The U.S. severe thunderstorm season of 2012 has begun to impact the catastrophe bond market as two catastrophe events have resulted in qualifying ultimate net losses for two of USAA’s Residential Reinsurance cat bond deals. According to ratings agency Standard & Poor’s two specific outbreaks of severe thunderstorm and tornadic weather have qualified under the terms of last years Residential Reinsurance 2011 Ltd. (Series 2011-1) and the more recent Residential Reinsurance 2012 Ltd. (Series 2012-1).
Both of the affected Residential Re transactions provide USAA with a source of protection against losses from hurricanes, earthquakes, severe thunderstorms, winter storms, and wildfires on an annual aggregate basis. Standard & Poor’s base their rating on the notes issued by these cat bond transactions on the likelihood of the attachment point being reached and now that these two severe thunderstorm events have qualified it means that the probability of the attachment point being breached has increased slightly.
The current risk period for these two Residential Re cat bonds runs from 1st June 2012 to 31st May 2013, so has only just begun. The two catastrophe events which have qualified under the terms of the deals are Catastrophe Series 77 and 78, two severe thunderstorm events (so including damage from tornadoes and hail we believe). These events have resulted in ultimate net losses of $95m and $45m respectively to USAA. The attachment points for the two cat bonds are $1.365 billion for the Residential Re 2011 notes and $1.571 billion for the Residential Re 2012 notes, so the amount of losses required to reach those points have been reduced slightly.
Standard & Poor’s said that it has lowered its ratings on the Residential Reinsurance 2011 Ltd. (Series 2011-1) Class 5 notes to ‘B’ from ‘BB-‘ and on Residential Reinsurance 2012 Ltd. (Series 2012-1) Class 5 notes to ‘BB-‘ from ‘BB’, and placed each class on CreditWatch with negative implications.
S&P says that there is a third catastrophe event which will likely become a qualifying event, Catastrophe Series 83, but they are waiting to receive a loss estimate which will likely come early next month. Whether that loss amount could result in a further downgrade is uncertain. S&P also expect to receive updated modelled on all three events and once they receive those results they will revisit the CreditWatch status.
S&P also say that assuming there is no increase in the loss estimates on Cats 77 and 78, they could lower the ratings on each class of notes by one-to-two notches depending on the loss estimate of Cat 83. Losses of around $70m from Cat 83 would likely affect the ratings. However, due to the passage of time and the seasonality of the covered events, this amount is just an estimate. S&P would expect any additional covered events to affect the ratings as well. To qualify as a covered event, the minimum loss to USAA must be at least $50m.
There is a chance the notes could be upgraded again in 2013 once the hurricane season is over, says S&P. Hurricanes contribute the largest threat to these cat bonds and if they get through the season unscathed, and no other qualifying events occur, then the probability of attachment could be considered reduced and the ratings upgraded again. The notes would also be upgraded again if the cat bonds make it to the end of the current risk period without reaching the attachment points.
The qualifying losses are really not that extensive at this stage, being such a small amount of the attachment totals, however S&P are taking the correct step in downgrading the notes to alert investors to the slightly more risky nature of these deals thanks to the qualifying losses.
It’s worth noting that there are other tranches of notes which have been issued within these cat bond deals, however of the rated tranches the two downgraded by S&P are the ones obviously exposed. The Residential Re 2011 (Series 2011-1) deal has three tranches of notes but the other two are on a per-occurrence basis so not affected. The Residential Re 2012 (Series 2012-1) deal also has three tranches of notes, the affected Class 5 notes are aggregate, the Class 3 notes are per-occurrence so not affected, but an unrated Class 7 tranche of notes are also annual aggregate and have a lower attachment point of $900m so we have to assume the losses might qualify for that tranche too. There is also a Residential Reinsurance 2011 Ltd. (Series 2011-2) cat bond with severe thunderstorm exposure, but that deal was not rated and details were scarce at the time of issuance, it may well have become more risky due to these events qualifying as losses as well.
These are the first cat bond rating impacts due to catastrophe events of 2012 and as such likely to impact the secondary market prices of these cat bond deals. We’ll keep you updated as the risk period progresses for these cat bonds and if any further information becomes available from S&P.