More details on the recently launched Golden State Re II Ltd. catastrophe bond transaction have come to light, showing how time of day is a key factor of a qualifying earthquake, with the publication of a pre-sale report from Standard & Poor’s.
The transaction, which is essentially a renewal for the December 2011 Golden State Re Ltd. cat bond, sees the California State Compensation Insurance Fund (SCIF) seeking to secure a new source of capital market reinsurance protection for workers compensation claims caused by earthquakes.
The notes issues will protect the SCIF from workers compensation losses caused by earthquakes in the California area, on a per-occurrence bases using a modelled loss trigger. The transaction provides four years of coverage, one more than its maturing cat bond provided.
Our article discussing the launch of the deal a week ago gave the basic details on the transaction structure, its trigger, the attachment probability, expected loss and coupon range. S&P’s pre-sale report adds value here by providing some insight based on the rating agencies assessment of the transactions risk factors.
S&P said that it has assigned its preliminary ‘BB+(sf)’ rating to the Series 2014-1 Class A notes to be issued by Golden State Re II Ltd. This rating is based on the lowest of the natural catastrophe risk factor, ‘BB+’, the rating on the assets in the reinsurance trust account, ‘AAAm’, and the creditworthiness of the ceding insurer.
The ‘bb+’ natural catastrophe risk factor was derived by S&P using the risk model that the transaction was structured with. RMS is the risk modelling firm in question and its RMS U.S. Earthquake Casualty Model, updated in 2014, as implemented in RiskLink version 13.1 is the model in use for the deal.
S&P notes that the risk modelling for the cat bond is based on the notional portfolio of SCIF risk as at 30th April 2014, so if the cat bond is triggered the actual exposure will be different due to the passage of time, but not sufficiently to cause any concern. The notional portfolio is expected to adequately reflect the covered business throughout the life of the deal. An updated notional portfolio may be provided with the reset, which should help to keep any gap between notional and actual exposure to a minimum.
S&P always tests the modelling results and sometimes applies incremental stress factors, such as adjusting the modelled probability of attachment, if its criteria require it. S&P’s catastrophe bond rating criteria prescribes that it applies a 7.5% stress level to a modelled loss transaction, although this can differ depending on the company’s strengths, concerns and mitigating factors.
S&P said that the modelling results for this deal assumed qualifying events are evenly distributed throughout a day. Since the timing of an event will have an impact on the loss amount, an important factor as this is based on workers compensation so is most exposed during the working hours of the day when workplaces are busy, S&P reviewed two sensitivity tests that adjusted (in hourly increments) the time of each stochastic event by plus and minus two hours and six hours from its original time.
After performing these stress tests S&P constructs a new exceedance probability curve for the cat bond and found that the results were still consistent with a natural catastrophe risk factor of ‘BB+’. This is one of the benefits of a rated cat bond, a third-party applying its own stress tests and analysing the cat bonds risk factors. For some investors this can be a welcome contribution to understanding the deal, particularly if their own resources are restricted.
S&P noted its concerns about the transaction. Firstly, the time of day factor having such a potential impact on the resulting event index level (hence the additional testing mentioned above. Secondly, the fact that there may be triggering events which are not captured by the model, always an issue with an earthquake bond particularly in an area with so many faults as California. And third, the investment risk that the Treasury money market funds used as collateral may have, although as we all know these are about as low-risk as collateral assets can get.
Based on RMS’s risk analysis there have been three historical events which could have generated an index value high enough to breach the attachment level of the notes had they occurred at specific times of day. These are the 1857 Fort Tejon earthquake had it occurred at 2 p.m. and the 1906 San Francisco and 1994 Northridge earthquakes, had they occurred between 9 a.m. and 3 p.m.
However, each of these historical earthquake events actually occurred at times where the modelled index values that RMS generated were not in excess of the attachment point. This shows just how the modelled loss trigger has been constructed to closely match the modelled loss with a workers compensation claim level, thus providing the cover the SCIF seeks.
The main exposure for this earthquake is in California, despite it covering all 50 U.S. states. In fact 99.99% of the SCIF portfolio is located in California, hence the coverage is targeted there. For an event to qualify it must be at least magnitude 5.5, which does mean that recent events such as the Napa earthquake would have qualified and may have resulted in the index values having to be generated by the calculation agent, although with no chance of reaching the trigger we’d imagine.
In terms of which part of California is most risky for this cat bond, Los Angeles County contributes 52.1% of the expected loss, Orange County 10%, Alameda County 6.1%, San Bernardino 5.8% while the rest contribute under 4%. Even San Francisco only contributes 3.6% to expected loss. This shows that the focus of the notional workers compensation portfolio’s exposure is on Los Angeles.
Employees working in offices make up 47% of the employees covered, which again ties in with a focus on LA. 9am to 4pm on a weekday is the riskiest time for this cat bond with the modelled contribution by time of day highest between these hours, according to S&P.
The way the cat bond trigger has been constructed ensures it provides the coverage the SCIF requires, for workers compensation claims it suffers due to earthquakes. The index value could therefore be very different for an earthquake occurring outside working hours, or at the weekend, compared to one which occurred in the middle of a working day.
The contribution to modelled losses by time of day even dips slightly around lunchtime, as more workers will be outside of the workplace should an earthquake occur at that time. This is intelligent use of modelling and data to construct a catastrophe bond that meets the needs of the ceding party.
We will update you further as this transaction comes to market. You can find the full details on Golden State Re II Ltd. (Series 2014-1) in our catastrophe bond Deal Directory and once the transaction is completed it will also be added to our ILS Market Dashboard and Statistics.