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Rating Action:

Moody's assigns provisional ratings to Merna Re's proposed debt securities

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.

New York
Kevin Lee
Asst Vice President - 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

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