In a landmark deal, the California Earthquake Authority (CEA) have completed the transfer of $150m of earthquake risks directly to capital markets investors for the first time. Previously the CEA had tapped the catastrophe bond market for cover through the Redwood Capital series of deals which were facilitated by Swiss Re, but for the first time they have gone it alone (with the support of Deutsche Bank) and forgone the use of a reinsurer.
They’re hailing the deal as the first earthquake only catastrophe bond without the use of a traditional reinsurer and they say it is intended to be a benchmark, allowing them to follow on with further low-cost transactions which will expand their sources of reinsurance cover (diversification) and claims paying ability.
“This deal is a game-changer,” said CEA Chief Executive Officer, Glenn Pomeroy. “Traditional reinsurance has been valuable for the CEA and will be going forward. But the CEA must diversify and expand its claim‐paying resources. A diverse set of risk-transfer tools, which includes not only reinsurance and catastrophe bonds but also post-earthquake federal loan guarantees, will help us make earthquake insurance more affordable and more widely used.”
That is a powerful statement and really extolls the benefits of the cat bond, particularly the benefit that can be gleaned by a large corporate with a massive reinsurance requirements seeking another, alternative source of re/insurance. It’s one of the things that the cat bond market was designed to be good at, but to date, as most deals involve a traditional reinsurer it hasn’t quite lived up to that promise.
The CEA is the largest earthquake insurer in the U.S. With over 800,000 policies in force, $600m in annual premium revenue and more than $9 billion in overall claim-paying capacity, the CEA writes 70% of all residential earthquake policies sold in California. Yet fewer than 12% of California households choose to buy earthquake insurance. The CEA uses a large reinsurance programme to which provide $3.1 billion out of the CEA’s $9.4 billion claim-paying capability.
They say that while reinsurance is appropriate to help them manage the financial risks of insuring against earthquakes, it comes at a high cost. Over 14 years, CEA has paid $2.8 billion to reinsurers, over 40% of its $6 billion total premium revenue. They seem keen to reduce that reliance on traditional reinsurers and cat bonds are a great way to achieve that while also reducing their reliance on federal loans.
Under the transaction, which you can find details of in our Deal Directory, the CEA entered into a three year reinsurance contract with Embarcadero Re Ltd. a Bermuda domiciled SPV which has been established for this and future CEA cat bond transactions. The transaction was led by Deutsche Bank Securities enabling Embarcadero Re to sell $150m of three year cat bonds to investors at a floating rate of 6.6% above U.S. Treasury money market funds. AIR Worldwide performed risk modelling duties.
They say the transaction was significantly oversubscribed. It was another extremely popular diversification opportunity for the established ILS and cat bond investors, but we hear from sources also interested some reinsurance investment funds who saw it as a cheaper opportunity than a traditional reinsurance linked investment. That’s positive for any future issuances that the CEA try to bring to market.
“This deal establishes a multi-year, repeatable method of risk transfer that’s less costly than traditional reinsurance,” said Tim Richison, CEA’s chief financial officer. “We intend to be back in the marketplace every four to six months and will continue to do so as long as there is interest from investors. Using the same structure in future transactions will make it easier for investors to understand and be comfortable with the terms, and will build the investor base to increase market capacity for follow-on deals.”
The fact that this transaction has resulted in a cheaper form of cover than traditional reinsurance is extremely powerful. It shows that the market conditions are right for issuance, and by making transactions more efficient, by forgoing the use of a reinsurer, or perhaps by using combined structuring and modelling firms, the costs can be lowered to provide a very reasonably priced source of cover. It will be interesting to see if EDF experience a similar lowering of cost with their Pylon transaction which is in the market at the moment.
One other factor that the CEA highlight from the deal is its ability to reduce their basis risk. They say that they expect the Embarcadero Re deal to provide them with total indemnity for actual reinsured losses and claim expenses covered by the contract. Sometimes indemnity deals leave substantial basis risk they say, but they expect Embarcadero Re Ltd. to afford them protection against that, leaving them retaining zero basis risk effecting a perfect match between their exposure and reinsured losses.
Standard & Poor’s gave the single tranche of $150m Series 2011-1 Class A notes which were issued by Embarcadero Re Ltd. a rating of ‘BB-‘.
It’s going to be interesting to see if the CEA stick to their word and try to issue another deal within six months. The fact that they achieved this issuance in such a cost-effective manner suggests that they may try again much sooner than that. With reinsurance rates widely expected to rise should any more major disasters occur around the globe cat bonds could begin to be seen as a cheaper option for many types of risk transfer, which will be particularly interesting if corporates can be encouraged to the market in greater numbers.