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Rating Action:

Moody's assigns definitive ratings to Merna Re's debt securities

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 Catastrophe Fund.

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.

New York
Tse Wing Lee
Vice President - Senior Analyst
Financial Institutions Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

New York
Robert Riegel
Managing Director
Financial Institutions Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

No Related Data.
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