Back in July we wrote about the downgrade of two outstanding catastrophe bonds due to a number of qualifying catastrophe events resulting in ultimate net losses for the sponsor USAA. Residential Reinsurance 2011 Ltd. (Series 2011-1) and the more recent Residential Reinsurance 2012 Ltd. (Series 2012-1), both suffered losses due to severe thunderstorms and tornadoes earlier this year but now the loss estimates have been reduced resulting in an upgrade back to the original ratings.
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 ratings are based on the likelihood of the attachment point being reached for the cat bond notes. In July S&P said that the two qualifying events had cleared the deductible limit of $50m and so one Class 5 tranche of notes from each cat bond had an increased attachment probability and so had to be downgraded and placed on CreditWatch negative.
The two cat bond issuances only saw their Class 5 tranches of notes impacted with the downgrade, as these were the notes which trigger on an annual aggregate basis. When S&P took the downgrade action in July there were two severe thunderstorm catastrophe events which were thought to have caused sufficient losses to impact the cat bonds. Catastrophe Series 77 and 78 resulted in net loss estimates of $95m and $45m respectively, while a third event, Catastrophe Series 83, was thought likely to qualify but estimates were not ready at the time.
Catastrophe Series 78 has now had its ultimate net loss (UNL) estimate reduced to below the $50m deductible so it is no longer a qualifying event for either cat bond. Catastrophe Series 77’s loss estimate remained at $95m of UNL for USAA and so still qualifies. Catastrophe Series 83 resulted in a loss estimate of $92m and so qualified as a loss for both transactions. S&P note that Hurricane Isaac did not qualify as a loss for either of these cat bonds. So the total covered loss estimates from the two qualifying events, 77 and 83, comes to $187m.
When S&P lowered the ratings in July they said that if covered losses did not increase there was a chance of the ratings being upgraded again, and that is what has now happened. With the disappearance of catastrophe 78 from the total qualifying losses, S&P now deem the loss experience of these two cat bonds commensurate with maintaining their original ratings. There is also the passage of time to consider. Both tranches of notes will reset in 2013 and so the annual aggregate attachment point will return to its original level. Given that we are almost through the Atlantic hurricane season and the tornado season is past its peak, these notes would generally be considered a little safer now.
Standard & Poor’s have reversed their downgrades, raising the ratings for Residential Reinsurance 2011 Ltd. Series 2011-1 Class 5 notes to ‘BB-‘ from ‘B’ and Residential Reinsurance 2012 Ltd. Series 2012-1 Class 5 notes to ‘BB’ from ‘BB-‘, and both series have been removed from CreditWatch.
One of the common discussions about indemnity cat bonds is the issue of loss estimates, how accurate they are and when they become a final estimate of ultimate net loss. This downgrade, upgrade saga is a prime example of this issue in action, although it is only ever witnessed where loss estimates are relatively close to the qualifying deductible amount.
Losses take time to develop with indemnity cat bonds, so with the current popularity of that type of trigger in the cat bond market it is likely we will see these kinds of rating actions on other transactions in the future. It’s also worth noting that similar uncertainty can occur where industry-loss trigger cat bonds have catastrophe loss estimates amended, so this rating fluctuation is not just a feature of indemnity deals.