Swiss Re Insurance-Linked Fund Management

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Cat bonds not immune from U.S. debt ceiling issues, Queen Street III on watch


Anyone who thought that catastrophe bonds were immune from the financial market uncertainty surrounding the U.S. debt ceiling has been proven wrong as Munich Re’s Queen Street III Capital Ltd. cat bond is placed on a negative credit watch due to collateral issues triggered by the debt ceiling issue.

The Queen Street III catastrophe bond provides Munich Re with $150m retrocessional protection against European windstorm risks with a combined statistical return period of around 50 years over a three-year term. The deal was issued in mid-2011 and so runs until mid-2014.

The transaction uses a dedicated collateral asset investment fund, MEAG Queen Street III, which was established at the time of issuance and is managed by Munich Re asset management subsidiary MEAG MUNICH ERGO Kapitalanlagegesellschaft mbH. The Bank of New York Mellon provide indenture trustee services to the collateral for the cat bond.

Due to the uncertainty surrounding the U.S. debt ceiling, on October 11th the MEAG Queen Street III fund saw a decline in its per-unit mark-to-market value. As the fund is designed to hold the collateral until the cat bond matures or a payout is required the fund faces strict asset value guidelines which state that the per-unit value may not fall below $100.00.

Because the per-unit value fell below this guideline amount the indenture trustee, Bank of New York Mellon, requested the liquidation of the fund and reinvested the remaining assets into Federal U.S. cash reserves. The proceeds from the liquidation amounted to $149,969,566.47, resulting in a loss of principal of $30,433.53, or two basis points).

As a result of this loss of collateral there is now a chance that the Queen Street III Capital cat bonds investors will not receive their full principal on maturity of the notes. As a result of this, ratings agency Standard & Poor’s placed its ‘B+ (sf)’ rating on the $150m of notes issued by Queen Street III Capital on CreditWatch negative.

S&P said; “The CreditWatch placement reflects that there is a one-in-two chance of a downgrade to ‘CC (sf)’ in the next three months if we consider there is a high probability that the noteholders will not receive 100% of the $150 million principal originally deposited in MEAG Queen Street III.”

S&P said it may affirm the rating at ‘B+ (sf)’ if it believes that the probability of a loss of principal by the maturity date is low. This will depend on whether the collateral is able to be invested in assets which could increase in value or whether, perhaps, the issuer could elect to top-up the collateral account to $150m again.

Given the small amount of collateral lost here this is not a major event for investors, although still an annoying occurrence for those exposed we’re sure. If it is possible to top-up the collateral under the terms of the deal, then Munich Re may elect to do so simply to shut this issue down.

However, what this does show is the reason why at Artemis we never claim cat bonds to be fully uncorrelated assets. Cat bonds and ILS exhibit very low correlation to wider financial markets, but the vagaries of the economy and financial markets mean that unusual occurrences such as this can impact catastrophe bond investors. Hence cat bonds have a low correlation, not no correlation at all.

It may be that this case has occurred purely due to the language used in the cat bond offering, stating that the fund had to be liquidated if its per-unit value fell. There is every chance the the per-unit value may have recovered once the U.S. debt ceiling issue passed which may have meant that this issue need not have happened (offering language aside).

Artemis has not heard of any other catastrophe bond collateral accounts which have experienced similar issues, however many others which invested in U.S. related treasuries may have seen a drop in the values of assets in the collateral account as the debt ceiling negotiation was occurring. It’s likely these assets will have recovered value after the debt ceiling issue was resolved, so unless the terms featured a similar clause no impact will have been noticed.

The collateral assets are often forgotten once a catastrophe bond has been issued. The value of assets in collateral accounts can go up and down and even the secure U.S. treasuries that collateral is typically invested in will not be immune to the largest financial market shocks, as this example shows.

It will be interesting to see how this credit watch gets resolved for Queen Street III Capital. We’ll update you when S&P report on the state of the collateral account again, which it says it will do within up to three months.

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