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Rating Action:

Moody's rates Cyrus Reinsurance II Ltd's proposed bank loans

27 Nov 2007
Moody's rates Cyrus Reinsurance II Ltd's proposed bank loans

New York, November 27, 2007 -- Moody's has assigned the following ratings to three proposed bank loans of Cyrus Reinsurance II Limited ("Cyrus Re II"): Ba1 to the $65 million senior secured term loan, Ba3 to the $20 million senior subordinated secured term loan, and B3 to the $20 million junior subordinated secured term loan.

"Cyrus Re II is a type of limited purpose reinsurer that is commonly referred to as a 'sidecar'," explains senior analyst Kevin Lee. "The sidecar will be capitalized with $35 million of equity and $105 million of term loans (75% debt, 25% equity)," notes Mr. Lee. "The term loans are arrayed in tranches, each having a different probability of attachment, expected loss, and priority with respect to interest and principal payments, hence the difference in ratings."

Cyrus Re II is expected to provide collateralized quota share coverage exclusively to two subsidiaries of XL Capital Ltd (NYSE: XL) -- XL Re Ltd (Aa3/stable) and XL Re Europe Ltd (the "Ceding Companies"). If the quota share agreement is executed, the Ceding Companies will pass on (cede) -- and Cyrus Re II will assume -- 10% of the premiums and losses on a future portfolio of non-proportional catastrophe reinsurance contracts. Those underlying contracts will be written in 2008 and will cover natural catastrophe risks throughout the world. The future portfolio is expected to be similar to the Ceding Companies' existing portfolio as client retention tends to be relatively high. This quota share agreement, if executed, will be distinct and separate from the Ceding Companies' previous sidecar, Cyrus Reinsurance Limited.

The ratings for the term loans are supported by Moody's financial modeling to determine both the probability of default ("PD") and expected loss ("EL") to lenders. The most important inputs into the financial model are the annual aggregate probability loss curve derived by the Ceding Companies (the "Base Curve"), premium assumptions, and investment income assumptions. Moody's applied stress factors and performed sensitivity analysis on all three inputs (see below). The PDs and ELs from our simulation runs were then compared to Moody's idealized default rates and expected loss rates over a weighted average life of about 1.7 years for each loan. Finally, the assigned ratings also reflect, in our opinion, sufficient alignment of interests between stakeholders.

For more information on Moody's approach to rating sidecars, as well as a comparison of sidecars and cat bonds, please refer to our special comment titled "Reinsurance Sidecars: Moody's Five Principles", dated March 2007.

Key rating factors include:

1) MODEL RISK: Catastrophe modeling error is the most important risk factor. The Ceding Companies modeled their existing portfolio using RMS 6.0 peril models that are common in the industry. Parameter uncertainty, the quality of input data, and how the models are used can all contribute to modeling error.

In general, the current portfolio is diversified with respect to geography and layers of coverage. A majority of the current portfolio consists of personal lines and standard commercial risks which generally offer more homogeneous data than industrial and surplus lines risks. The Ceding Companies receive exposure data from clients or brokers for nearly all underlying contracts, allowing the Ceding Companies to duplicate the modeling work with all discretionary (more conservative) settings applied (e.g., near-term hurricane event rates, secondary perils like storm surge, fire following and, when feasible, sprinkler leakage, loss amplification, and secondary uncertainty). One notable exception is assumed retrocession business (2.5% of current portfolio limits), for which exposure data isn't available, but is nonetheless modeled by the Ceding Companies. Many of the covered perils are modeled using RMS 6.0 peril models. European Flood, European Earthquake and attritional losses (e.g., Midwest floods, brushfires, etc.) are modeled using in-house curve fitting methods.

Moody's has applied a moderate load to the Base Curve to account for the following elements: 1) potential deviations from the expected portfolio (e.g., exposure growth and change in mix); 2) difficult-to-model classes of business such as industrial and surplus lines risks (estimated to be roughly 20% of current portfolio limits); 3) non-modeled contract elements such as loss adjustment expenses and extra-contractual obligations (i.e., bad faith claims); 4) inherent uncertainty in peril modeling especially as it relates to perils like earthquakes where little historical data is available for model calibration; and 5) a small load for perils that are not modeled by any methods such as volcanic eruption, meteorite impact, tsunami, domestic terrorism and industrial/residential conflagration.

2) DEFAULTS ARE SENSITIVE TO RATE AND INVESTMENT INCOME ASSUMPTIONS: Our analysis suggests that default rates and expected loss rates to debt holders are sensitive to assumptions about premium rates and investment yields. This is fairly intuitive given that equity capital is thin (75% debt, 25% equity) and tranche attachment points are relatively low. That is to say, investors will have to rely more on premium income and investment income to defray losses. Premium rates in 2008 are uncertain. In our financial modeling, we have modeled for the possibility that rates may fall up to 20% from their 2007 levels. Additionally, we have modeled investment returns stochastically.

3) ALIGNMENT OF INTERESTS: In Moody's opinion, there is adequate alignment of interests between stakeholders given that the Ceding Companies will retain 90% of premiums and losses with ample skin in the game. Additionally, any reinsurance purchased by the Ceding Companies for its retained portfolio would inure to the benefit of the sidecar. Dividend distributions to shareholders are prohibited, mitigating some of our concerns about the highly levered capital structure.

4) CASH WATERFALL: At each quarterly interest payment date, trust assets that exceed loss reserves and a reserve cushion can be released to pay interest. However, capacity must exist to fully pay all remaining scheduled interest and principal on the senior secured term loans before any trust capital can be released to pay interest and principal on the senior subordinated or junior subordinated loans. The same rule applies to the priority of payments between the senior subordinated and junior subordinated loans. This cash waterfall is reflected in our financial modeling.

The following ratings have been assigned with a stable outlook:

Cyrus Reinsurance II Limited -- $65 million senior secured term loan at Ba1;

Cyrus Reinsurance II Limited -- $20 million senior subordinated secured term loan at Ba3;

Cyrus Reinsurance II Limited -- $20 million junior subordinated secured term loan at B3.

Cyrus Reinsurance II Holdings SPC is majority-owned by investment funds affiliated with Highfields Capital Management LP. Its subsidiary, Cyrus Reinsurance II Limited, is a Class 3 Bermuda reinsurer ("sidecar") that is expected to enter into a collateralized quota share reinsurance treaty with XL Re Ltd and XL Re Europe Ltd (the "Ceding Companies"). The treaty will cover policies incepting between January 1, 2008 and July 1, 2008. Lenders will be at risk for events occurring between January 1, 2008 and July 1, 2009. Capital cannot be returned to investors before September 1, 2009 and equity capital cannot be returned to shareholders until all three loans have been repaid.

For more information, visit our website at www.moodys.com/insurance.

New York
Kevin 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

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