The latest catastrophe bond transaction to be sponsored by American International Group (AIG) is a complex deal involving multiple perils, a broad trigger and providing reinsurance protection for a diverse and unusual book of business. More details about the Tradewynd Re Ltd. (Series 2013-1) cat bond have now emerged as the notes received a preliminary rating.
The Tradewynd Re cat bond has been generating a lot of interest and discussion in the marketplace. It’s one of those transactions which has its supporters and detractors, largely due to the nature of the underlying book of business that the cat bond will provide reinsurance protection for.
The deal is another encouraging sign that the cat bond market, and the insurance-linked securities (ILS) investor base, is maturing and becoming open to more unusual deals featuring broader books of underlying insurance business. That is another positive step forwards which will assist the markets continued growth and ability to match traditional reinsurance cover.
However there are aspects of Tradewynd Re which are new, or unusual, in the catastrophe bond market and as a result opinions seem divided on the deal. Despite this division, the deal is heading towards completion having upsized by 25% to $125m although investors have demanded higher pricing and it’s likely to complete offering an interest coupon at the top end of the original range.
Ratings agency Standard & Poor’s has now published a preliminary rating for the notes along with a pre-sale report, meaning that more details on the transaction are now available to us.
Tradewynd Re Ltd. is a Bermuda domiciled SPI which will issue a single Series 2013-1 Class 1 tranche of notes, the sale of which will collateralize a source of multi-year reinsurance protection for AIG subsidiary and affiliate companies. The deal has a five-year term with maturity due in July 2018.
The first interesting point to note is that the deal allows for new subsidiaries or affiliates acquired by AIG during the term of the transaction to be included under the protection, as of the start of a new annual risk period, provided the ceded business is substantially similar to the subject business. That’s a feature that has either not been obvious in any other cat bonds or is perhaps even new, generally deals either name the beneficiaries or state current subsidiaries and affiliates, but perhaps this is just more verbosely worded than we’ve seen before. Either way, it’s a useful feature for AIG to include in the deal.
The Tradewynd Re cat bond will provide AIG with a source of fully-collateralized reinsurance protection for named storms (so tropical storms and hurricanes) and earthquakes. The earthquake protection also includes ensuing damage caused by ground-shaking, including fire following, sprinkler leakage, liquefaction, tsunami and ensuing flood that result in claims or liability in the covered area. The protection afforded is on a per-occurrence basis and the transaction uses an indemnity trigger based on AIG’s ultimate net losses.
It’s interesting to see items like sprinkler leakage, liquefaction and tsunami explicitly named as covered under the terms of the deal. In fact the deal can include other types of ‘ensuing damage’ provided it can be proved to have been caused by the qualifying earthquake event. The reason for including such a broad coverage is likely due to the diverse book of business underlying the deal.
The covered area for named storms is: Alabama, Arkansas, Connecticut, Delaware, Florida, Georgia, Hawaii, Illinois, Indiana, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Mississippi, Missouri, New Hampshire, New Jersey, New York, North Carolina, Ohio, Oklahoma, Pennsylvania, Rhode Island, South Carolina, Tennessee, Texas, Vermont, Virginia, West Virginia, and the District of Columbia, as well as the Gulf of Mexico and the Caribbean (Bahamas, U.S. Virgin Islands, Bermuda, Puerto Rico, St. Maarten, St. Martin, Jamaica, Barbados, Cayman Islands, Dominican Republic, Trinidad and Tobago, Dominica, Grenada, Guadeloupe, Haiti, British Virgin Islands, Martinique, Montserrat, Netherlands Antilles, Aruba, St. Kitts and Nevis, Anguilla, St. Lucia, St. Vincent and the Grenadines, Turks and Caicos, Antigua and Barbuda and St. Barts.
You may notice that the Gulf of Mexico is in italics above. The explicit inclusion of the Gulf of Mexico is another important factor in this deal given the subject business includes energy and engineering risks such as oil exploration and drilling and the subject business also includes cargo, hull and recreational marine risks. This may be the first catastrophe bond to provide coverage for risks in the Gulf of Mexico itself.
The covered area for earthquakes is for all 50 states of the U.S., the District of Colombia and Canada.
The transaction features a broad trigger, according to S&P, meaning that events which occur outside of the covered area, but that cause losses within the covered area, can qualify under the terms of the cat bond. This is a useful addition given the explicit inclusion of risks such as tsunami, as it means AIG’s losses from a tsunami affecting the U.S. coastline from an earthquake that could be thousands of miles away would still be covered.
The Tradewynd Re cat bond covers a diverse and unusual book of AIG’s insurance business. Some of the lines of business covered are extremely unusual in the cat bond market or even completely new to cat bonds and have never been included in deals before. The subject business includes AIG policies which have exposure to losses caused by physical damage and time element coverages and contingent time element coverages, according to S&P.
Time element coverages are largely business interruption related, items such as expenses, interruption costs, interest costs etc. This really broadens the potential for loss under the terms of the deal from a major catastrophe event, and makes the transaction about much more than just physical damage caused by an event, as the majority of cat bonds have always tended to be.
Specific lines of business included are; commercial property, energy and engineering, aerospace, marine, the physical damage component of AIG’s programs division, and the property components of AIG’s personal lines operations. The personal lines book includes residential coverage across the U.S. and Caribbean as well as items such as high net worth residential, auto, yacht and fine art. The energy and engineering part of the commercial book includes items such as oil refining, chemical operations, power generation, utilities and power plants, mining above and below ground, construction coverage and offshore oil rig coverage for exploration and production of oil and natural gas.
That’s an extremely broad book of business when you consider that the average cat bond includes commercial and personal residential properties, perhaps auto lines of business and some industrial risks. Including so many different lines of business makes it impossible to use any trigger other than an indemnity one and it is likely only now that investors have become so comfortable with indemnity triggers in cat bonds that a transaction like this has now become possible.
Interestingly, S&P mentions some coverages which are not included in the AIR Worldwide risk modelling for the deal. It cites damage to airplanes, marine and inland marine cargo, onshore oil rigs, and clean-up costs from pollution caused by covered perils. That last item, clean-up costs from pollution, is particularly interesting as with oil, energy and chemical risks included in the deal it suggests an element of spill liability is covered here too. That’s very unusual for a cat bond and the first time we’ve seen a spill related risk in a cat bond since the fated Avalon Re deal.
S&P does note however that unmodeled losses generally account for a very small percentage of the overall loss to the subject business. S&P said; “In catastrophe events over the last decade, they generally accounted for less than 1% of losses on the subject business. Even the largest catastrophes such as Katrina had unmodeled losses below 2% of total losses. Premiums for this business account for 7% of the premiums for the subject business.”
Commercial property lines of business contribute the largest percentage to the deals expected loss, at 61.3%, consumer lines are next at 29.4% of expected losses, followed by energy at 5.2% and specialty at 4.2%.
The transaction, at its current size of $125m, will cover 25% of AIG’s losses between an attachment point of $4.5 billion and an exhaustion point of $5 billion. AIG is required to retain 5% of the ultimate net losses. The initial probability of attachment is 1.60%, expected loss is 1.43% and probability of exhaustion is 1.30%.
The Tradewynd Re cat bond has a variable reset feature which allows AIG to adjust the protection the notes provide it. The attachment level can be adjusted within specified bounds, allowing the cover to move up or down the reinsurance tower and the interest spread would then be adjusted to compensate investors for either the increased or reduced risk. At each annual reset, of which there are four, the attachment probability must be between 1.2% and 2.2% and the interest spread paid to investors will fluctuate up or down accordingly, depending on AIG’s coverage needs.
Based on AIR’s historical loss analysis, there have been two earthquakes which would have caused the Tradewynd Re cat bond to default. The 1906 San Francisco earthquake would result in $6.76 billion in losses and the 1812 New Madrid quake would result in $5.64 billion, both causing a full loss of investor principal. The analysis showed that there have been no named storms which would have caused a loss of principal, with the closest in terms of modelled ultimate net losses being $3.51 billion from the 1926 Great Miami Hurricane, $3.37 billion from the 1938 Great New England Hurricane, and $2.64 billion from Hurricane Andrew.
The proceeds from the sale of the notes issued by Tradewynd Re will be deposited in a collateral account and invested in highly rated U.S. Treasury money-market funds.
The notes will pay investors an interest spread of 8.25%, which is at the top end of the 7.25% to 8.25% range that the deal began marketing with. It’s likely that investors have demanded the top end of price guidance in return for supporting this cat bond for AIG due to the unusual nature of the subject business.
Standard & Poor’s assigned its ‘B+ (sf)’ preliminary rating to the $125m Series 2013-1 notes to be issued by Tradewynd Re Ltd.
Hopefully this additional detail helps to portray the unusual nature of this cat bond, which we find encouraging to see coming to market. It’s another sign of a growing maturity within the cat bond and ILS space as we see new cat bond structural features, unusual perils and unusual subject business coming to market more often. The deal is expected to settle early next week.