BREAKING! Bloomberg: Allstate

Mr CLS, a favorite commenter of ours on Yahoo ALL nailed this one well in advance in his post, “The Cheshire Cat who sat in the Willow tREe.”

A. M. Best now puts Lehman Brothers linked cat bonds on credit watch. The bonds in question are:
Ajax Re Ltd
Carillon Re Ltd
Newton Re Ltd.
As the guarantor of the swap counterparty has become bankrupt that technically means the swap agreements are terminated.

Willow weep for me, bend your branches down along the ground and COVER me.

Of course this all begs the question, who is covering Allstate’s Hurricane exposure? Was today’s commentary by AM Best on Allstate’s financial strength a bit premature? Perhaps leave out something? The good folks at Bloomberg tell the what and it is HUGE:

A catastrophe bond sold by Allstate Corp. faces “imminent” default following the collapse of Lehman Brothers Holdings Inc., Standard & Poor’s said. It would be only the second such security to fail in a decade.

New York-based S&P downgraded $250 million of debt sold by Allstate’s Willow Re Ltd. to D, the lowest grade, from CC, according to a Jan. 30 statement. Northbrook, Illinois-based Allstate set up Willow Re as a means of selling the bonds in 2007 to protect against claims from hurricanes, and investment losses by Willow Re aren’t tied to Allstate’s own portfolio.

The issuer has notified Standard & Poor’s that it will not have sufficient funds to make the scheduled interest payment,” S&P analyst Gary Martucci in New York wrote in the statement.So-called cat bonds have gained popularity as a way for insurers to protect against natural disasters, and buyers demand outsized returns because they risk losing their entire investment to the insurer if the catastrophe is large enough. With Willow Re and other bonds backed by Lehman, investors are on the verge of losing a portion of their stake because of a financial calamity instead of a natural one.

“The market was already pricing Willow Re in the area of 50 cents,” said Christophe Fritsch, head of insurance-linked securities at Axa SA in Paris. “New deals will improve dramatically. Investors will make sure that they will only be exposed to insurance risk and won’t take credit risk.”

Returns Guaranteed

Willow Re is one of four catastrophe bonds that used contracts sold by Lehman to guarantee returns on collateral backing the notes and to make interest payments. Lehman’s collapse in September nullified the guarantees, leaving the securities open to market value losses on the collateral.

“Since Lehman’s bankruptcy terminated the total-return agreement, a portion of the interest and principle due to noteholders is subject to market risk,” said Maryellen Thielen, a spokeswoman for Allstate. “The default of Willow Re does not create any contractual obligations for Allstate.”

Thielen said Willow Re intends to pay about 95 cents on the dollar for its scheduled February payment. The bonds, due to make an interest payment today, have a five-day grace period until a default is declared, the S&P statement said.

The defaulted bond accounts for less than 5 percent of Allstate’s overall reinsurance program, Thielen said.

S&P grades the other three cat bonds that used Lehman as a swap counterparty at either CC or CCC, its third and fifth- lowest ratings.

Hurricane Katrina

Bond investors in Zurich Financial Services AG’s Kamp Re 2005 Ltd. were the first to lose money when property damages caused by Hurricane Katrina in 2005 exceeded the threshold that entitled Zurich to keep investor funds to pay insurance claims.

Scor SE, France’s biggest reinsurer, is seeking to sell $200 million of catastrophe bonds to transfer potential losses on U.S. earthquakes, S&P said last week.

“Despite some drawbacks on a very small number of transactions, the outlook for 2009 is very good as the market expects to see a number of new transactions that will offer higher yields to reflect the current market environment,” said Michael Stahel, head of insurance-linked investments at Clariden Leu in Zurich.

Ms Thielen is subtly deceptive in her remarks that, “The default of Willow Re does not create any contractual obligations for Allstate.”  As our good friend Mr CLS would point out this does have an impact on Allstate. When a company buys reinsurance it is transferring some of its risk risk to a third party and in turn gets to take a credit towards statutory capital reserves for the amount of the risk transferred. If the bonds default it will impact Allstate in several areas including it’s reinsurance program and it’s rate up calculations with the various State DOI’s (Departments of Insurance). Other commentators such as gold guru Jim Sinclair are more pessimistic and for good reason given the implosion of our financial system:

All our insurance companies are broke. Thank you one more time to the OTC derivative manufacturers and distributors.

We’ll be following this story as it develops. Meanwhile Willow RE’s bagholders, I mean bondholders, gently weep.


6 thoughts on “BREAKING! Bloomberg: Allstate”

  1. I would imagine Allstate will need to pay its bad investment along to the consumer at some point in the future?

    Can we determine if State Farm is facing a money problem which has lead it to reduce the size of its insurance underwriting in Florida?

  2. Without knowing the exact terms of the bonds and the swap deal, and how much Lehman was paid and took out of the pot, this situation may not be all that bad. In most deals, principal funds invested by the investors who bought the bonds are held in trust for the benefit of, in this case, Allstate as the reinsured, and the investors if there is no trigger event to repay the bonds. Those funds should continue to yield an investment return, albeit less than the one to be delivered under the swap (which is why the Allstate representative said investors will only get paid 95% of their expected interest payment).

    If the investors put the bonds into default, presumably they should be able to recoup their full principal amount plus some investment return. Allstate of course loses the future protection of the reinsurance the bonds were to provide, and is out of pocket for some or all of its reinsurance premium and deal expenses.

    If the bonds are not put into default, then the investors are subject to market fluctuation on any attempt to trade the bonds; alternatively they wait out the term of the deal and are either repaid with a diminished investment return upon maturity or not depending upon whether there will have been a covered catastrophe which latter result is a risk they assumed when buying the bonds in the first place.

  3. Excellent points Mr Sposato.

    If these bonds were accurately priced to the marketplace when issued then in my mind the diminshed return would be a deal breaker given the risk.

    What I keep rolling through my mind is the irony that TARP funds are most likely keeping other such guarantees in tact.

    I picture the guarantee as some sort of embedded derivative with the bond itself. Can you comment as to the typical structure of such a security. The guarantee is what I’m trying to get my arms around.


  4. Sop

    An interest rate swap would effect the change in payout amount if the bonds had some sort of variable payment schedule.

    But it sounds like they may have sold some other sort of derivative out of the structure. This was a very common way to juice up your second tier securitzed products (CDOs). In a CDO you might sell a default swap on Allstate out of the structure. If you would do that on a CAT bond I don’t know. Obviously if some sort of instrument with a contingent payout was backed by Lehman it would be gone now.

    I was stunned when I learned what was put in CDOs so I at this point not much would surprise me with CAT bonds either.

    OK, I take that back, a default swap on Allstate in one of their own CAT bonds would stun me.

  5. We found it Chris and my thanks to you for coming back to post again. Russell tells me your blog is most interesting.

    What we’re finding and this is the case with Willow Re is the underlying assets were not munis or treasuries but instead mortgage backed securities (subprime). In Willow’s case it was all B rated stuff that has cratered in the absence of the Lehman Total Return Swap that was attached to the financial instrument.

    Suppose someone got greedy and decide to pocket the difference hoping to make up for it with the extra returns from subprime mortgages. The more we dig the worse the stench becomes.

    Is there a less transpareent market than Cat Bonds?


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