Aozora Re Ltd. (Series 2014-1)

The Aozora Re catastrophe bond is sponsored by primary insurers Sompo Japan and Nipponkoa Insurance Company, Artemis understands from market sources. The two insurers, which are both part of the NKSJ Holdings group, are set to merge to become a single entity named Sompo Japan Nipponkoa Insurance later this year. Both are first time catastrophe bond sponsors.

Aozora Re will seek to issue two tranches of Series 2014-1 notes in this transaction, with one tranche denominated in USD and the other JPY. Artemis understands that whether both tranches are issued will ultimately depend on demand and appetite from investors. The different currencies used may suggest that the JPY tranche will be marketed to Japanese ILS investors, although some ILS managers do have JPY denominated funds now which could make this tranche targeted at them.

Both tranches will be exposed to Japanese typhoon events and the resulting losses from wind, flood, surge, rain, hail or tornado damage. Both tranches will use an indemnity trigger and the reinsurance protection they provide will be on a per-occurrence basis over a slightly less than three-year period, until April 2017.

Interestingly, sources told Artemis that both tranches of notes have the same risk profile, attaching at the same level and exhausting at the same level, so the main differences between them would appear to be the currency and also that the collateral of the USD tranche will be invested in U.S. treasury money market funds while the JPY tranche will be invested in Japanese Yen denominated money market funds. Again, that suggests the tranches will be marketed to different groups of investors.

Both tranches of notes offered in this Aozora Re cat bond have an attachment probability of 0.57%, an exhaustion probability of 0.49% and the expected loss is 0.52%. The notes will attach at JPY 513,500,000,000 and the exhaustion is at 536,000,000,000, which is a layer of the sponsors reinsurance program sized around $230m.

The Aozora Re cat bond will allow the sponsors to elect to perform a variable reset if they choose, where the expected loss has to be kept within certain predefined bounds and the coupon will be adjusted accordingly for investors.

A Class A tranche of notes will be USD denominated and is marketed with price guidance of 2.25% to 2.65%. A Class B tranche of notes will be JPY denominated and features price guidance slightly higher at 2.3% to 2.7%. The JPY coupon may be higher purely for currency exchange reasons.

Update 1:

The publication of Standard & Poor’s presale report for this catastrophe bond raised some concerns and complexities in the transaction which are worth mentioning.

The Aozora Re cat bonds modelling was performed using SJNK’s exposures as at 30th September 2012. S&P notes that it has been told that the subject business has not changed materially since that date, however that is quite a long period during which subtle changes may have occurred.

S&P highlighted, as usual, a number of concerns with the cat bond transaction, however in this case they are a little more unusual than in other recent cat bonds to come to market.

S&P said that around 13% (based on total insured value) of the exposures covered had an unknown location, that around 34% of the initial modeled loss is from industrial and commercial lines and that demand surge is not modelled. These factors could result in unexpected losses to NKSJ, outside of the expected losses from the modelling we would assume. It also suggests that certain exposures have not been modelled fully given their location was unknown.

Mitigating factors noted by S&P include the fact that 66% of the expected loss contribution is from personal lines exposures and that there are no individual or groups of properties that create any concentration concern. Also that NKSJ will retain a percentage of the ultimate net losses for each covered event, thus reducing the potential impact to these cat bond notes.

Another potential concern noted by S&P is that the AIR risk model used for this cat bond does not contain historical events after 2006. However only one event after that date, Typhoon Roke in 2011, has caused losses in excess of ¥3.8 billion. Losses from Roke totaled approximately ¥29 billion, according to S&P.

Also, there have not been any typhoon events since 1947 that would have generated sufficient losses to reach the attachment point, said S&P. This is a remote risk, with a very high attachment point. 1959′s Typhoon Vera had the highest estimated ultimate net loss of ¥286.5 billion, however that number would need to increase by nearly 79% to reach the initial attachment level, and by 34% if the attachment was adjusted to the maximum under a variable reset. The next two events that generated the greatest ultimate net loss totals were 1961′s Typhoon Nancy and 1991′s Typhoon Mireille with loss amounts of ¥214.5 billion and ¥181.7 billion, respectively.

On the subject business, S&P said:

The subject business is a subset of the ceding insurer’s overall insurance portfolio and comprises fire insurance policies, movable-all risks (that is, property that can be moved outside of the insured premises) insurance policies, motor insurance policies, and engineering insurance policies. Motor insurance and fire insurance policies account for more than half of SJNK’s underwriting portfolio on a net premium income basis. All products cover typhoon and some products cover flood risks under standard policy forms. Losses related to movable-all risks, motor, and engineering insurance policies will only be covered under the reinsurance agreement by application of the adjustment factor.

Fire insurance is subclassed into personal, commercial, and industrial subject business lines of business. Personal consists of policies covering residential dwellings and contents. Commercial consists of commercial policies covering stores and offices, etc., as well as equipment and products within such premises. Industrial consists of industrial policies covering buildings and factories, as well as equipment, devices, products, and other unfinished products within such premises.

Also worth noting is that the region that contributes the most to expected losses is southern Japan, the area most prone to typhoon losses, with Fukuoka and Nagasaki prefectures contributing 19% of expected losses between them while Tokyo is just under 6%. Meanwhile wind contributes 90.8% of expected losses while flood only contributes 9.2%, on a building type basis dwellings are 41.3%, government housing loan scheme properties 24.6%, commercial 18.6% and industrial 15.5% of expected losses.

S&P notes that while the Class A notes are US dollar denominated the sponsor will be retaining any currency risk between the conversion from ultimate net losses, which will be calculated in JPY and any loss to noteholders which will be in USD.

The variable reset is worth noting as it allows the ceding insurer to adjust the modeled expected loss within a range of 0.52% to 1.04% at each reset date. S&P said that the probability of attachment based on the maximum expected loss is 1.15% and is the probability of attachment used to determine the nat-cat risk factor.

Interestingly, S&P also said that at the variable reset the expected loss can increase from the initial level 0.52% to 0.70% without any increase to the risk interest spread, so investors may not be compensated for some increase in risk profile with this cat bond, an unusual feature. Should the expected loss increase above 0.70% then the risk spread will be adjusted accordingly.

As a result of the first three concerns we mentioned above, the unknown location of some exposures, the industrial and commercial exposure and the lack of demand surge modelling, S&P said that it has adjusted the probability of attachment more than its rating criteria specifies to make allowance for these concerns and to derive its preliminary rating for the notes.

Update 2:

The Aozora Re cat bond has been cut down to a single tranche, with only the Japanese Yen denominated tranche B notes being issued.

The deal is now said to be JPY 10 billion, which is just slightly under the $100m, meaning that the sponsor will likely receive the amount of cover it had been seeking.

The Class B tranche has the same risk of attachment as the previously proposed Class A, so the sponsors are effectively receiving the same protection from the cat bond, just through a JPY tranche of notes instead.

The Class B notes were launched with price guidance of 2.3% to 2.7%, which had been pitched 0.05% higher than the Class A notes despite having the same risk level. At the latest price guidance today Artemis understands that the range marketed has dropped down to 2% to 2.25%.

Update 3:

The Aozora Re catastrophe bond completed at JPY 10.125 billion, which is approximately $99.35m USD. The notes which had launched with price guidance of 2.3% to 2.7%, which subsequently dropped down to 2% to 2.25% last week, finally priced at the bottom end of the reduced guidance at 2%. This is the lowest ever coupon on a Japanese typhoon catastrophe bond, again demonstrating investors appetites for risk.