Lets connect the damages verdict in Bossier to reinsurance, securitization via cat bonds and global finance

I sometimes pinch myself someone as financially sophisticated as Mr CLS posts with us on Yahoo Allstate. Before I get to his post there is one concept that must be understood in reinsurance. Under traditional reinsurance the ceding party (such as State Farm) gets to take a credit on their balance sheets for the risk transferred to the reinsurer for the amount of reinsurance purchased. A problem with Cat Bonds is the lack of specific attachment points in loss payments (unlike traditional reinsurance) means the collection of the cat bond trust proceeds is de-coupled from the amounts actually paid to the insureds for their losses making it possible for an unsavory insurer to both collect for losses via the Cat bonds and stiff their insureds.

So what happens when traditional reinsurance is then backed by Cat bonds for a homeonwers policy which was also bundled and sold via securitization (think life settlements)? Mr CLS asked that exact question this morning and as per usual he followed the money to Bermuda:

Securitization for HURRICANE risks ABOVE the Hurricane Storm Surge water line.

“If I couldn’t differentiate between wind and water, I could NOT pay”, said adjuster Matthew Thiele.

The final version said “When the investigation indicates that the damage was caused by excluded water and the claim investigation does not reveal independent windstorm damage to separate portions of the property, there is NO COVERAGE available under the homeowners policy.

So where is the “Transfer of risk” through securitization?

What was the “credit” taken on liability balance sheets or off balance sheets for this transfer of risk?

Would a balance sheet credit be taken (say in the securitized HO policy of Bossier) for:
a) $2,300 (the initial payment loss)
b) $93,480 (the supplemental payment 4 years later)
c) $650,000.00 (the full policy limits)

S&P rate Alpha Wind 2000-A Ltd’s $90 million

These HURRICANE securities provide $90 million of retrocessional coverage to ARROW RE, a wholly owned Bermuda reinsurance subsidiary of Goldaman, Sachs & Co. Arrow Re has reinsured a $100 million portion of an excess-of-loss treaty covering STATE FARM Group (State Farm) policies, primarily homeowners, in Florida. This securitization represents a 90% cession of that risk to the holders of the securities.

The analysis included estimated losses for buildings, contents, additional living expenses, and an allowance for demand surge, the additional cost of building materials that often follows a hurricane.

Securityholders are subject to payments dependent on the triple-‘A’ rating on Swiss Re as guarantor of the total return swap counterparty (and, thus, asset guarantor), the unrated Arrow Re as the weak link in a chain of agreements leading back to State Farm, and the outcome of the peril modeling.

Alpha Wind has put the security proceeds into a collateral account with Bank of Bermuda Ltd as indenture trustee and invested in HIGH-QUALITY ASSETS whose final maturities may not exceed 15 years.

The collateral account supports State Farm’s reinsurance (through Arrow Re) of certain insured hurricane losses in Florida.

Under the retrocessional agreement, Alpha Wind is bound to follow the fortunes of Arrow Re with respect to its payments to State Farm under the reinsurance contract.

In today’s new fangled securitized world the ramifications of this scenerio are important. Under traditional Re the answer to the question is  straightforward, not so much (and by huge degrees) with Cat Bonds. I suspect most state DOI’s do not have the expertise to understand these concepts much less regulate them.

sop

2 thoughts on “Lets connect the damages verdict in Bossier to reinsurance, securitization via cat bonds and global finance”

  1. ” A problem with Cat Bonds is the lack of specific attachment points in loss payments (unlike traditional reinsurance) means the collection of the cat bond trust proceeds is de-coupled from the amounts actually paid to the insured for their losses making it possible for an unsavory insurer to both collect for losses via the Cat bonds and stiff their insured.”

    I never considered this possibility. At what point does the reinsurance enter into the realm of gaming? Reinsurance with a gaming component attached. When the payment of “insurance” does not depend upon a risk which you have assumed or hold is it insurance? I guess when the Courts moved away from the principle that if you charge for coverage than coverage is provided despite what the contract might exclude, these issues were the unintended consequences?

  2. This is the most fertile ground with Cat Bonds. There is some very good congressional testimony from the early part of this decade that lays out the myriad of problems related to regulating Cat Bonds that do not apply to traditional Re.

    Something else you mention that has been a topic of converstaion since the oral arguments in Corban is the legal concept that coverage follows premium. Team Corban had a full plate and did an excellent job in oral arguments at the MSSC but if there was one point the legal observers that speak with us consistently would have liked to have seen forcefully made that wasn’t in the oral arguments is that point.

    Finally, as an auditor by trade if I find a hole in an internal control system you can bet bottom dollar at least a few of the insiders in the organization see it as well with the less than honest types poised to take advantage. Mark my words it is a question of when an insurer is busted for doing just what I laid out, not if it will occur.

    Does anyone seriously think Jimbo the Clown or Mike Chaney is capable of regulating this?

    sop

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