Higher Hurricane Risk Model a Possible 'Catastrophe' for Bond Ratings?
By MATTHEW BRODSKY, senior editor/Web editor of Risk & Insurance®
If you haven't heard about the new RiskLink V11 U.S. hurricane model from Risk Management Solutions Inc., you will, especially if you sell or buy insurance for U.S. hurricane risk. In the meantime, the new catastrophe modeling update has caused a veritable storm surge of news in the catastrophe bond world.
The reason for it is because the new hurricane model, released Feb. 28, could dramatically change the numbers for U.S. hurricane exposure, including increased loss estimates, especially for commercial properties. The results from the new model could be "materially different" enough from the older version that Standard & Poor's felt warranted to announce possible ratings downgrades for 16 catastrophe bonds.
"The criteria we use to rate the issues--"Methodology And Assumptions For Rating Natural Catastrophe Bonds," May 12, 2009--states that if a model update significantly changes results, we will review those deals that used older versions of the model and take the appropriate ratings actions," S&P said in a statement.
As Karen Clark, head of an eponymous catastrophe risk consulting firm put it, the new model could bear huge changes for "entire books of business."
RMS, the modeling firm at the center of the issue, does not sound concerned by S&P's announcement.
"It makes sense that S&P is updating its view of risk," said Peter Nakada, managing director of RMS Risk Markets.
Why are CAT models important for CAT bonds? Many of today's nonlife catastrophe bonds are parametric based, meaning they are designed around specific occurrences, locations, magnitudes and probabilities of disasters like hurricanes and earthquakes. The models are the tools trusted to generate those numbers. But what if the tools change?
"I'm not sure investors have a good sense for how volatile the numbers are," Clark said.
Talking with one of the major investors in this asset class, however, gives you a sense that investors are familiar with how models work.
"I think they've been slowly learning. And it didn't take just this S&P announcement to learn that," said John Seo, co-founder and managing principle of Fermat Capital Management LLC, the Westport, Conn.-based investment fund that specializes in catastrophe bonds.
Seo said that this is not news for core investors in this asset class, and that it's part of an "ongoing revelation" for newer investors.
For any investor, it shouldn't be a surprise. RMS has been issuing guidance on its newest hurricane model version for a year, Seo said.
"The market reaction ought to already be priced into the market," said RMS' Nakada, who also explained that his firm has been announcing the model changes to investors ahead of time.
Another reason S&P's announcement shouldn't be a surprise is because many bonds are already set up with "model reset" provisions in their structure, as Nakada and Seo explained. Simply put, either after model changes or automatically on a periodic basis, many bonds are designed to be readjusted. That way, if underlying exposures or modeling assumptions change, the bonds can be tweaked so that the expected loss for investors, a one-in-100-year loss for example, remains the same.
Let's not forget, too, that every one of the 16 bonds in question is below investment grade, with ratings of BB+ or below. It would not a big deal for noninvestment grade bonds to fall a couple notches, according to Seo. It'd be a big deal for a bond to drop from investment grade to noninvestment grade, or if any rating downgrade threatened to put a bond under water, he said. But that's not the case here, Seo said.
"We live on the noninvestment side of the track," Seo kidded about investors like himself. "On this side of the track, if anything, you like to see this stuff happen from time to time. It means we're not asleep at the wheel on the risks."
The new RMS hurricane model could be a more serious development for insurers and reinsurers, though, if S&P asks to use RMS' new numbers for capital requirements and other ratings calculations, said Clark, who founded one of the big three modeling firms, AIR Worldwide. For some insurers, they could be looking at probable maximum loss estimates from the new model that increase 30 percent to even 100 percent versus the older version.
"It will mean enormous disruptions for these companies," she said.
April 26, 2011
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