, liquidity, leverage, audit, transparency and reporting, and daily pricing and liquidity, which gives owners of these ETF shares an additional level of regulatory oversight and investor protection. The end result? Retail investors have the ability to access sophisticated investment vehicles while still being protected under 1940 Act regulations. 

Catastrophe bond ETFs are required to publish external audit opinion, prospectuses and annual reports, post daily NAVs, disclose their portfolio composition and alert investors to relevant risk factors. The SEC also calls for another layer of visibility regarding the material risks associated with cat bond ETFs, including event, modeling, liquidity, valuation and offshore structure risks. By gaining exposure to cat bonds through ETF ownership, inventors receive access to highly-desirable assets typically reserved for institutions, but with the guardrails and transparency needed to manage risk. 

The introduction of cat bond ETFs is a powerful example of how regulation can bolster innovation in financial markets and assist in democratizing access to certain investment products and asset classes. 

For financial advisors, understanding of how cat bonds can be owned within an ETF should also be a reminder that due diligence doesn't stop at performance metrics. Careful investment due diligence should begin with structure, access, and legal oversight.