This post begins with a bleg. Exactly how does State Farm derive $4 billion of reinsurance coverage from $1.1806 billion of actual notes outstanding? There are some very bright financial minds that are stumped by that question. So in this game of Slabbed emulates Jeopardy, let’s set up the question and bleg at the beginning when the deal included toxic paper (which I emphasize):
CHICAGO–(BUSINESS WIRE)–Fitch Ratings expects to assign the following ratings to the proposed notes of Merna Reinsurance Ltd. (Merna Re) listed below:
–$500,000,000 tranche A ‘AAA’;
–$1,200,000,000 tranche B ‘AA+’;
–$850,000,000 tranche C ‘A-‘;
–$690,000,000 tranche D ‘BB’;
–$780,000,000 tranche E ‘B+’.
The expected ratings address the likelihood that note holders will receive full payments of interest and principal in accordance with the terms of the transaction documents. These expected ratings are contingent on final documents conforming to information already received.
The expected ratings on all notes are based on stressed modeled loss statistics provided by an independent, third party modeling firm; the transaction’s legal and cash flow structure; the financial strength of the sponsor, State Farm Mutual Automobile Insurance Company (State Farm); and the credit enhancement provided by the subordinated notes.
This transaction effectively transfers a portion of State Farm’s risk of natural catastrophe losses in the U.S. and Canada including hurricane, earthquake, tornado, hail, winter storm and brush fire to the capital markets. Thus, the rated securities are indemnity-based catastrophe bonds that provide cumulative, three-year aggregate excess of loss protection. The cumulative three-year indemnity-based trigger and $4 billion size of this transaction make this transaction unique relative to prior catastrophe bonds.
However Fitch issued final ratings and reaffirmed only the $1.1806 billion of Merna Re cat bonds and notes. Check out this press release (PR) from this past December:
Fitch Ratings has affirmed the ratings of $1.2 billion of Merna Reinsurance
Limited’s (Merna Re) outstanding notes and term loans as follows:
–$256,000,000 tranche A principal-at-risk variable rate notes due 2010 ‘AAA’;
–$647,600,000 tranche B principal-at-risk variable rate notes due 2010 ‘AA+’;
–$155,000,000 tranche C principal-at-risk variable rate notes due 2010 ‘A-‘;
–$94,000,000 tranche A term loan, senior secured credit facility ‘AAA’;
–$19,000,000 tranche B term loan, senior secured credit facility ‘AA+’;
–$9,000,000 tranche C term loan, senior secured credit facility ‘A-‘.
The affirmations consider the transaction’s stressed modeled loss statistics, the lack of catastrophe losses ceded into the structure to-date, the credit quality of the relevant counterparties and the credit quality of the invested assets held in the reinsurance trust.
However the Artimis website and it’s excellent blog either understood the answer to our question or didn’t question the anomaly. This is from this past December:
Merna Reinsurance Ltd. is an SPV (special purpose vehicle) set up in June 2007 for an alternative risk transfer deal for State Farm. The deal essentially transferred $4 billion of natural catastrophe risk from State Farm, the largest homeowners and auto insurer in the U.S., to investors, either as bonds or as loans.
Fitch Ratings has recently re-affirmed the ratings of each of the tranches of notes, this usually happens at least once during a deals lifetime as a way to reassure investors that their investment in the notes is safe.
Given the current economic climate and the heavy catastrophe losses incurred this year you would imagine that State Farm would have been a little nervous prior to this reassessment of their deal.
To which I observed in an email to Russell asking for help:
As Bugs Bunny would say something is screwy in St Louie!
Russell is not only a good friend to the people of the Gulf Coast he is very astute financially. Between he, me and Steve we’ve not been able to solve the case of the missing cat bonds. What we did find was very frightening in it’s own right. Let’s start with the cat bond pumpers over at Guy Carpenter as they work very hard putting a positive spin on the disaster and keep their sinking ship afloat with this press release from February 4, 2009:
NEW YORK–(BUSINESS WIRE)–Catastrophe bonds withstood the impact of onerous market forces in 2008, brought on by turmoil in the global capital markets, according to a new briefing on catastrophe bond market activity published by Guy Carpenter & Company, LLC, the leading global risk and reinsurance specialist, and GC Securities, a division of MMC Securities Corp. The cat bond market update found that as a whole, in terms of issuance volume, 2008 was the market’s third most active year since catastrophe bonds were introduced in 1997, accounting for 11 percent of all issuances.
Thirteen issuances, all but two of which occurred in the first half of the year, brought USD2.7 billion in new and renewal capacity to market in 2008, according to Guy Carpenter’s findings. After a record-setting year in 2007, cat bond issuance in 2008 fell 62 and 52 percent in terms of risk capital and number of transactions, respectively.
The report also found that after the events of mid-September 2008, several firms that were planning catastrophe bond issuances for the fourth quarter elected to defer those issuances to the first quarter of 2009. As a result, the total amount of risk capital outstanding dropped 14.5 percent, from USD13.8 billion at year-end 2007 to USD11.8 billion at year end 2008.
“Put to the test by the unprecedented circumstances of 2008, the cat bond market proved its resilience as the market absorbed the impact of concurrent financial and property catastrophes,” said David Priebe, Chairman of Global Client Development at Guy Carpenter. “And, while cat bond spreads did increase during the tumultuous days of September, they did not do so at the same rate as the credit markets generally.”
Let’s do the time warp again……
If you read down the press release you’ll find a belated acknowledgment that no cat bond offerings have been floated since Summer 2008. You”ll also find on the Artimis list of transactions only one offering has been attempted since Wall Street’s subprime implosion, the one the folks at Guy Carpenter were pumping in their press release no doubt. There is a problem with the deal IMHO. First let’s start with the google translation of a Romanian insurance publication 1Asig.ro which contains this news story dated March 2, 2009:
French reinsurers score placed on the market for catastrophe bonds worth 200 million USD. The operation covers the risks of storm and earthquake in the U.S.. STANDARD & POOR’s (S&P) a desemnat rating-urile preliminare pentru aceste titluri. Standard & Poor’s (S & P) has assigned preliminary ratings are for these titles.
This show will be in three tranches, placing titles on the market with a variable rate. First and the second tranche have been designated by the S & P rating is B +. The third payment was evaluated with the B-rating will be issue by the SPV (Special Purpose Vehicle) ATLAS V Reinsurance Ltd. Risk analysis and modeling for transaction data were performed by AIR Worldwide Corp.in Boston.
In the past, SCOR has also placed a series of tools for security risks. In December 2007, SCOR has issued bonds for the storms of disaster in Europe and in Japan by seismele the SPV IV ATLAS Reinsurance Ltd.
Wow B+ is the best rating the S&P could assign in these troubled times? I wonder what kind of assets will be in the trust?
Was the Merna Re deal itself a clue something was wrong with the Cat bond market? Check out from page 5 of the May/June 2008 newsletter from the publishers of the Insurance Insider article titled “Merna Re falls into illiquid secondary market: State Farm’s giant investment grade cat bond is suffering in the secondary market. Is it a sign of contagion from the credit crisis?“:
State Farm’s 2007 landmark catastrophe bond, Merna Re, is coming under pricing pressure in the secondary market, as investors seek to sell large chunks of the investment grade notes, according to sources.
An over-supply of Merna notes for sale in the market has led the main insurance linked securities (ILS) traders to indicate large discounts on the issue pricing for the bond, Trading Risk can reveal.
According to sources, the majority of traders were quoting prices for the notes in April at between 95-98 percent of notional. Swiss Re Capital Markets was even indicating prices in the low 90-percents of notional (see table below), although no
trades are thought to have taken place at that level.
Swiss Re declined to comment.
The Merna price decline contrasts with other cat bonds which continue to trade above notional value, reflecting continued interest in ILS.
Merna Re, however, was always a standout from other ILS, not least because of its size. At $1.06bn, it is the largest single catastrophe bond issuance to date and the investment grade ratings on the three tranches of notes means the bond was purchased predominantly by multistrategy institutional investors, as opposed to specialist ILS ones. This appears to be contributing to the difficulties, as some of these investors are having to sell positions to gain liquidity in their core portfolios, or are seeing opportunities elsewhere as spreads widen on other investment grade securities.
“Merna is really held by people out of the cat bond markets,” one major ILS investor told Trading Risk. “They were really going for a different class of investors – it’s not a surprise that it’s been more caught up in the broader markets contagion,” he added.
Investors in Merna Re at the beginning of 2008 are thought to include Fidelity Management & Research Co, Baillie Gifford & Co Funds and Vanguard Group, as well as more traditional ILS investors such as Genworth Life & Annuity Insurance Co.
According to observers, there are other pressures on Merna. These include the large size of the lots for sale, the appetite of dedicated ILS funds who would normally be the main traders in the secondary market, and concerns over the credit risk on the investment portfolio supporting the $1.06bn principal.
“The problem with Merna is that a lot of the guys that are holding it, hold blocks of $50mn, and they want to sell it up to $50mn,” an investor told Trading Risk. “The traders aren’t allowed to principal that much, which has caused some illiquidity for the volume. If the blocks were $5mn, then it would sell and clear,” he added.
However, some are spotting opportunities amidst the difficulties. Michael Stahel, head of insurance-linked investments at Clariden Leu bank said that although Merna did not initially fit his investment criteria due to the low yield of investment grade securities, “we started to buy Merna when it started to appear in the market and the price was considerably below par”.
“It became attractive for us because of the discounting – you buy at 95ish and it’ll be re-paid at par. So you make money on that recovery. That puts a whole different perspective on the return of that bond,” he added.
Some market commentators also speculate that credit risk concerns over the impairment of certain assets held within the collateral account at the special purpose vehicle – which is guaranteed under a total return swap by Merrill Lynch – may also be a factor behind the sale of Merna notes. If so, it’s an indication that the non-life ILS sector cannot divorce itself entirely from the broader market difficulties.
With the benefit of hindsight we can clearly see what the smart money knew at the time: The cat bond market had become toxic and the luster of the Merrill Lynch financial guarantee contained in the embedded Total Return Swap was quickly wearing off which explains the new money and sales push to investors unfamilar with the unique operating charteristics of cat bonds. I noted this in the whispers column in the same newsletter on page 16:
“Credit crisis contagion? Not here”, say most supporters of ILS, keen to highlight the noncorrelation of the Trading Risk universe with the wider credit markets.
However, the wholesale selling of State Farm’s giant Merna Re cat bond may be one of the first signs of the effects of the wider credit market turmoil on non-life ILS.
According to one dealer’s pricing sheets, the price on Merna’s A notes have fallen from 103 of notional last September, to around 91-92 by the end of March, making it one of the worst ILS performers in the secondary markets.
And in the Trading Post, come whispers that it is not only the general liquidity stampede which is sparking sale orders among Merna investors.
With over $1bn in Merna’s special purpose vehicle, the list of approved investment was “somewhat extended” from the traditional government bonds and treasury notes, says more than one Trading Post regular. It is these funds which are used to generate LIBOR to service the bond’s coupon.
According to the Post’s barflies, the investment portfolio included some wider investments which have, or are in danger of becoming, impaired. This leaves investment bank Merrill Lynch, the total return swap counterparty guaranteeing the principal, potentially exposed because it will have to make up the shortfall at maturity.
And in these extraordinary times – when institutions such as Bear Stearns need to be rescued – the selling of Merna in the secondary markets has been exasperated by fears among investors that Merrill may not be around or be able to pay back the principal in 2010, when the notes mature.
“Investors have their principal in assets with a swap over it. It’s nice to get your spread, but you also want your principal back” one Trading Post regular commented. “People largely want to make sure that their principal is safe.”
As a consequence, Merna has become another security damaged by the “Bear Stearns effect” – where investors reduce their credit counterparty exposures to banks which are thought to be suffering in the current market conditions.
When you also add the fact that many Merna investors are not ILS specialists – and may therefore be particularly keen to liquidate non-core assets – then there is little wonder that the bond has suffered so poorly, of late. Champions of ILS, however, hope the trend is short-term.
As the largest-ever catastrophe bond and with investment grade ratings, Merna has a lot resting on it. But if the worst happens, investors can depend upon a whip-round at the Post…
History has proven the commentary in the newsletter spot on but it does not further our understanding of how State Farm gets $4 billion of reinsurance coverage with just under $1.2 billion dollars in Cat Bonds. It is also clear TARP is the only thing keeping the Merna Re deal afloat right now, even if the assets backing some of it are now toxic.
Even worse for the industry the news from here becomes more unpleasant as there is no new capital coming into this murky financial market. Could the implosions of these deals and lack of new capital into the reinsurance market better explain why State Farm and Allstate filed huge rate up requests in Florida last year? Could the implosion of Willow Re’s bonds be the real reason for the recently requested Allstate New Jersey rate up request? Check this out from Trading Risk, an excellent resource for reinsurance information:
Swiss Re explores $1.55bn CEA exposure hedges
Swiss Re mulls reinsurance derivatives and private placements as it fails to issue $650mn of Redwood cat bonds for the CEA.
Swiss Re is probing all sectors of the trading risk universe in an attempt to hedge layers of the $1.55bn of exposure it assumed on the California Earthquake Authority (CEA) reinsurance programme in December.
The reinsurer is understood to be pursuing various routes to shift the exposure off its stretched balance sheet, including cat bond issuance, industry loss warranties, private reinsurance placements and RepliCat deals – effectively a reinsurance derivative based on losses on a third party reinsurers’ programme as an index trigger for payment.
As reported in Trading Risk last November, the Warren Buffett-backed Swiss Re planned to retain $900mn of the risk on its own books, but was warehousing $650mn for the CEA with a view to securitising it in the form of a Redwood series cat bond – until the insurance linked securities (ILS) market refused to re-open in the fourth quarter.
A hardening traditional market, coupled with mainstream ILS investors selling vast quantities of cat bonds in late 2008 and investor caution over structures following the Lehman Brother’s collapse, has meant the market has not been able to reach consensus on cat bond pricing.
Nowdy we’ve yet to welcome Warren Buffett to slabbed but the time is drawing very close as Mr Buffett very recently recapitalized Swiss Re due to crushing losses there. This mess in the reinsurance markets is becoming a target rich environment.