Chapter 20
Fixed Income Case Study, Swap Market: The Allstate Corporation
THE ALLSTATE CORPORATION1
Event Summary
On February 6, 2009, it was announced that a $250 million catastrophe (cat) bond, Willow Re, issued by Allstate in 2007 and backed by Lehman Brothers, had defaulted on an interest payment. Allstate Corporation was the ceding insurer of Willow Re—one of four cat bonds that had Lehman Brothers Special Financing Inc. listed as their counterparty in a total return swap. The swap was terminated due to the collapse of Lehman Brothers in September 2008. The bond, due to mature in 2010, was issued to cover potential exposure to storms in the northeastern United States.
Event Details
Catastrophe (cat) bonds are a type of insurance-linked security used to manage exposures to natural disasters. Investors in a catastrophe bond receive coupon payments, but can lose some or all of their principal if a specific type of natural disaster occurs in a particular region and claims are made. The bonds were first developed in the 1990s. Cat bonds became well known after Hurricane Katrina devastated New Orleans in 2005. The catastrophic hurricane led to payments totaling $190 million that were paid out by Kamp Re to cover claims against Zurich Financial Services. Kamp Re was the first catastrophe bond to suffer a publicly acknowledged total loss of principal, although there may have been earlier wipeouts that were not disclosed to the public.
Willow Re was issued in 2007 by Allstate Corporation to protect the auto and home insurer from claims linked to windstorms in New York, New Jersey, and Connecticut. The bond was to mature in 2010. Cat bonds are backed by a pool of collateral that is held to make sure that interest and principal payments can be made if a disaster triggers claims. The value of the collateral pool is guaranteed or topped up by a total return swap; the swap transaction is designed to compensate for any decline in the value of the collateral.
In the case of Willow Re, as well as three other cat bonds (Ajax Re, Carillon, and Newton Re), the swap counterparty was Lehman Brothers Special Financing Inc., a unit of Lehman Brothers, which collapsed in September 2008. At that time Lehman was involved in protecting about 4.4 percent of the cat bond market, according to an industry expert. Lehman's collapse terminated Willow's total return swap and left note holders with exposure to the collateral pool and credit risk. Rating agencies sharply downgraded the bonds; the implication was that they faced a greater probability of default given that it was unlikely Willow Re would find a replacement counterparty for Lehman and the market value of collateral in the pool was uncertain.
Control Failings and Contributory Factors
Undertook Excessive Risk
The sudden collapse of its total return swap counterparty—a unit of Lehman Brothers—left Willow Re exposed to credit and market risk in the fall of 2008. Cat bonds were marketed as being a “pure insurance play” that was exempt from such risks.
Corporate/Market Conditions
Uncertainty as to the market value of collateral securing the bond also led to problems with making a scheduled interest payment in February 2009.
Corrective Actions and Management Response
Willow Re defaulted on a scheduled interest payment on February 6, 2009. A spokesperson for Allstate Corporation said that Willow Re had paid 95 percent of the scheduled interest payment and that it would continue to meet its reinsurance obligations. “The default of Willow Re does not create any contractual obligations for Allstate,” the company said.
Despite the default on the interest payment, the reinsurance contract between Willow and Allstate remained in effect: Allstate continued to pay its reinsurance premium, and Willow paid out every quarter to note holders, who also received any revenue on assets in the collateral account. If a qualifying catastrophe were to occur before the bond matures and damage claims were to reach a specific threshold amount, the value of any payment made to Allstate would depend on the value of the pooled collateral.
Lessons Learned
The problems incurred by several cat bonds that had Lehman Brothers as total return swap counterparty show that investors in such bonds may face credit and market risk in addition to insurance risk. On December 10, 2008, Reuters quoted a research note issued by Lane Financial LLC, a broker-dealer that specializes in risk transfer between insurance companies and capital markets: “The [insurance-linked securities] market was founded on the idea that it was a pure insurance play, invulnerable to nasty things like credit risk. It has not lived up to its own rhetoric.” As of May 2009, a second Lehman-backed cat bond, Ajax Re, was reported to have defaulted on interest payments.
Exposure to Lehman Brothers was a common weak link in four catastrophe bonds and led to calls for improved transparency and stricter controls on collateral quality. The issuance of new catastrophe bonds fell from 27 bonds worth $7.3 billion issued in 2007 to 13 bonds worth $2.7 billion in 2008.
The collapse of Lehman Brothers is widely considered to have dampened enthusiasm for such products. In 2009, investors in such bonds began to require stricter controls against credit risk in the management of collateral held against the bonds; this includes a requirement that collateral be held in U.S. Treasuries or similar high-grade collateral, rather than illiquid or long-term securities.
A report by Fitch Ratings on March 9, 2009, suggested that new structures were being added to encourage investors to return to the cat bond market. These enhancements included asset portfolios invested in more liquid securities, such as government-backed securities, with shorter maturities matched to those of the bonds. Similarly, enhanced cat bonds would also feature greater disclosure of the assets owned, more frequent marking to market, and topping up of market value declines by the swap counterparties.
NOTE
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