Catastrophe Bonds and Why Mariah Will Matter
Four years after a tornado ripped through Joplin, Missouri, the legal battle over a catastrophe bond linked to its losses is likely over. But both investors and legal professionals agree that the issues surfaced in the lawsuit will continue to haunt the industry unless the role of reporting agencies — and how cat bond disputes are settled in the first place — is resolved.
“As the market matures these type of actions are going to become more common,” says Kiran Soar, partner and head of reinsurance at London law firm Ince & Co. “That is not to say commonplace, but this certainly isn’t going to be a one off.”
Mariah Re was issued in November of 2010 was one of the first catastrophe bonds to move away from large perils in North America such as major hurricanes and earthquakes to cover a smaller but more frequent storms like tornados and severe thunderstorm. The bond’s sponsor is American Family Insurance of Madison, Wisconsin.
Mariah’s was put at risk when series of severe storms and tornados in the U.S. in April and May of 2011, including an tornado that struck the city of Joplin, Missouri. Investors were initially put on notice by the report agent, ISO’s Property Claim Services, that losses were unlikely to reach the bonds exhaustion point of $925 million. But several months later PCS updated its report on the storms increasing the loss by $118 million, triggering the bond and wiping out investors.
A lawsuit was filed on behalf on investors in 2011 arguing that the trigger for the bond was invalid because of falsified lass report. However, last week a New York Federal judge dismissed claims after ruling that the terms governing the definition of and process for qualifying events of the cat bond are “unambiguous.”
Why — not if — Mariah Re paid American Family was always at the center of investor objections in regards to the catastrophe bond, says Dirk Schmelzer, senior portfolio manager for insurance-linked securities (ILS) at Plenum Investments AG in Zurich
“I completely agree that American Family should have been covered for their losses and that their claims were justified,” Schmelzer says “But the ultimate problem is that– at the point in time that was reporting its losses following — the reporting agencies led us to believe that the tornado would cause a much smaller loss as it was described as a non metro event.””
This was especially problematic for those trading Mariah in the secondary market following the tornado, looking to take advantage of the price discrepancies.
“The secondary market trades that were done at that time that relied on bad information,” Schmelzer adds. “While you always trade on information that is incomplete, in this case you have an actual spreadsheet in front of you that was changed very late in the process and after we were told PCS had closed the book.”
Rationalizing, and making the clear, the role of reporting agents in ILS and catastrophe bonds is something brokers need to address and is being done in several recent structures, Schmelzer says. “You need to trade on information where losses are provided by a calculation agent that is accurate and true in that transaction.”
The role of catastrophe modeling firms, insurance loss reporting agencies and other third-party agents involved in ILS transaction’s will get more legal scrutiny as the market attempts to expand into other perils and also as it writes more indemnity based contracts, Soar explains.
“As the ILS works its way out of traditional property cat into other lines of business, then it stands to reason it will be getting into areas and that are less modellable and where it knows less about the perils insured, particularly for casualty business. These types of complaints will have a lot of traction and people will question the payout,” Soar says. “The market bases many of its contract triggers on what these third parties say and a huge amount of money turns on that. It’s a question that needs to be answered.”
Soar adds that the Mariah Re action can be seen as a market positive if the industry “learns its lessons” about the clarity of ILS triggers. “The bonds need to be structured so there is a better understating of how indexes work and there are clear contact terms with index providers where their roles are defined. And the case is a lesson not just for indexed based ILS contracts, but also indemnity based contracts. Indemnity based contracts require a lot of disclosure, but if the 1980s and 1990s taught us anything in the traditional reinsurance world, they told us that disclosure is a difficult issue and future disputes may well turn on what the investors were told.”
Schmelzer says that while the Mariah Re case is pushing market participants to change practices, there was still a cost.
“It helped in a way that brokers are paying much more attention to reporting risk, including fallback provisions that detail if one reporting mechanism doesn’t work, there is another one available,” he explains. “There is also more standardized formatting loss reports. On the downside, we lost the money. And it didn’t help because cat bond market is a develop business and this type of dispute sends a pretty negative signal.”
Ince & Co.’s Soar agrees that a broader — and possibly more difficult — issue for the ILS market to overcome that was brought out by the Mariah Re case is how ILS disputes are handled. At the moment ILS disputes are executed much the same way reinsurance disputes were handled 30 years ago: high-profile and painful court cases.
“In one sense you can say that this is the result of a growing market getting in disputes, learning its lessons, amending what it does and moving on,” Soar says. “However, there were aspects of this that were fairly ugly and it’s not the type of publicity that ILS really needs.”
A possible solution to ILS disputes is the creating of a cross-border arbitration panel, similar to the “Bermuda Form” system of arbitration created by the pharmaceutical industry.
“That system works because it separates the venue from governing law,” Soar adds. “It follows New York law, but the venue is London. London is an instantly recognized centre of international arbitration, with clear rules to make the process efficient, quick, fair and confidential. But as most of the trading takes place in New York, New York law is sometimes preferred by some investors. It could work much the same way. Non one wants things dragging on for years, costing significant legal fees. Parties should be able to have their disputes heard in private, quickly and efficiently, by people who understand ILS.”
Despite the loss and the negative publicity, investors felt that the Maria Re case needed to be heard by the market.
“The problem is that there was only one pot of money that was available, so the only thing you can sue against it the $100 million of notional that was issued,” Schmelzer says. “Hopefully this is a wake up call.”
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