Current Trends in RISK-LINKED SECURITIZATIONS

Risk Management, August, 2001 by Morton N. Lane, Roger Beckwith

Introduction

Towards the end of the year 2000, any paper describing current trends in insurance-linked (now fashionably dubbed risk-linked) securitization would have been short. There was one trend to describe them: declining--to the point of disappearing--issuance. In November, however, Munich Re and AGF rode to the rescue.

At twelve months end, given our off-calendar summaries of activities (March 2000 to March 2001), the score is not so bad. Given 2001 completion of SR Wind, initiated in March but completed in April, the box score for the last year is:

Pre 3/98    4/98 - 3/99   4/99 - 3/00   4/00 - 3/01

$886.1(*)    $1366.9(*)    $1219.4(*)    $1126.0(*)
7 Deals      7 Deals       11 Deals      10 Deals

(*) $=million

This table demonstrates a sideways movement of the market size, but our examination of the details reveals continued experimentation in the character of the securities. We also see more peril coverage as Figure 1a and 1b illustrate.

[GRAPHS OMITTED]

There is, in addition, more use of securitization-techniques in direct underwriting. This does not show in 144A statistics. Deals done by Saab, Rolls Royce and the CEA--arguably securitizations--are not included in the tabulation; neither is the innovative risk swap between State Farm and Tokio Marine. The alternative risk transfer market as a whole appears to be progressing. Specific securitizations are evidently only part of the story.

Why did the activity pick up from November on? The answer lies in the firmness of the retrocessional market and the coincidence of year-end renewals. Ever since the French storms Lothar and Martin in 1999, there has been the prospect of a tight market for retro and some reinsurance. In such circumstances, theory would suggest that cedents would want alternative sources of coverage. Capital markets are the scripted source. And for brave issuers, they performed on cue, providing coverage that was cheaper than the existing traditional markets.

In describing current trends we proceed as follows. First, we describe the nature of each separate deal. Second, we identify trends in the character of issuance. Finally, we focus on the perils embedded in the securities and comment on the challenges they pose to prospective investors. Relative pricing is not discussed here.

The Deals Alpha Wind 2000

This transaction was notable in several respects. It was the first transaction by the State Farm group, which chose to conduct two coverage experiments this year. The other experiment was the risk swap with Tokio Marine. The Alpha deal involved two tranches and cessions from three State Farm Companies to Arrow Re, which in turn ceded to the Special Purpose Vehicle Alpha Wind.

As we had predicted last year, one noticeable trend in securitization was the issuance of equity tranches in order to avoid consolidation on the part of the ceding company. Typically, these equity pieces are of the order of 3 percent of the deal. State Farm took double precaution, once by ceding to Arrow (the Goldman Sachs transformer) and second by issuing the whole junior tranche (42 percent of the deal) as preference stock.

Rated BB by Standard and Poor's, the senior coverage ran for twelve months and involved a portfolio of wind coverages, particularly in Florida. The structure was otherwise a conventional aggregate excess of loss indemnity cover. The senior piece was rather finely priced at the London Inter-Bank Offered Rate (LIBOR) 456 basis points. The junior tranche (the preference shares) was priced at LIBOR 700 basis points.

Residential Re

The structure of United Services Auto mobile Association's (USSA) fourth issuance is by now well known. It is the quintessential cat bond. The investor gets 40 percent of USAA's first $500 million of incurred losses, excess $1 billion, if and only if the insurer has suffered this loss as the result of a Class 3 (or greater) hurricane. In exchange, the investor receives (this year) LIBOR 410 basis points.

Originally issued as a $500 million security in 1997, the deal size was cut by more than half to $200 million last year in a price-validating competition with the traditional market. Absent that cut back, securitization numbers would have continued to grow in both 1999 and 2000.

NeHi

Vesta Fire Insurance Group was the cedent of this Aon transaction, utilizing the on-shore issuing capabilities of the INEX Insurance Exchange. Total size was $50 million, and it covered North East hurricane risk together with tropical storm risk in Hawaii.

AIR, the risk consulting firm, constructed a suitable wind model and investor payout was related to the modeled losses excess $135 million.

Rated at BB by Fitch, it was issued in two tranches. Like Residential Re, its senior tranche was priced at LIBOR 410 basis points.

Mediterranean Re

Assurances Generales de France (AGF) is a new entrant to securitization, and its issues provided an interesting structure as it sought to design coverage acceptable to AGF and the capital market investors.

With losses denominated in euros and the issuance in dollars, AGF sought protection from losses due to European windstorms and French earthquakes in both absolute and relative foreign exchange terms. Furthermore, while each of the tranches cover both wind and quake events with a co-reinsurance (or quota share reinsurance) of 65 percent, the first wind event is singled out to have a co-reinsurance of only 35 percent. Why this should be so is not clear. What is clear is that the design was tailored to AGF's needs--affirmation, perhaps, of the specific retrocessional aspects of AGF's inaugural effort.