Risk modelling agency RMS’s new US wind model triggered downgrades to many catastrophe bonds. Peter Nakada of RMS Risk Markets, examines the logic behind this and how investors have reacted to the situation.
W
hen RMS revealed its 2011 US hurricane model release, Trading Risk’s headline trumpeted “Hurricane RMS” for its impact on the market. Before long, the new hurricane model,
like a pop star diva, was known by just one name—v11. New data and science, and vast increases in computational power,
enabled RMS to improve the view of hurricane risk dramatically. With this enhanced view of risk also came an increase in the level of risk. For the industry overall, losses at the 100-year return period increased by around 50 percent. With the way the insurance-linked securities (ILS) market views risk, the changes seen were even larger, with expected loss (EL) on average doubling.
Insurance, reinsurance and ILS market participants braced for a
reaction to this dramatic new view of risk. Would rates in the traditional reinsurance market harden significantly? Would catastrophe (cat) bond prices for hurricane bonds plummet? Would bonds originally modelled by RMS react differently from those modelled by AIR or EQECAT?
This article describes what we saw happen in the ILS market and provides a hypothesis for what is going on.
SPONSORS ‘BLOWN’ AWAY RMS had been communicating change guidance information for the
best part of a year, so the market knew there were changes afoot. No sponsors wanted to issue a US hurricane cat bond using a model that was soon to change, nor to be the first to take a v11 bond to market. While some sponsors chose to use other models, many of the RMS shops chose not to issue cat bonds for the 2011 hurricane season at all.
The ILS market has traditionally been a ‘technically priced’ market.
Spreads have been set as a relatively predictable multiple of the modelled EL on the bond. This worked well when all three modellers were relatively close together in risk estimates. However, with the RMS view of risk increasing so much, issuers (and the intermediaries that advised them) were unsure as to whether the market would maintain the same EL multiples, or whether it would keep the spreads roughly the same and adjust the EL multiples.
RATING AGENCIES REACT Immediately after the announcement of the increased probabilities of
attachment, Standard & Poor’s (S&P) and A.M. Best reacted by asking the sponsors of all outstanding hurricane cat bonds originally modelled by RMS to provide updated ELs for their bonds. RMS worked with the sponsors to provide this information, which both agencies used to re-rate the bonds. In total, there were 11 bonds downgraded by S&P and one downgraded by A.M. Best.
What was interesting about this move was that S&P apparently also solicited AIR’s risk metrics for some of the bonds in question, to get a ‘blended’ view of risk for these bonds. However, RMS was not asked to provide risk metrics for any of the hurricane bonds outstanding where AIR was the modeller of record.
Certainly there is consistency in the rating agencies’ reliance only on
the modeller of record for updated ELs to re-rate bonds. After all, there was only one EL considered when rating the bond originally. However, following this approach leads to an awkward situation where two identical bonds have different ratings because one was modelled by RMS and the other not.
NEW VIEW, BUT NO
CHANGE IN PRICING We have a window into investors’ reactions through the clients that
license Miu, our ILS portfolio management platform. We found that most of these investors were eager to get their hands on the new view of hurricane risk to assess the impact on their portfolios and to understand the RMS view of risk for new cat bond issuances. Investors were looking to incorporate the new RMS view of risk into their decision-making processes with urgency. Once investors were able to digest the new view of risk, they seemed broadly comfortable.
However, secondary market prices show that hurricane bonds have been
changing hands at pre-v11 prices. Furthermore, the hurricane cat bonds that have come to market (using other modellers) were selling like hot
November 2011 | INTELLIGENT INSURER | 41
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