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Nephila’s Stratosphere Re in “rarefied air” as investment grade cat bond


Getting an investment grade rating for a securitization of property catastrophe insurance risks is “rarefied air”, something that the recently completed $100 million Stratosphere Re Ltd. (Series 2020-1) cat bond covering tail risks on Nephila Capital’s fronted business has achieved.

ratingFitch Ratings assigned the investment grade ‘BBBsf’ rating to the Stratosphere Re cat bond recently, in a transaction that priced at the lowest end of its guidance demonstrating ample investor demand for what is an innovative insurance-linked securities (ILS) transaction.

The rating agency notes that it has been more than 10 years since a property catastrophe bond achieved a rating of this level.

Investment grades do matter, as securities with one can attract interest from a broader swathe of the capital markets.

Achieving this level of rating is a required step if significant cessions of tail risk are to be channelled into the capital markets, as this would require real depth of capital and access across the markets, to generate the levels of efficiency desired.

Fitch Ratings explained that the primary intent of the Stratosphere Re cat bond issuance was to mitigate and transfer some of the tail risk assumed by Nephila’s erstwhile fronting partner State National Insurance Company Ltd..

State National fronts U.S. primary insurance property business for Nephila and accumulates a great deal of tail level exposure as a result. This sits inefficiently on the balance-sheet and can become a constraint on how much fresh fronting can be undertaken, as only so much tail risk can be held.

As a result, opening up a new channel to the capital markets to cede away this tail risk into the deepest, most liquid available capital pool is essential, as the fronted strategy grows. Therefore an investment grade rated catastrophe bond is a desirable tool, as it could open up access to more capacity in the future.

Fitch further explains why the fronted ILS model followed by Nephila and others generates this tail risk, saying that due to the sizeable total insured values associated with primary property insurance business it is an inefficient use of capital to attempt to fully collateralize the whole of the risk pool.

So a fronting insurer with a rated balance sheet and providing collateral (from Nephila’s ILS funds and reinsurance vehicles) up to the level considered unlikely to be exceeded, can offer a much more effective alternative.

But this model can leave a substantial amount of tail risk on the balance-sheet of the fronting insurer and with relatively few tail risk hedging options available, the tail risk can limit the mount of alternative capital a fronting insurer can work with and discourages others from offering a similar service to ILS funds and investors.

But if you can open up a pipeline to the broadest sources of capacity available to absorb tail risk, in a fully securitized note offering that has an investment grade rating you could be onto an innovation that can make this fronted ILS model significantly more elastic, in terms of capital flexibility and making collateral work much harder as well.

“The structure of Stratosphere Re has broad applications for the ILS market,” Fitch believes, saying “It provides a unique method for ceding fronting insurers’ tail risk, lowering a barrier for the assumption of primary property business by collateralized capacity providers.”

The transaction also offers investors a way to access extremely remote level property catastrophe exposures in the catastrophe bond market, which tend to offer a much higher multiple given the remoteness of the risks involved as well, ultimately a better risk adjusted return theoretically.

Fitch said that “Nephila’s expertise in (re)insurance underwriting, transaction structuring and alternative investment portfolio management drove the transaction,” while fronting partner “State National’s distribution, administrative expertise and rated balance sheet were used to create the underlying insured portfolio.”

Nephila Capital has looked to the investment grade world before, with its innovative Gamut Re transaction back in 2007, which leveraged collateralised debt obligation (CDO) technology to bring a diversified pool of catastrophe risks to investors.

Broadening its access to capital markets has always been part of Nephila Capital’s strategy, alongside sourcing risks in the most direct and diverse manner.

Combining the two, the ILS manager creates the most efficient and effective routes for insurance related risks to travel from origination right through to final home with capital, a model which this latest innovative cat bond structure could add significant benefits to.

Fitch notes that the remoteness of the risks and the dual event trigger (the first event cannot cause a loss) were both key factors that supported the ability for Stratosphere Re to secure an investment grade rating.

The modeled probability of attachment for the Stratosphere Re 2020-1 notes is just 0.185%, significantly lower than most catastrophe bonds, while a coupon of 2.75% ensures a high multiple of nearly 24 times the one-year modelled expected loss, a much higher multiple of return than your typical cat bond deal.

The market averages a multiple of around 2.6 times the expected loss currently, so this investment grade security paying such a high multiple will no doubt have been attractive to some.

In fact, it is these remote risk, lower return, but higher multiple securities that could be extremely attractive to the world’s largest bond investors, as a diversified source of relatively uncorrelated returns.

“Successful placement of Stratosphere Re may foretell future evolution and growth of the catastrophe bond market,” Fitch notes.

Adding, “An investment-grade rated catastrophe bond may attract several new investor constituencies, particularly insurance companies that are sensitive to higher regulatory capital requirements for unrated or non-investment grade rated bonds.”

The question of course is who else bu Nephila could generate a pool of primary property insurance tail risk of sufficient size to warrant full securitization like this?

Perhaps no one on their own at this time, but this could become a useful tool that the Markel stable-mates of State National and Nephila Capital can use to manage their own exposure and to make the use of their balance-sheet and collateral all the more efficient.

Separately, another fronting player could look to this as their pipeline to the capital markets to enable them to front more business for a range of ILS funds, issuing regular tail risk cat bonds to hedge exposures and allow their balance-sheet to do more.

It’s a fascinating development and undoubtedly another sign of the innovative approach Nephila Capital takes to matching and managing risk and capital for its cedents and investors, keeping its particular version of the market-chain (from origination to capital) as slick and efficient as possible.

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