Farmers Insurance Group secured its first ever catastrophe (CAT) bond in December 2021, gaining collateralized reinsurance protection against named storms, earthquakes, fires and other severe weather events that impact US territories.
The inaugural $160 million CAT bond was structured by Swiss Re Capital Markets. It consists of two classes of principal at-risk variable rate notes as issued by Topanga Re Ltd., a special purpose vehicle incorporated in Bermuda.
Through the issuance, Farmers secured $100 million of per-occurrence protection across a four-year risk period, and $60 million of annual aggregate protection across a two-year risk period, both on an indemnity basis.
Jean-Louis Monnier, head of Retro & ILS Structuring of Swiss Re’s Alternative Capital Partners, said it was good to see Farmers accessing the CAT bond market for the first time. The move was certainly received well by investors, he added, who are attracted to insurance linked securities (ILS), like CAT bonds, because of their potential to produce attractive risk-adjusted returns and desirable diversification benefits.
The transaction, issued under Rule 144A of the US Securities Act, includes an innovative four-year subrogation extension feature to improve the mechanics by which investors are able to benefit from subrogation recoveries.
“This is new [and] important,” said Monnier. “The way it works is, under certain conditions, this mechanism would extend the bond and basically give more time for Farmers to crystallize the benefit of potential subrogation, and then, in turn, pass on any recoveries to investors. Effectively, in doing so, the CAT bond mechanism further converges with traditional reinsurance.
“Why is it important on this transaction in particular? This transaction is exposed to wildfire risks, and recent wildfires have led to quite substantial subrogation recoveries, so it was essential to add these mechanisms so that investors could make subrogation assumptions relating to that risk.”
In traditional reinsurance, there’s an unlimited amount of time for an insurance company to return subrogation recoveries to their reinsurance partners. However, with a bond, insurance companies can only return subrogation recoveries for as long as the transaction is alive. The innovative mechanism in the Farmers CAT bond extends the subrogation period to four years to ensure that investors can benefit from recoveries during that period.
“Farmers was very much in support of having an extended mechanism to give investors the confidence that if there were subrogation recoveries, they would have more time to benefit from them,” Monnier explained.
Wildfires are a large potential source of subrogation to insurers and other impacted parties, especially if a company – for example, a utility company – is deemed to be liable for the fire’s ignition. Moving forward, Monnier expects to see more transactions like the Farmers CAT bond with similar subrogation extension features.
Prior to this new mechanism, insurers with wildfire exposures could secure CAT bonds, but they were heavily scrutinized by investors. Monnier explained: “The question is whether investors would be able to get the full benefit of subrogation in the assessment of the risk or not, or whether they considered that there could be a risk that the transaction could terminate before subrogation recoveries were crystallized. This obviously differs from transaction to transaction.
“This extension mechanism certainly gives investors more confidence that they could benefit from subrogation recoveries, and this, in turn, would mean that they should be more supportive of transactions with this additional extension mechanism to the extent that the subrogation period could have a meaningful impact on the recoveries.”
Farmers is not alone in tapping into the ILS market to source complimentary capacity for their traditional reinsurance program. According to Monnier, most large insurance companies have accessed the ILS market in recent years.
“I think the reinsurance market is still strong in the sense that the majority of risks being ceded are ceded to reinsurers,” he told Insurance Business. “Certainly, following periods of losses, having an additional tool at your disposal to achieve the risk management objectives of insurers is definitely something that cedents and sponsors have used in recent years. But I would say it’s more of a general trend and not necessarily directly correlated with the CAT activity that we’ve seen.”