The special purpose insurance (SPI) vehicle has now been registered for investment bank Credit Suisse’s Operational Re Ltd. transaction, which will see the firm look to secure insurance for its operational risks through a catastrophe bond-style ILS securitisation.
Artemis first wrote about this transaction back in January when it became apparent that Credit Suisse was looking to bring an innovative transaction to the investment community, using an insurance-linked securities (ILS) or cat bond structure to secure risk capital to back its operational risk insurance needs.
At that time few details were known, but come February Artemis covered the launch of the transaction to investors, further details on the mooted coverage and structure, as well as the suggested name for the issuance vehicle of Operational Re Ltd.
Then in March it became clear that feedback from institutional investors, which include ILS fund managers as well as hedge funds, fixed income investors and other institutions, had provided feedback that led to Credit Suisse electing to split the transaction into two tranches of notes.
At the time, it was understood from sources that Credit Suisse would target an April issuance for Operational Re Ltd., but that again proved ambitious as completing the novel ILS deal has now dragged on into May.
But progress is now being made, as has become clear with the news reported by the Royal Gazette’s Jonathan Kent of the registration of a new special purpose insurer (SPI) named Operational Re Ltd. in Bermuda.
So to refresh your memories, the Operational Re Ltd. transaction will see investment bank Credit Suisse enter into a five-year operational risk insurance agreement with Zurich, for as much as CHF700m (approx $690m) of cover.
Zurich intends to retain 10% of the operational risk covered by the insurance policy and the rest, as much as CHF630m (approx $620m), will be securitised and issued as two tranches of notes to investors by Operational Re Ltd., in exactly the same way as a catastrophe bond deal.
Operational Re Ltd. is an indemnity cover for Credit Suisse, providing it with operational risk insurance capital for “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events,” according to a presentation seen by Artemis.
The insurance policy and Operational Re notes will cover some of Credit Suisse’s operational risk losses above the investment bank’s retention at CHF3.5 billion, the attachment point, and up to CHF4.2 billion, or the exhaustion point, beyond which Credit Suisse will retain losses.
The underlying policy and the Operational Re ILS notes will provide Credit Suisse with annual aggregate protection against operational risk losses. The types of operational risk events that could impact the bank are split into scenarios, with specific limits to ensure that no single operational risk loss event, or category of loss, can trigger these notes on its own.
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.
With the transaction now split into two tranches based on feedback from certain investors who wanted a minimum coupon for supporting the deal, investors have a choice of where to support Credit Suisse’s risk transfer needs and at what point they might face losses.
Of the CHF630m of notes, the junior, more risky tranche will offer a fixed coupon of 5.5%, while the senior coupon offers investors 4%. The junior tranche will cover the first CHF300m of losses suffered by the Operational Re ILS notes, with the senior covering the remaining CHF330m after the junior tranche has been exhausted.
That gives 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.
Of course the motivation for this transaction is two-fold for Credit Suisse.
The first is reinsurance market related, as the investment bank went to market looking for an insurance policy to cover its operational risks, but couldn’t find the coverage it wanted so has designed the policy which it feels will help it hedge its operational tail risks more effectively.
However, in order to secure the insurance from Zurich reinsurance capacity is required and the traditional reinsurance market could not provide this capacity, so it has turned to the insurance-linked securities (ILS) and capital markets instead.
The use of a securitisation structure, or catastrophe bond, is an efficient way of transforming insurance risk into an asset that can be backed and invested in by capital market investors, hence Operational Re Ltd. was born.
The other reason, is related to regulatory capital and Basel III. Operational risks are part of Basel III capital calculations, so by offloading some of it by securing this insurance policy in a transaction modelled according to Basel III guidelines Credit Suisse will effectively strengthen its regulatory capital position.
According to a report from Bloomberg, the sale of the Operational Re Ltd. notes was slated for completion on the 6th May, in just two days. Bloomberg also reported that the junior, riskier tranche of notes have been fully subscribed, which would suggest that the senior tranche will likely become fully subscribed as well.
Operational Re remains a fascinating and innovative use of the catastrophe bond and ILS structure for the transfer of risks and procurement of insurance or reinsurance cover. It signifies another milestone in the ILS market, as the asset class broadens further to cover additional classes of insurance business and types of risk.
However it remains the case that this ILS deal will not be for everyone, as some ILS fund managers will find operational risk too correlated with financial markets, and with low correlation a key selling point for the ILS asset class adding this deal to their portfolios may not be compelling.
But there are some ILS fund managers that look set to invest if the deal successfully completes, along with other institutional investors from regulatory capital hedge funds (which largely target the junior tranche) and family offices, to insurers and fixed income investors, we’re told.
Perhaps most important though, is the fact that a successful issuance of Operational Re will signal clearly that the catastrophe bond and ILS structure is a suitable vehicle for the transfer of a much broader range of risks than we see in the market today.
That bodes well for future ILS market expansion, as there are risks that are currently uninsured or uninsurable that an ILS structure could perhaps cover, providing the reinsurance capacity necessary to enable the insurance policies to be written.
The Operational Re Ltd. SPI is now registered with the Bermuda Monetary Authority at ILS and insurance management specialists Horseshoe’s address. We’ll update you as and when any news of the completion of the deal emerges.