Swiss Re Insurance-Linked Fund Management

Original Risk: A Society for Change Agents

Sierra cat bond targets parametric quake cover for mortgage asset manager


A particularly interesting and novel catastrophe bond transaction has been launched to the market, with the Sierra Ltd. (Series 2019-1) deal seeking $150 million of parametric U.S. earthquake protection for an investment manager that largely invests in mortgage related assets.

parametric-earthquake-insuranceIt’s an interesting transaction for a number of reasons, given the sponsor or beneficiary of the parametric quake insurance protection would be an investment fund that we’re told allocates most of its assets into the U.S. mortgage credit market.

Asset holders of U.S. mortgage securities and other mortgage linked investments are naturally very exposed to earthquake risks, given the mortgage holders or homeowners in many cases do not have sufficient cover, while the mortgage banks and even the GSE’s are not mandated to purchase mortgage insurance protection.

The beneficiary is effectively a direct insured that has turned to the capital markets as a source of earthquake risk protection, leveraging the catastrophe bond structure to secure the necessary funding for its underlying insurance or reinsurance protection.

We also see this as a landmark transaction as major asset owners are exposed to more perils than just earthquake risk, with climate related perils, severe weather, storms, sea level rise and other natural catastrophe exposures often heavily embedded into their investment portfolios.

This new Sierra Re catastrophe bond is an example of a large asset owner leveraging the insurance-linked securities (ILS) market, with a cat bond structured to use a parametric trigger, as a way to secure an efficient source of capital markets disaster insurance funding that will pay-out contingent on the occurrence of a specified event.

It’s a use-case we’ve been championing for years, explaining that mortgage holders such as the two government-sponsored enterprises (GSE’s) Fannie & Freddie should transfer their earthquake risk, that banks exposed to mortgage loans should cover their natural disaster exposures or mandate customers do, and that there are climate or natural related peril exposures embedded in asset portfolios that could (perhaps should) be hedged and transferred.

This cat bond provides a niche but important example of how the cat bond and ILS market can assist an asset owner to reduce the natural disaster exposure embedded in its investment portfolio and as a result it’s both encouraging to see come to market and also perhaps a sign of a future area of growth for ILS and catastrophe or climate risk transfer as a whole.

Sources said that Sierra Ltd. has been established as a Bermuda based special purpose insurer (SPI) to issue catastrophe bonds on behalf of its sponsor.

The beneficiary of the risk transfer protection will be an investment fund under the management of Bayview Asset Management, LLC, we’re told, that allocates its capital into mortgage related securities.

Bayview MSR Opportunity Master Fund, LP, is a Cayman Islands domiciled investment fund, investing predominantly in GSE sourced mortgage credit related securities, which are exposed to loan defaults and as a result have exposure to major earthquake risks.

Should a significant quake occur it could dent the performance of the portfolio of mortgage related assets significantly, as homeowners went delinquent on their loans and struggled to make repayments, affecting the valuation of mortgage credit assets.

Hence a parametric trigger structure is a good solution, as it could pay-out quickly to boost the investment fund at a time when its assets are devalued due to the quake.

The transaction will see Bermuda based special purpose insurer Sierra Ltd. issuing two tranches of Series 2019-1 notes that will be exposed to U.S. earthquake risks on a parametric trigger basis, providing a source of earthquake risk transfer and insurance to the Bayview managed investment fund.

It’s a novel transaction, but one that makes a good deal of sense given the earthquake exposure within the mortgage securities investment marketplace is significant. So having a source of capital that can pay out quickly, should a major quake occur, would help an investor or investment manager mitigate its exposure somewhat and benefit the investors.

Both tranches of Series 2019-1 cat bond notes issued by Sierra Ltd. will be exposed to earthquakes in the U.S. states of California, Oregon, South Carolina and Washington, we understand. These are likely the states with the highest earthquake risk and greatest concentration of mortgage loans in the investment portfolio.

The notes will provide their coverage through a parametric trigger that uses USGS data as its input and on a per-occurrence basis, across a term that is expected to be just under three years but with a single risk period, it seems.

If an earthquake occurs in the covered area, the parameters associated with it will be taken and an index derived to identify whether the quake was severe enough to breach the trigger and cause a payout for either tranche of notes.

Sierra Ltd. will look to issue and sell to investors the two tranches of notes and the proceeds will be used as collateral to underpin the risk transfer agreements, as insurance or reinsurance capital secured in case of a triggering event occurring, while the investors will be paid a coupon for holding the risk.

A Class A tranche of notes is being offered as a $100 million layer of risk, with an attachment probability of 1.77%, an expected loss of 0.79% and a coupon guidance range of 3.25% to 3.75%, we understand.

A Class B tranche is targeting $50 million of coverage, across a riskier layer that has an attachment probability of 4.13%, an expected loss of 2.71% and a coupon guidance range of 5.5% to 6.25%.

This is going to be a very interesting catastrophe bond to watch come to market, as it presents a risk the ILS investment community knows well, structured in a way investors appreciate (parametric), but for a beneficiary and use-case that is currently less familiar to it.

It’s a first of its kind transaction for the catastrophe bond market, due to the beneficiary or counterparty being unique as an asset manager’s fund. But if successful this could stimulate interest much more broadly in transferring earthquake risk among holders of mortgage related risks, assets and securities.

Asset holders can benefit from being able to tap into the ILS market using parametric triggers to secure efficient, quick paying disaster insurance capacity, as too can large corporations that often also carry significant exposure to natural perils such as earthquakes.

We think it’s only a matter of time until more transactions of this kind come to market. Think the GSE’s, mortgage holding banks and investors, corporate giants with thousands of staff or significant infrastructure located in earthquake hot spots, investment giants carrying huge climate and catastrophe exposure in their portfolios, or even the natural disaster risks faced by government-owned portfolios of infrastructure, as well as numerous other use-cases.

Transferring some of this peak risk exposure, while securing a predictable, efficient and fast-paying source of capital, has got to be better than going bare on these kinds of exposures. Especially when you have investors, employees, or indeed voters to answer to.

This Sierra Ltd. catastrophe bond transaction is intriguing and an encouraging advancement for the catastrophe bond market that could stimulate more transactions of a similar kind.

We are told this transaction will issue in January, giving plenty of time for investors to get comfortable with the transaction.

You can read all about this Sierra Ltd. (Series 2019-1) cat bond transaction in the Artemis Deal Directory and we’ll update you as any further information comes to light on its journey to market.

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