Operational Re Ltd.

Global investment banking group Credit Suisse has been testing the investment market (both ILS and traditional fixed income we understand) appetite for an ILS transaction which would ultimately provide the capacity to back an insurance policy covering the banks operational risk exposures.

The offering would, if successful, provide a fully-collateralised source of insurance and reinsurance protection which would back a CHF700m (approx $687m) operational risk insurance policy provided by insurer Zurich, with Zurich retaining 10% of the risk and the remaining CHF630m (approx $620m) ceded to the deal’s investors.

Credit Suisse turned to the ILS market and fixed income capital markets when it found that traditional reinsurance capacity could not be found to back the transaction.

Credit Suisse is targeting a completion of this Operational Re Ltd. ILS issuance by March and wants to enter into the insurance agreement with Zurich that month.

Credit Suisse is still seeking a five-year term for the insurance protection provided by Zurich and ultimately underwritten using the capital raised via the sale of ILS notes from Operational Re and the transaction remains structured on an annual aggregate and indemnity trigger basis.

As the issuer, Operational Re Ltd. will sell its notes to investors in order to collateralise a reinsurance agreement between itself and ceding insurer Zurich. That quota-share reinsurance agreement will see Operational Re taking 90% of the CHF700m insurance policy risks to be collateralised with the investor capital, leaving Zurich with the other 10%, hence the CHF630m of notes available.

To all intents and purposes Operational Re Ltd. is a catastrophe bond issuing vehicle, just covering a new type of risk. It’s a clear sign that the structure can be leveraged for a wider range of risks than the market currently features, and the fact this issuance is progressing is encouraging for the sector.

The bond would be triggered when Credit Suisse suffered over CHF 3.5 billion of losses under the operational risk insurance agreement in any annual risk period (the attachment point), with an exhaustion point set at CHF 4.2 billion.

Sources said the deal is cleverly structured such that it cannot be triggered by a single loss event, and so requiring a build up of operational risk impacts to the investment bank before investors could lose any principal.

If the operational risk ILS is successfully brought to market it will be a first, perhaps paving the way for repeat transactions from other issuers. It would be another demonstration of the broadening of the ILS market and that the ILS and cat bond structure is eminently suitable for a wider range of risks than are currently transferred in the ILS market.

We’re told investors would receive a 4% of notional coupon for their investment and that the notes, if issued, would have an expected loss of 0.15%. That makes the operational risk ILS deal fairly remote in terms of risk, but the key will be in helping investors to understand that.

Update 1:

The CHF630m operational risk insurance linked catastrophe bond or ILS structure Operational Re Ltd. is still being marketed by global investment banking group Credit Suisse, with April now being targeted for completion and the structure split into junior and senior tranches.

A two tranche structure enables investors to select where to allocate capital, on a risk and return appetite basis, with the junior offering a higher coupon than the senior.

A junior tranche will cover the first CHF300m of losses suffered by the Operational Re ILS, while the senior will cover the remaining CHF330m, but only attaching after the junior tranche has been exhausted, we understand. So in order for both tranches of the Operational Re ILS bond to suffer total losses Credit Suisse would have to suffer an aggregated operational risk indemnity of at least CHF4.2 billion. However, it’s important to note that no single operational risk loss could cause a loss to the notes, as the per-event limit is said to be CHF3 billion.

That means for the Operational Re ILS notes to suffer exposure to event there would have to be an aggregation during one of the annual risk periods.

We understand the two tranches of notes are now being offered with coupon guidance, with the junior tranche coming with guidance of 5.5%, while the senior coupon is said to be 4%.

The covered insurance policy has a relatively remote risk, with the expected loss said to be just 0.15%. With the ILS only taking a 90% share of losses in the policy that means the coupons on offer should prove attractive to investors, both the more traditional type and the ILS investors with an interest in this deal.

We understand that Milliman Inc. has been appointed as a risk modelling and calculation agent for this transaction.

We’re told that the investors that will back this transaction are varied, ranging from some specialist ILS investment managers, to hedge funds focused on regulatory capital opportunities, to insurance companies, family offices and also some of the world’s larger fixed income bond investment companies.

Update 2 (May 4th 2016):

The new special purpose insurer (SPI) named Operational Re Ltd. has now been registered in Bermuda for this transaction.

The notes will provide cover for some cyber risk exposures, such as IT system failure that causes business interruption, fraudulent behaviour both of external parties and employees of the investment bank, fiduciary issues, losses due to improper business practices or unauthorised activity, accounting errors, documentation errors, regulatory compliance issues, HR issues, discrimination in the workplace or even personal injury.

It’s a wide-ranging insurance cover but the way the Operational Re transaction is structured, to prevent a loss to noteholders from a single operational risk event or category alone ensures that for any payout to be made by the notes Credit Suisse would have to suffer a major impact to its business, just the scenario that ILS structures and risk capital are best placed to provide protection.

The junior tranche an expected loss of just 0.15%, while the senior tranche has an expected loss of 0.2%, both very low in the world of catastrophe bonds and ILS.

Based on Credit Suisse’s internal operational risk model it appears that the probability of the Operational Re notes facing a full loss of both tranches is about 1-in-1200, which is very remote. Based on an analysis of historical operational risk losses suffered by Credit Suisse, no losses would have occurred to the Operational Re notes from 2001 to 2014, reflecting just how unusual a loss event would need to be.

It’s said that the riskier junior tranche of notes has been fully subscribed, largely by regulatory capital hedge funds, and sources said it is expected that the senior tranche will also be subscribed and the deal is expected to launch in May now.

Issuance of Operational Re Ltd. has taken time because Credit Suisse needed to generate investor support for what is a new type of risk, build an investor base and also as the timing needs to be close to its results, we understand.

Update 3 (May 17th 2016):

We’re told that the latest terms for the transaction show a targeted size of CHF270m for the overall operational risk insurance protection, with Zurich still expected to retain CHF70m and the Operational Re Ltd. special purpose insurer set to issue CHF200m of notes to provide the fully collateralised reinsurance protection.

While Zurich’s retention will remain the same size, the percentage of the insurance policy to be retained by the insurer is of course increasing quite significantly.

The transaction remains split into two tranches, with a riskier junior tranche sized at CHF110m and a senior tranche at CHF90m, we understand.

Credit Suisse will itself continue to retain an operational risk loss of CHF3.5 billion, with that effectively the attachment point, but the other terms of the Operational Re operational risk cat bond all remain the same, we’re told.

So the underlying insurance policy and the reinsurance from the Operational Re ILS notes will still provide Credit Suisse with annual aggregate protection against certain operational risk losses. With specific limits still in place to ensure that no single operational risk loss event, or category of loss, can trigger these notes on its own. So this is effectively a second and subsequent loss event ILS deal.

We’re told that the pricing has also been adjusted on one of the tranches of notes to be issued by Operational Re Ltd.

The riskier junior tranche of Operational Re notes will continue to offer investors the 5.5% coupon we wrote about recently here. But the senior tranche has had the coupon raised slightly, to 4.5% from the previous 4%.

Update 4 (May 26th 2016):

Investment bank Credit Suisse’s Operational Re Ltd. transaction, which uses a catastrophe bond structure to secure insurance via the capital markets for operational risk exposures, has now been successfully settled at CHF 220m in size (around $223m).

A number of factors changed as the deal made its final progress to market, with investors requirements resulting in the issuance of a third tranche of notes and the risk retention held by insurer Zurich reducing down to just CHF50m, Artemis understands.

Artemis has now seen the final terms and pricing agreed for the Operational Re transaction, which show that Credit Suisse increased the size of the deal slightly from the CHF200m it had shrunk to ten days ago, to complete it at CHF220m (US$222 million).

So, as we understand it from the details seen, the investment bank now has in place a CHF270m operational risk insurance policy from insurer Zurich, effective today, with Operational Re providing CHF220m of the capital via a reinsurance arrangement between itself and the insurer, collateralised by the sale of the three tranches of notes to investors.

The insurance arrangement underlying the Operational Re notes runs from today for just over five years, to the end of May 2021, Artemis understands, providing Credit Suisse with a mostly collateralised source of operational risk cover for the duration of this term.

Credit Suisse continues to retain CHF3.5 billion of operational risk losses before the insurance would kick in (so the attachment point) and we understand that it still cannot be triggered by a single operational risk event, with the coverage on an annual aggregate basis.

Before close, the transaction changed slightly, in terms of the number of tranches of notes issued by Bermuda domiciled special purpose insurer Operational Re Ltd.

We understand that a CHF105m Class A-1 tranche, a CHF5m Class A-2 tranche both pay investors a 4.5% coupon, with the A-2 tranche a Reg S issuance in larger denomination notes, so likely to meet a specific investors needs. Meanwhile the riskier junior tranche remained a CHF110m Class B set of notes that was also issued, and will pay investors a 5.5% coupon.

So it looks like the operational risk insurance coverage that Credit Suisse will receive through the transaction will be just over 80% provided by the reinsurance sourced through the capital markets and this insurance-linked securities (ILS) transaction, with investors in Operational Re on the hook for CHF220m of qualifying losses while Zurich retains CHF50m of the risk.