ILS Intelligence
The first cat bonds were issued as early as 1994, but the landmark issue
Residential Re sponsored by USAA in 1997 obtained the first credit rating for a cat bond from Standard & Poor’s (S&P).
The rationale for obtaining a credit rating was simple: insurance event risk
was unfamiliar to corporate bond traders, who were used to determining the likelihood of a company defaulting on its business obligations. The parallel to corporate default for cat bonds was the probability of a catastrophic event occurring that triggered a reduction in the principal. Since credit rating agencies such as Fitch, Moody’s and S&P assigned credit ratings to corporate bonds based on the likelihood of them defaulting, it was thought that having rating agencies assign the same type of credit ratings to cat bonds based on the probability of their subject catastrophe(s) occurring would give corporate bond traders an apples-with-apples comparison of risk with securities that they already traded.
This rationale was valid and in practice appears to have been moderately successful in the early and mid-2000s. According to Munich Re, the percentage of non-insurance specialist investors in cat bonds grew from less than 30 percent of the investor base in 1997 to 53 percent in 2007. While this increase cannot be attributed entirely to the presence of a credit rating, it was likely to have been a positive contributor to this growth.
Many investors liked the idea of having an independent view of a cat bond’s risk profile provided by a rating agency. Some of these investors limited their investments solely to bonds that possessed a credit rating because they lacked an in-depth knowledge of insurance risk, which they felt the rating agency provided them. That this type of investor is a buyer of cat bonds validates the rationale for having a cat bond rated and is consistent with the theory discussed earlier. Have recent rating actions worked against attracting this type of investor to the cat bond market?
38 | INTELLIGENT INSURER | November 2011
THE IMPACT OF RATING ACTIONS Recent cat bond rating actions by S&P have highlighted the role of
catastrophe simulation models developed by third-party consultants in the assignment of credit ratings and raise a question surrounding the impact of potential ratings volatility on direct cat bond trading for non- insurance investors.
On April 18, 2011, S&P placed 17 cat bonds (revised later that day to 16)
on credit watch negative due to the release of a new US hurricane model by catastrophe modelling vendor Risk Management Solutions (RMS). This was a record number of bonds being placed on watch at one time and, to our knowledge, the first large-scale rating action taken because of the upgrading of a catastrophe model.
We will not go into the details of the model in question here, but note
that its estimation of hurricane risk in many areas of the US differed significantly, and in most instances was higher, than its previous model release. As a result, S&P ultimately downgraded six of these bonds on July 12, 2011. This is not the only recent rating action because of a catastrophe model change, as S&P also downgraded another US-exposed catastrophe bond in May 2011 due to a recent change in an Applied Insurance Research (AIR) catastrophe model.
That S&P would take such actions is not surprising given the magnitude
of the RMS model’s changes, but it may wish to consider revising its cat bond rating methodology to explain its philosophy regarding catastrophe model changes in more detail.
S&P’s current cat bond rating methodology, Methodology and Assumptions for Rating Natural Catastrophe Bonds, published on May 12, 2009, contained the following statement regarding rating reviews as a result of catastrophe model changes: “If a modelling company issues an updated model and we believe there are significant changes in our
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