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Don't cry over spilt beer

Dear friend,

What a week — the first CDO-backed reinsurer has come into being on the same day that details emerged of what at $4bn must be the largest single Cat bond in history.

What’s a CDO? I hear you cry. Well, a CDO is a collateralised debt obligation.

What’s a collateralised debt obligation? I hear you cry once more (but this time ever so slightly feverishly). Well, a collateralised debt obligation is a bond/debt instrument that effectively bundles and packages up other bonds or debt instruments.

“So you buy a load of debt one end and you sell some other debt linked to the first lot of debt?” I hear you say.

“That’s right”, I answer somewhat smugly.

In this case a company that is going to play in the Cat bond market is planning to sell off tranches of other debt linked to how the Cat bonds perform to some other people. It’s not that complicated — until you start thinking about the underwriting chain.

Under this system I buy homeowners insurance in a Cat zone, the insurer buys reinsurance, the reinsurer buys retro through a Cat bond vehicle, a hedge fund buys the Cat bond and now somebody else buys the hedge fund’s CDO.

You can breathe out now.

Back in the old days we always thought retro underwriters ended up taking on huge unintended risks, because they were too far removed from the original risks to have an accurate take on what the real underlying exposure was.

Every major loss event of the last fifty years has borne this out

So pity the poor CDO buyer here — he’s another two steps removed from my little house on the bayou. Analysing one of these beauties must take roomfuls of supercomputers. It must be like holding a telescope up to your eye the wrong way round while you try to pour yourself a beer.

Before long you’re likely to spill something all over your jeans.

Today’s risk is being sliced, diced and packaged off in ways that were scarcely imaginable to mere mortals.

Chances are tomorrow’s losses will be packed up and shipped out in a million new unimaginable directions too.

Make sure you have a spare pair of jeans on hand.

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