Residential Re 2011 notes downgraded on greater attachment probability due to Sandy

In a move which was to be expected, rating agency Standard & Poor’s have downgraded one aggregate class of notes issued in USAA’s Residential Reinsurance 2011 Ltd. (Series 2011-1)  catastrophe bond transaction as a result of the qualifying losses caused by hurricane Sandy. On the 6th November S&P placed the Class 5 notes of both Residential Re 2011 and also Residential Reinsurance 2012 Ltd. on CreditWatch with negative implications after USAA released an estimate of ultimate net losses from Sandy.

Both of the Class 5 notes issued under each cat bond provide cover for multiple perils, hurricane, earthquake, severe thunderstorm, winter storm, and wildfire, on an annual aggregate basis. Two events have already caused qualifying losses for the notes, Catastrophe Series 77 (a Colorado and Wyoming wind and hail tornado that occurred on the 6th of June) and Catastrophe Series 83 (a central and northeast U.S. wind and hail tornado that occurred on the 28th of June) which between them have generated estimated covered losses of $187 million. These covered losses effectively reduce the amount of future losses required to reach the cat bonds attachment points, thus increasing the probability of attachment.

For hurricane Sandy, which has been designated Catastrophe Series 90, the estimate from USAA is for an ultimate net loss range from a low of $129m to a high of $363m, with a point estimate of $291m. This will be added to the $187m from earlier events and reduce the attachment point. The the attachment points for the two USAA cat bonds are $1.365 billion for the Residential Re 2011 Class 5 notes and $1.571 billion for the Residential Re 2012 Class 5 notes. The risk period for both deals runs until 31st May 2013 when the attachment points would be reset and old qualifying losses from prior risk periods are discarded for the purpose of the deal.

So, the now three covered events, including Sandy, have decreased the amount of future losses necessary to trigger an event payment and in the view of S&P increase the risk associated with these cat bond notes. Risk modeller AIR Worldwide has provided S&P with updated probabilities of attachment for the notes for the remainder of this risk period and the ratings are now based on the new probabilities, which S&P haven’t published.

The Residential Reinsurance 2011 Ltd (Series 2011-1) Class 5 notes have been downgraded to ‘B+(sf)’ from ‘BB-(sf)’. The Residential Re 2012 Class 5 notes remain on their ‘BB(sf)’ rating.

Both tranches of notes remain on CreditWatch negative as S&P says there is the potential for USAA’s ultimate net losses from Sandy to increase. S&P says that if losses from Sandy were to come in at the high-end of the estimate, the Residential Re 2011 notes rating could be lowered by up to two notches and the Residential Re 2012 notes rating could be lowered by one notch. S&P expects to resolve the status of each cat bonds CreditWatch within 90 days.

So this is the first downgrade of a catastrophe bond due to losses caused by hurricane Sandy. These Residential Re cat bonds look to be safe from any principal losses given that the attachment points are much higher than the current aggregated loss levels. However, if we look at USAA and compare their percentage market-share in the Sandy affected north-east U.S. states to the current industry loss levels, there is a chance that USAA may have to increase their estimates were industry losses to come in at the high-end. USAA have close to 3% of the market according to various sources in the region. For example 3% of a $20 billion industry loss is over $500m, which is higher than the top end of USAA’s current estimate. It will be interesting to see whether there is any more loss creep to come for USAA from this storm. If there is it still won’t trigger any of their cat bonds but it does make them more risky through the first half of 2013 when they will have other perils such as tornadoes to contend with.

You might like to read our article from yesterday which looks at what could happen to Sandy exposed cat bonds as loss estimates creep upwards.