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13 Jun 2007
Moody's assigns provisional ratings to Merna Re's proposed debt securities
New York, June 13, 2007 -- Moody's has assigned the following provisional ratings to Merna
Reinsurance Limited's ("Merna Re") proposed debt securities:
(P)Aa2 to $500 million Tranche A; (P)A2 to $1,200
million Tranche B; (P) Baa2 to $850 million Tranche C;
(P)Ba2 to $690 million Tranche D; (P)B2 to $780 million
Tranche E. Moody's will assign definitive ratings upon review of
final executed documents.
Merna Re is an independently owned reinsurance entity sponsored by State
Farm Mutual Automobile Insurance Company ("State Farm Mutual")
that will provide fully collateralized, three-year aggregate
catastrophe excess-of-loss retrocessional 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.
"Merna Re's structure resembles that of an indemnity catastrophe
bond," notes analyst Kevin Lee, "except that investors
will provide cumulative -- rather than single year -- aggregate
excess-of-loss protection over three years."
Merna Re will enter into a retrocession excess-of-loss agreement
with Oglesby Re, and will lay off those risks to debt investors
through a combination of notes and bank loans. Proceeds from the
debt offerings will be placed into trusts as collateral for potential
claim obligations to Oglesby Re.
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. 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 would have, hypothetically, caused an $82
million 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.,
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" turned on except for storm surge
(e.g., near-term hurricane frequency assumption,
aggregate demand surge for hurricane perils, and occurrence demand
surge for other perils). 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, like 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.
The following provisional ratings have been assigned with a stable outlook:
Merna Reinsurance Limited -- $500 million Tranche
A at (P)Aa2;
Merna Reinsurance Limited -- $1,200 million
Tranche B at (P)A2;
Merna Reinsurance Limited -- $850 million Tranche
C at (P) Baa2;
Merna Reinsurance Limited -- $690 million Tranche
D at (P) Ba2;
Merna Reinsurance Limited -- $780 million Tranche
E 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.
Asst Vice President - Analyst
Financial Institutions Group
Moody's Investors Service
Financial Institutions Group
Moody's Investors Service
No Related Data.
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