Kizuna Re II Ltd. (Series 2015-1)

Tokio Marine & Nichido Fire is seeking to sponsor the issuance of a single tranche of cat bond notes through its Bermuda domiciled special purpose insurer Kizuna Re II Ltd. this year.

Kizuna Re II Ltd. will issue a single tranche of Series 2015-1 Class A notes with a preliminary deal size of JPY25 billion (approximately $205m) to secure a fully-collateralized source of reinsurance protection for earthquake exposures including fire following across the whole of Japan over a four-year term, with four annual risk periods.

Also included are any losses resulting from tsunamis or volcanic eruptions that are caused by an earthquake during the term of the cat bond and S&P noted that the volcanic eruption exposure is unmodelled. There’s an element of earthquake triggered flood risk in this cat bond too, with flood losses, including any caused by dam or levee rupture or sprinkler leakage, covered.

Protection from the Class A notes will be on a per occurrence basis and the cat bond will feature an indemnity trigger. The notes will cover losses from Tokio Marine & Nichido Fire’s portfolio of personal, commercial and industrial property exposures across Japan.

Standard & Poor’s explained more about the subject business:

The covered exposures comprise commercial business that includes, but is not limited to, fire policies covering buildings used as shops and offices, as well as their contents; and industrial business that includes fire policies covering properties such as factories and warehouses, as well as their contents. Although the majority of policies fall within the category of fire policies, these two lines comprise policies categorized as fire, engineering, movable all risks, and business interruption policies (less than 30 policies have business interruption coverage) unless otherwise specified. Marine policies are not part of the covered exposures. Earthquake coverage for both property damage and business interruption is an endorsement to the standard contract earthquake endorsements that cover debris removal expenses (limited to 10% of the earthquake payout amount). The coverage includes fire policies and engineering and movable all risks policies. In all fire policies, earthquake fire expense insurance (EFEI) is covered in the standard contract. The modeled results indicate the majority of expected losses come from earthshake.

Personal business consists of fire policies written on buildings used only for dwellings and household goods. Policy holders purchase earthquake coverage as a separate endorsement.

For personal lines, all dwelling earthquake covers except for EFEI are ceded to Japan Earthquake Reinsurance Co. Ltd., the government-backed plan, and, therefore, are not reinsured under the reinsurance agreement. The covered exposures include policies in which TMNF is not the lead co-insurer. This accounts for less than 10% of earthquake total limit.

The overwhelming contribution to expected loss is related to the commercial and industrial policies. The total insured value for commercial, industrial, and personal business fire policies are based on replacement value or actual cash value (estimated replacement value less depreciation of property). The majority of the policies are written on a replacement-value basis.

We understand that the sponsor will retain a share of each loss of at least 10%, under the terms of the cat bond. The notes have an attachment point of JPY310 billion (approx. $2.5 billion) up to an exhaustion point of JPY350 billion (approx $2.9 billion), so covering a JPY40 billion (approx. $330m) reinsured layer of the sponsors programme.

On the risk modelling side, since 1700, there have been two events–the 1923 Taisho Kanto quake with the epicenter in the Kanagawa prefecture (part of the greater Tokyo area) and the 1707 Hoei earthquake with the epicenter in the Wakayama prefecture–that would have triggered the bond.

S&P explained; “The Hoei was the most powerful earthquake in Japan before 2011’s Tohoku earthquake, and it possibly caused an eruption of Mt. Fuji later that year. This 1923 event as modeled resulted in a 100% principal reduction. The modeled principal reductions from the 1707 event were modeled with (73% principle reduction) and without (68% principal reduction) the effect from the tsunami.”

Importantly, the number of historical earthquake events that could have impacted this cat bond does not increase if the 0.07% increased expected loss figure is used.

It’s also worth noting that the 2011 Tohoku earthquake would not have come anywhere near attaching the Kizuna Re II 2015-1 cat bond notes, as its ultimate net loss would only have been ¥95 billion and the attachment point is ¥310 billion.

This is a very remote risk Japan quake cat bond. The initial modelled attachment probability is said to be just 0.021%, while the exhaustion probability is 0.016% and the expected loss 0.018%.

The least risky layer of last years Kizuna Re II 2014-1 catastrophe bond had an attachment probability of 0.41% and an expected loss of 0.21%, so were considerably riskier than this new tranche which is being issued.

In terms of pricing guidance, we understand that the Kizuna Re II 2015-1 Class A notes are being offered to investors with coupon guidance of 2% above the return of the underlying investments. We’re told that there is no range being offered, which suggests that the deal will likely just close at a 2% coupon.

The 2014 Kizuna Re II deal priced the least risky tranche of notes at 2.25%. But if you compare the multiples, the 2015 deal will have a very high multiple, given the very low expected loss number, so investors are getting compensated more in terms of multiple to coupon.

This 2015 cat bond features a variable reset, we understand, but even if the sponsor chose to move the layer to the riskiest it is allowed under the terms of the deal it would still be a much more remote risk than its 2014 deal.

The collateral assets for this cat bond are being invested in Japanese Yen denominated investment funds, we understand, the first time this has been the case for a Tokio Marine & Nichido Fire cat bond we believe.

Standard & Poor’s has assigned an investment grade rating to a catastrophe bond for the first time since 2008, as the remote risk nature of the underlying Japanese earthquake risk helped the Kizuna Re II 2015-1 cat bond to a ‘BBB- (sf)’ preliminary rating assessment.

S&P explained; “This is the first property related nat-cat bond we’ve assigned an investment grade rating to since 2008.”

Gary Martucci, Director of Financial Services Ratings at S&P, explained some the reasoning behind the rating to Artemis; “TMNF’s market share offset some of the stress typically applied to a transaction where the cedent has a much smaller market share since their losses will more likely mirror the industry. In addition, given TMNF’s market share, by looking to the highest probability of attachment based on the variable reset, we believe there’s a significant amount of conservativism captured.”

Martucci went into more detail on the preliminary rating of these notes, saying; “To assign the nat-cat risk factor, we applied an adjustment to the time-dependent and time-independent results to reflect the possibility that the probability of attachment may be greater than the models had anticipated.

“Typically, we use the more conservative of these results, but there was a large difference between the two in this particular transaction. In year 1, there was more than a 10-fold increase in the estimated probability of attachment by moving from time-dependent to time-independent modeling, 2.1 bps versus 21.4 bps. This large difference seems to result at least in part from the recent Tohoku earthquake. The time-dependent result is lower because such an event decreases the amount of stress on a fault, making subsequent events less likely.”

An interesting point on this deal from S&P’s pre-sale report is the fact that the underlying portfolio can change, effectively raising the expected loss, but the coupon will remain the same.

S&P explains; “This issuance is structured to keep the attachment and exhaustion points constant, so, as exposures change, the probability of attachment, exhaustion, and the modeled loss will increase and decrease, subject to a maximum expected loss of seven basis points (bps). The interest spread will remain constant.”

However with this being such a remote risk transaction and with the deal likely to have a huge multiple investors are still being compensated for this additional uncertainty while the sponsor will benefit from additional flexibility in the structure as its portfolio changes.

S&P explained further:

AIR did the modeling using TMNF’s exposures as of March 31, 2014, and AIR’s time-dependent catalog. The probability of attachment, expected loss, and probability of exhaustion based on this catalog were 0.021%, 0.018%, and 0.016%, respectively.

When rating catastrophe bonds linked to earthquakes, we look at both time-dependent and time-independent analyses, and usually use the more conservative of the two. The time-independent analysis probability of attachment is 0.214%. The time-independent expected loss and exhaustion probabilities are 0.194% and 0.181%, respectively.

This issuance is structured to keep the attachment and exhaustion points constant, so, as exposures change, the probability of attachment, exhaustion, and the modeled loss will increase and decrease, subject to a maximum expected loss of seven basis points (bps). The interest spread will remain constant.

When rating nat-cat bonds that permit variable resets, we look to the highest probability of attachment permitted, which is based on the modeled annual expected loss cap of seven basis points (bps). Based on the time-dependent occurrence exceedance probability (OEP) curve, if the expected loss is seven bps, the attachment point would be ¥238.6 billion and the probability of attachment 10.5 bps. Based on the time-independent catalog, the probability of attachment and expected loss would be 35.5 bps and 30.5 bps, respectively. Our analysis for the second through fourth risk periods assumes the expected loss for each reset to be seven bps. We then stress the results to determine the nat-cat risk factor.

To assign the nat-cat risk factor, we applied an adjustment to the time-dependent and time-independent results to reflect the possibility that the probability of attachment may be greater than the models had anticipated. Typically, we use the more conservative of these results, but there was a large difference between the two in this particular transaction. In year 1, there was more than a 10-fold increase in the estimated probability of attachment (POA) by moving from time-dependent to time-independent modeling (2.1 bps versus 21.4 bps). This large difference seems to result at least in part from the recent Tohoku earthquake. The time-dependent result is lower because such an event decreases the amount of stress on a fault, making subsequent events less likely.

The stress factor that we applied to determine nat-cat risk factor reflected a number of factors. Our criteria list indicative stress levels for varying transactions with industry loss transactions having a 10% stress and indemnity transactions a 20% stress. Although losses for this transaction are calculated on an indemnity basis, TMNF’s large market share in some ways makes it more similar to an industry loss transaction. We would not expect a carrier of its size to have losses that greatly differ from its proportional share of the market’s losses. We also considered that the transaction contains some small amount of unmodeled risks and the transaction had a variable reset feature that we were treating very conservatively by looking to the highest probability.

We then select the next rating category below this adjusted POA that’s greater than or equal to the adjusted probability of attachment from our nat-cat risk factor table. This adjustment results in varying margins between the initial parameter values needed to trigger a payment from the noteholders to the issuer under the reinsurance agreement and the parameter values at the probability of attachment commensurate with the assigned rating.

Update 1:

The Kizuna Re II 2015-1 catastrophe bond was upsized by 40% thanks to strong demand from investors. The offering size grew to JPY 35 billion, which is approximately $290m.

Update March 2016:

The four-year term Japanese earthquake cat bond was the first to see its collateral assets invested in a Japanese Yen denominated investment fund and that fund is now to be liquidated. Which raises the possibility of this being due to the recent shift to negative interest rates at the central bank of Japan or to potential tax obligations or costs in moving to another permitted investment fund.

The notes are being redeemed under an early redemption event number VI. Standard & Poor’s describes this as permitting:

“The cedent to terminate the reinsurance agreement and redeem the deal early if it believes the supplemental premium payments (the annual service provider expenses) or a fee charged or imposed on any cash credit balance in the JPY deposit account or collateral account is likely (in TMNF’s sole discretion) to exceed $750,000 in a risk period or $2 million during the term of the transaction.”

According to rating agency Standard & Poor’s the collateral fund, the JPMorgan JPY Cash Liquidity Fund, is to be liquidated by its manager JPMorgan Asset Management on the 11th March 2016 and proceeds from that fund, including the collateral from this cat bond, will be disbursed to investors on 14th March.

The funds in the Kizuna Re II 2015’s cat bond collateral account will be held in cash during the period between liquidation and disbursement, S&P explained.

The Kizuna Re II cat bond transaction featured six possible redemption event options, and the fact that the sponsor has elected to do so under this particular redemption clause is due to the collateral account and this fund liquidation, with the negative Japanese interest rate one possible cause.

S&P explained that this particular redemption event has no early redemption payment associated with it, so the sponsor, Tokio Marine & Nichido Fire Insurance Co. Ltd., will not need to compensate investors in the Kizuna Re II notes for the termination of the deal, they will simply receive their principal back.

So it’s possible that the fund is being liquidated due to an inability to meet investment return targets due to the negative interest rate situation in Japan, with this affecting the cat bond. Or there could have been cost or tax implications associated with the liquidation and moving to another fund.