Posted on 26 Jul 2011
Risk Management Solutions Inc.'s updated U.S. hurricane model has already had an impact on both existing and new catastrophe bonds, said an A.M. Best Co. analyst.
An estimated 71% of existing cat bond capacity outstanding is exposed to U.S. wind risk, according to a second quarter insurance-linked securities market update by Willis Capital Markets & Advisory.
The immediate impact of RMS' RiskLink Version 11.0 US Hurricane Model led to the revision of attachment and exhaustion probabilities, and expected loss percentages, of 32 tranches of existing catastrophe bonds, said Asha Attoh-Okine, managing senior financial analyst of insurance-linked securities at A.M. Best Co.
"All but three of these tranches showed an increase in expected losses," Attoh-Okine said."The ratings on some of these catastrophe bonds have been downgraded as a result of the increased attachment probabilities using this revised model."
For instance, earlier this month, A.M. Best downgraded the debt ratings to "b" from "bb-" on $100 million series 2009-1 Class A and to "ccc" from "b" on $75 million series 2009-1 Class B principal-at-risk variable rate notes issued by Montana Re Ltd. The rating actions were in response to A.M. Best's receipt of new attachment probabilities using the new model. The updated attachment probabilities showed a significant increase when compared to those previously calculated with the archived model, which was used in the initial modeling, A.M. Best said.
The Montana Re notes provide Flagstone Reassurance Suisse S.A. with $100 million protection against U.S. hurricanes (Class A) and $75 million protection against U.S. hurricanes and earthquakes (Class B). The protections are based on a modified property claim services index trigger on a per occurrence basis covering a three-year period that runs from Nov. 30, 2009 to Nov. 30, 2012.
Willis noted the second quarter has been relatively quiet for new cat bonds, especially when compared with last year.
Only four new property catastrophe bonds came to the market, adding $592 million of risk capital, compared with 2010, when the second quarter saw eight new transactions bringing $2.1 billion to the market, Willis said, noting the RMS model and first-quarter loss activity impacted the market.
Of the eight publicly rated cat bonds covering peak property/casualty exposure issued so far this year, none have used RMS as the modeling agent, Attoh-Okine said.
"Are sponsors avoiding using the RMS’ RiskLink Version 11.0 Hurricane Model when issuing cat bonds?" he asked. "One may partly attribute the recent slowdown in cat bond issuance in the second quarter of this year to uncertainty surrounding interpretation of the RMS model output and its impact on cat bond pricing and most sponsors preoccupied with assessing recent large catastrophe losses."
Investors, who have historically been satisfied with a single model, are now discussing multimodel approaches to risk, Willis said. "The art of cat bond underwriting is evolving," Willis said.
While Munich Re's $300 million Muteki cat bond transaction is a total loss due to the Japan quake, investors do not appear to be shying away from the market place, Attoh-Okine said.
"This will probably not scare investors entering the cat bond market. There are over 50 dedicated ILS investors in this market. These are highly sophisticated investors who understand the risks and rewards associated with investing in ILS products," he said.
Willis said the cat bonds triggered by the Japan quake might prove to be an incentive for more sponsors to come to the market.
"It provides even more evidence to sponsors that these deals work as designed," William Dubinsky, managing director of Willis Capital Markets & Advisory, said in an email. "It may make cat bonds more economically viable for regions and risks where they haven't been in the recent past."
While the third quarter -- the heart of the U.S. hurricane season -- is traditionally a quiet time for new cat bonds to be issued, there's still time for sponsors to build on the $1.6 billion issued so far this year to make 2011 a strong year for cat bonds.
"To eclipse last year’s issuance of about $4.5 billion, a projected amount of approximately $3 billion would have to be issued during the second half of 2011," Attoh-Okine said. "This number may be achievable given that dedicated investors have ample cash to deploy, reinsurance rates are now gradually firming up and insurers could start to look for alternatives from the traditional reinsurance market to cede their cat exposure."
However, he said, if the reinsurance market continues to be soft and the traditional reinsurance market becomes cheaper relative to issuing cat bonds, then "achieving this number would be a herculean task."
"Notwithstanding a quiet second quarter by historical standards, the second half of the year should be busy based on a combination of visible pipeline, sponsor need, and investor appetite to take risk, Dubinsky said, noting there would be "pent-up demand. Most of the activity may be deals without U.S. hurricane risk."
Willis said the third quarter could benefit by some of the same forces that curtailed issuance in the second quarter. For instance, both sponsors and investors should have had time to become more comfortable with the new RMS model and how it will impact pricing.
Plus, the increase in non-U.S. catastrophe reinsurance pricing may naturally lead to more non-U.S. deals in the third quarter and beyond, Willis said.
This is assuming a "relatively benign U.S. hurricane season. If we see a large U.S. loss, all bets are off," Willis said in the report.