It might not appear particularly magical but Merlin CDO 1 BV does stand out as the first synthetic CDO of insurance and reinsurance entities. Structured by SG CIB, the transaction provides Hannover Re with credit protection on 99 reference entities in the reinsurance sector. It has sold reinsurance recoverables credit risk into the capital market.
One way reinsurers manage risk is through buying retrocession from other reinsurers – in other words laying off risk. Historically, Hannover Re was heavily reliant on retrocession but the rating agencies had voiced their unhappiness with the amount of reinsurance recoverables this left on its balance sheet. The obvious problem is that there is credit risk because until Hannover Re actually claims the money from the reinsurer it bought retrocession from, it is exposed to fact that they might not be able to pay when the time comes.
Balance sheet
"In addition to reducing the number on their balance sheet they were looking at ways to manage the remaining credit risk. We developed a solution using CDO technology, in the same ways that banks use CDO technology to securitize loans and other debt obligations; this is a variation of that technology.
"One of the big challenges was to come up with a credit event definition that works for Hannover Re but that investors could get comfortable with and understand," says Clare Hennings, managing director, head of insurance group solutions at SG CIB. She explained that a big challenge for the Merlin structure was meeting those two objectives and getting it to work in the context of a CDO.
A total of €95 million-worth of five-year notes were sold. The four issued tranches were rated triple A (€25 million), double A (€25 million), single A (€15 million) and triple B (€30 million) by Standard & Poor’s and priced at 58, 78, 132 and 245 basis points respectively.
The notes cover potential losses on the €1 billion portfolio in excess of the first-loss tranche that Hannover Re retained. The triple A super senior was also held by Hannover Re.
Fixed recovery
Unlike most CDOs, note holders have a fixed recovery rate, set at 35%. The credit event definition covers insolvency, bankruptcy and inability to pay reinsurance debts. It ensures that the cover is appropriate for Hannover Re, while providing a clear and simple loss mechanism for investors.
The transaction’s investors were mainly financial institutions – including bank correlation desks and bank portfolio managers – attracted by the benefit of exposure to the insurance and reinsurance industry. Credit exposure to this sector is limited. The distribution was concentrated in Europe and Asia. Hedge funds, traditionally a place to layoff reinsurance risk, were not highly prevalent.
According to bankers away from this trade it was an interesting solution that a number of others are looking at. It was not about cost, but more about risk management and market capacity. And unlike retrocession – there is little capacity constraint in the capital markets.
"In the context of a Solvency 2 world where unhedged risk carries capital implications, I think you are going to see many more risk transfer transactions," says Gareth Braithwaite, head of insurance origination at Royal Bank of Scotland.