Are ILS investors repeating the mistake of ‘Lehman’?
Prior to 2008 the standard Cat Bond collateral structure was using a total return swap (“TRS”) with the structuring investment bank. The investment bank invested the collateral into securities of their choice, subject to certain constraints, and swapped the interest rate into LIBOR and guaranteed repayment. Over time and little by little the collateral security requirements were weakened, as with all structured finance products, and the investment banks had greater scope. A cynic may say that the investment banks were given cheap rolling finance from the TRS product. Lehman was one of these banks, providing a TRS for 4 cat bonds. When Lehman failed investors had to rely on the underlying collateral, which was found to be highly rated, long duration CDOs and in one case a ‘regulation triple-X’ cat bond whose underlying risk was a poor performing portfolio of CDO and other investments. Given all the underlying investments were trading at a discount, these 4 cat bonds all lost value, some considerably. Due to inadequate structuring, the cat bond market, which purported to investors to be free of econometric risk, suffered losses as a result of Lehman failing.
Today we are seeing signs of a similar and even more dangerous structural weakness seeping quietly into the market. Starting with Alamo 2014, followed by Cranberry 2015 and Alamo 2015, cat bond investors are not only exposed to the physical perils, but they are also fully exposed to the credit risk of the reinsurance ‘fronter’, Hannover Re. Under normal circumstances Alamo, which is exposed to Texas hurricane, and Cranberry, which is exposed to Massachusetts hurricane, would diversify each other, given it is physically not possible for the same hurricane to hit both Texas and Massachusetts. However, given that both bonds are exposed to the credit risk of Hannover Re, these bonds can be affected by the same single event, which is most likely to be an econometric event as Hannover’s largest single risk is a capital event (e.g. Credit Crisis II driven by an economic collapse in China), but could also potentially be a pandemic event.
The new structure, presumably designed by GC Securities (as structuring and placing agent), has not been clearly explained to investors (despite requests for clarifications at road shows). The diagram in the investor presentation was simplified to the point that it ‘hides’ what is happening as per the documentation. The schematic made it appear that the Reinsured Reinsurer Trust Account was a trust account between Alamo, as grantor and the Texas Windstorm Insurance Association (“TWIA”) as beneficiary, and that Hannover Re had no link to this trust account (there was no visible connection / line between Hannover Re and the trust in the schematic).
This is not what actually happens and therefore the diagram was at best misleading.
In reality the transaction structure is more like that in Figure 1.
The note proceeds from investors flow into the Ceding Reinsurer Reinsurance Trust Account (“CRRTAc”), where Hannover Re is the beneficiary. As per the Ceding Reinsurer Reinsurance Trust Agreement (“CRRTAg”) Alamo and Hannover Re direct the trustee to transfer the funds from the CRRTAc to the Reinsured Reinsurance Trust Account (“RRTAc”).
The RRTAc holds assets belonging to the Grantor which is Hannover Re (and not the noteholders) for the sole use and exclusive benefit of the Beneficiary which is TWIA. These assets have to belong to Hannover – it is not possible to pledge assets that that belong to a third party, even if one possesses a pledge on those assets, otherwise it would be simpler and cheaper to allow TWIA to be beneficiary under the CRRTAc and not to have the RRTAc at all. This is why the funds by necessity were withdrawn.
Alamo (and therefore the noteholders) have no rights under the Reinsurer Reinsurance Trust Agreement (“RRTAg”) under privity of contract – it is a bi-party contract and not a triparty contract.
Given that Hannover has drawn down on the CRRTAc, the noteholders become common creditors of Hannover Re on day 1 of the transaction – it has been confirmed that noteholders do not have any lien on the assets within the Reinsured Reinsurance Trust, nor any other preferred credit position vis-à-vis Hannover Re.
It is also maybe important to note that the funds in the RRTAc are explicitly to collateralize the obligations of Hannover to TWIA i.e. to act as security for a reinsurance agreement that has legally nothing to do with Alamo.
At the termination the RRTAg requires the Trustee to transfer to the Grantor any assets remaining in the in the RRTAg – there is no mention / requirement to transfer the funds into the CRRTAc for the benefit of Alamo / Noteholders.
If Hannover is in financial difficulty / run-off the funds would not be transferred to the CRRTAc as they would be Hannover assets to be used as per the credit seniority waterfall where claimants are the most senior. Hence Alamo and the noteholders take full Hannover Re credit risk.
Risk Appears in Risk Factors
Each Information Memorandum contains a long list of risk factors, which investors are encouraged to read. Typically these are the same from Cat Bond to Cat Bond, therefore it is hardly surprising that investors do not read them in their entirety each issue, given that they understand the structures, provided such structures remain the same, and would expect placing agents to highlight any changes from the norm.
The Risk Factors in offering memoranda of these bonds explicitly state that an insolvency of Hannover Re could result in a delay in, or a reduction of, the repayment of the notes. The relevant risk factor mentions that the RRTAc may be subject to clawback in any insolvency proceeding of Hannover Re. It also goes on in great detail to explain that German Insolvency Law will override the documentation and that certain other creditors may take precedence over the redemption of the noteholders and further that the collateral released from the RRTAc will form part of the assets of Hannover Re for distribution to all creditors. The paragraph finishes with a clear statement that an insolvency of Hannover Re could result in a significant delay or reduction of the repayment of the principal of the notes.
From the risk factor it is clear that Hannover Re owns the assets and has full title against a non-preferential liability to noteholders.
One may conclude from this that:
- The assets in the RRTAc are assets on loan to Hannover from Alamo and Alamo accepts the credit risk, similar to a debt-finance issue.
- Alamo has not been remunerated to accept the credit risk of Hannover Re.
- The seniority of the debt to Alamo has not been stated and is not contained within the note documentation – it can therefore be assumed to rank with the lowest ranking debt – marginally above the equity behind claims and senior ranked debt. Here it is important to note that Hannover Re’s S&P rating is a ‘claims paying’ rating – a debt rating will be lower and can be considerably so, given that debtholders rank after all valid claims have been paid (which may take a very long time).
- The funds will appear as debt in Hannover Re’s accounts and capital structure. The total issued amount of the three issues is $1.4bn. A well-diversified reinsurer, as is Hannover Re, will be able to leverage this amount many times thereby allowing Hannover Re to write a multiple of $1.4bn of limit based upon this ‘free finance’.
- The funds must be invested in US Treasury Money Market funds, therefore it will appear on the balance sheet of Hannover Re that they hold $1.4bn of US Treasury investments. This would allow Hannover Re, if they so wished, to invest the rest of their assets more aggressively. In turn this would increase the probability that Hannover Re would face difficulty in a financial markets crash.
- As mentioned previously, it is likely that many noteholders will assume that Alamo and Cranberry are non-correlating and allocate them to different risk buckets. This would give investors and other interested parties a false picture of the diversity of such a portfolio.
It is possibly not a coincidence that it is Hannover Re and not one of the other reinsurers involved in this structure. It is believed by long-standing reinsurance market participants that Hannover Re has typically been the most creative in their capital structure when compared to it peers. Hannover Re have clearly entered into a great deal for them, although maybe not of their own making, however any great deal necessarily has losers on the other side of it.
It would appear that certain investors in the Cat Bond market are blindly walking into the same situation as the TRS and Lehman. It will be the wiser investors who realise the risk and either do not take it at all, or manage their limits considering the Hannover Re credit risk.
This structural weakness is even more risky than the Lehman TRS problem given that, with the TRS, the assets were there and the noteholders had title through the SPV when Lehman failed, the problem was valuing and selling them. With this new structure neither the noteholders nor the SPV have title to any assets – merely the credit risk of Hannover Re. If Hannover fails like Lehman there would be no assets to collect, whether difficult to value / sell or otherwise. The value of the bankruptcy-remote SPV in the securitisation designed to provide investors with pure catastrophe risk has been totally removed and replaced by full credit risk of Hannover Re – this totally defeats the merits of cat bond investing over reinsurer equity investing.