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10 Jul 2007
Moody's assigns definitive ratings to Merna Re's debt securities
$1,180.6 million of debt securities rated.
New York, July 10, 2007 -- Moody's has assigned definitive ratings to the debt securities of Merna
Reinsurance Limited ("Merna Re") following review of final documents.
These ratings are consistent with, and replace, the provisional
ratings assigned on June 13, 2007. The following definitive
ratings have been assigned: Aa2 to $256 million Tranche A
Variable Rate Notes; Aa2 to $94 million Tranche A Senior Secured
Term Loans; A2 to $647.6 million Tranche B Variable
Rate Notes; A2 to $19 million Tranche B Senior Secured Term
Loans; Baa2 to $155 million Tranche C Variable Rate Notes;
Baa2 to $9 million Tranche C Senior Secured Term Loans.
"Merna Re's structure resembles that of an indemnity catastrophe bond,"
notes senior analyst Kevin Lee, "except that investors will provide
cumulative -- rather than annual -- aggregate
excess-of-loss protection over three years." The
transaction, in effect, transfers a portion of State Farm
Mutual Automobile Insurance Company's ("State Farm Mutual") natural catastrophe
risks to investors.
Merna Re is an independently-owned reinsurance entity sponsored
by State Farm Mutual that will provide fully collateralized, three-year
cumulative aggregate excess-of-loss retrocession protection
to Oglesby Reinsurance Limited ("Oglesby Re"). Oglesby Re is a
wholly owned subsidiary of State Farm Mutual that will provide catastrophe
excess-of-loss reinsurance to State Farm Mutual for multiple
perils in the U.S. and Canada, including hurricane,
earthquake and fire following, tornado, hailstorm, winter
storm and brush fire.
Merna Re has raised capital through a combination of notes and bank loans,
the proceeds of which will be placed into trusts as collateral for potential
claim obligations to Oglesby Re. The notes and loans have substantially
similar terms, except for differences with respect to minimum denominations
and types of consents. Separate trusts have been set up for lenders
and note holders, and contractual provisions prevent lenders from
having recourse to note holders and vice versa.
The ratings for the debt securities are supported by Moody's probabilistic
analysis, using a financial model, to determine both the probability
of default ("PD") and expected loss ("EL") to debt holders over three
years, relative to promised interest and principal. The most
important inputs into the financial model are the probability curves of
net losses to Oglesby Re (the "Base Curves") derived by AIR Worldwide
Corp. ("AIR"). Moody's stressed the Base Curves to reflect
non-modeled elements as well as Moody's judgment about the inherent
uncertainty in the peril modeling (see below). The PDs and ELs
from this exercise were then compared to Moody's idealized default rates
and expected loss rates over an expected weighted average life of 3 years.
Finally, the assigned ratings also took into account two additional
qualitative considerations -- the use of an independent
third party to perform the catastrophe modeling work and the alignment
of interests between stakeholders.
Key rating factors include:
1) MODEL RISK: Catastrophe modeling error is the most important
risk factor. Moody's views positively that the catastrophe modeling
was done by an independent third party, and further, that
pro forma modeling of historical catastrophe events in 2004 and 2005 produced
modeled losses that were in line with or exceeded State Farm's actual
losses incurred to date.
Based on AIR's modeling of historical events, the 2003-2005
hurricanes, collectively, would not, hypothetically,
have caused a loss to the lowest debt tranche. Further, based
on AIR's modeling of historical events, the sum of the three worst
years of modeled losses to Oglesby Re (i.e., modeled
to approximate the losses from events which occurred in the United States
in each of 1812, 1886, and 2005) would not have impaired the
highest debt tranche, hypothetically.
The Base Curves were derived in two steps. First, AIR simulated
catastrophe losses on State Farm's underlying insurance policies using
its AIR CLASIC/2 v9.0 detailed level model (the "Escrow Model"),
with all "switches" (e.g., near-term hurricane
frequency assumption, aggregate demand surge for hurricane perils,
and occurrence demand surge for other perils) turned on except for storm
surge. Secondly, AIR imported these catastrophe loss curves
into proprietary software to simulate the impact of these losses on Oglesby
Re, reflecting inuring reinsurance and nuances of the Florida Hurricane
The risks covered in this transaction are predominantly homeowners' policies
and property perils of small business owners' policies. In Moody's
opinion, these risks are typically easier to model than industrial
or reinsurance risks as the exposures tend to more homogeneous and data
quality tends to be better. Nearly all of State Farm's data captures
year of construction and type of construction for insured buildings,
while square footage and number of stories are captured in the majority
of cases. But secondary property characteristics like roof covering
and tree exposure are not captured in the data.
Moody's increased or stressed the Base Curves to account for several items:
1) exposure growth between September 2006 and the first risk period (i.e.,
AIR's modeling was based on 9/30/2006 exposure data); 2) inherent
uncertainty in peril modeling especially as it relates to certain perils
and regions like New Madrid earthquake where little historical data is
available for model calibration; 3) non-modeled elements like
extra-contractual obligations (e.g., bad faith
claims) and inflation; 4) potential deviation from the initial portfolio
over time, though the concern is mitigated by the annual trigger
reset; 5) business lines that are not modeled (about 2% of
total limits for boats and movable personal property). These loads
are in addition to the 10% load which AIR has applied to the Base
Curves to reflect loss adjustment expenses.
2) ALIGNMENT OF INTERESTS: In Moody's opinion, there is good
alignment of interests between State Farm and Merna Re's investors given
that this transaction will be grafted into State Farm's existing catastrophe
reinsurance program. Oglesby Re's participation in the program
will sit alongside that of external reinsurers, and the reinsurance
agreements between State Farm and Oglesby Re will mirror those between
State Farm and external reinsurers. In this respect, there
is little opportunity for adverse selection. Furthermore,
losses caused by certain un-modellable perils, such as terrorism
and riots unrelated to covered perils, will be passed on to Oglesby
Re but not to Merna Re.
3) COMMUTATION MECHANISM: Merna Re and Oglesby Re will terminate
their reinsurance relationship through a commutation following the three
year ("losses occurring") risk period. Merna Re will extinguish
its liability to Oglesby Re by paying it a consideration equal to the
amount of estimated loss reserves, as determined by the lesser of
State Farm's estimate and that of an independent loss reserve specialist.
If losses are significant, Oglesby Re has the option to postpone
the commutation up to 24 months while losses are being determined which
should help reduce estimation error. Nevertheless, Moody's
has reflected some possibility for over-estimation of loss reserves
in our financial model.
4) PORTFOLIO AND RISK PROFILE: Moody's views favorably that both
the one-year and three-year modeled probabilities of attachment
and exhaustion will be kept roughly constant through an annual reset of
the gross dollar attachment and exhaustion points, in order to reflect
growth or deviations from the initial portfolio. Further,
State Farm's portfolio has been relatively homogeneous over time,
with much the same expected for the future.
5) CALL PROTECTION: Neither State Farm nor Oglesby Re can call the
debt. If the deal ends prematurely (i.e., due
to an event of default, termination of the reinsurance agreement,
or termination of the retrocession agreement), debt holders would
be entitled to principal plus the present value of all interest payments
that would have been owed to them through the scheduled maturity date
(further, these additional interest payments would be calculated
based on the debt outstanding at the time of termination). This
reduces the sponsor's incentive to call the debt if prices in the
traditional reinsurance market fall significantly in comparison to the
interest paid to debt holders.
The following definitive ratings have been assigned with a stable outlook:
Merna Reinsurance Limited -- $256 million Tranche
A Variable Rate Notes due July 2010 at Aa2;
Merna Reinsurance Limited -- $94 million Tranche
A Senior Secured Term Loans due July 2010 at Aa2;
Merna Reinsurance Limited -- $647.6 million
Tranche B Variable Rate Notes due July 2010 at A2;
Merna Reinsurance Limited -- $19 million Tranche
B Senior Secured Term Loans due July 2010 at A2;
Merna Reinsurance Limited -- $155 million Tranche
C Variable Rate Notes due July 2010 at Baa2;
Merna Reinsurance Limited -- $9 million Tranche C
Senior Secured Term Loans due July 2010 at Baa2.
The following provisional ratings have been withdrawn:
Merna Reinsurance Limited -- $690 million Tranche
D Senior Secured Term Loans at (P) Ba2;
Merna Reinsurance Limited -- $780 million Tranche
E Senior Secured Term Loans at (P) B2.
State Farm Mutual Automobile Insurance Company (insurance financial strength
at Aa1, stable outlook), together with its subsidiaries,
is the largest personal lines insurance organization in the United States
and one of the nation's largest writers of commercial multi-peril
insurance, primarily for small businesses. The company sells
through an exclusive agency force and provides insurance for about one
in every five households.
For more information, visit our website at www.moodys.com/insurance.
Tse Wing Lee
Vice President - Senior Analyst
Financial Institutions Group
Moody's Investors Service
Financial Institutions Group
Moody's Investors Service
No Related Data.
© 2019 Moody’s Corporation, Moody’s Investors Service, Inc., Moody’s Analytics, Inc. and/or their licensors and affiliates (collectively, “MOODY’S”). All rights reserved.
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