Societe Generale last week launched the first synthetic CDO of insurance and reinsurance entities on behalf of the world's fourth-largest reinsurer, Hannover Re. The deal, Merlin CDO I BV, applies synthetic CDO structuring techniques to the insurance and reinsurance industry.

"It's similar but different from the catastrophe bond securitizations that we have seen in the market," one market source said. "Similar in that it ultimately incorporates the risk of catastrophe bonds written by other reinsurers, but different in that this CDO functions more like a typical synthetic structure, where the structure protects Hannover Re from default by other reinsurance companies and not specifically the catastrophic risks these companies are exposed to."

Cat bond securitizations transfer risk to the capital markets, with investors bearing the losses from a qualifying catastrophic event, while the special purpose vehicle is fully collateralized at the outset. The sponsor's counterparty risk is limited to the specific catastrophic event, which contrasts with a traditional reinsurance contract, where contingent payments are dependent on the ability of the reinsurer or retrocession provider to meet its obligations.

Not magic

The Merlin transaction will issue notes that are credit-linked to a portfolio initially comprising 99 entities in the insurance and reinsurance business. A total of E95 million ($125 million) of Standard & Poor's rated notes, AAA, AA, A and BBB, will be issued with a scheduled maturity of five years and a legal maturity of six years. Under the credit default swap (CDS), the issuer will sell protection on the portfolio for losses exceeding E60 million and up to E155 million. The CDS references a single credit event linked to the bankruptcy, insolvency or inability of a reference entity to pay its reinsurance debts.

The notes cover losses to the portfolio of E95 million in excess of the first loss retained by Hannover Re. The credit event definition ensures that the cover is appropriate for Hannover Re, while providing a clear and simple loss mechanism for investors. SocGen bankers said that the fixed recovery rate of 35% provides transparency for investors and a simple payout mechanism for Hannover Re.

According to S&P analysts, unlike a typical synthetic CDO structure, noteholders are not exposed to recovery value volatility if entities default in the reference portfolio, since the recovery value is fixed at 35% of the nominal amount of each reference entity. "With a cat bond securitization, investors know the exact risks they are exposed to, but under this structure, investors can be exposed to any number of catastrophic events. What they are ultimately exposed to is the default risk of this portfolio of reinsurance companies, and the strength of the transaction really depends on how diverse the portfolio of these companies are," the market source said.

If a credit event occurs and is confirmed by an independent verification agent, the loss is immediately calculated as 65% of the notional amount of exposure. When the sum of all losses is above E60 million, the issuer will start making cash settlement payments for the amount of the excess up to the total amount of the notes. In exchange for the protection, the CDS counterparty will pay the protection premium in advance on a quarterly schedule. "By paying the premium in advance, the noteholders will be insulated from the credit risk of the CDS counterparty," S&P analysts said. "The premium is paid in advance by one quarter, and that is enough to cover any unpaid interest accrued in that period of time in the event of a CDS counterparty default."

The European market has increasingly seen reinsurance products evolve to fit capital market tastes, and market sources said that this next phase in structuring is a natural progression that is expected to find a larger investor base. According to SocGen, the book of investors for the Merlin deal predominantly comprised banks and fund managers who were not previously exposed to the sector. The distribution was concentrated in Europe and Asia.

"It's not surprising that we are seeing this kind of structure," another source said. "By synthetically referencing CDOs, it's easier to get better ratings. It also targets a wider base of investors. The market has already seen CDO deals packaging these risks through the Pinnacle and Bay Haven deal - Merlin is similar, but because it's synthetic it is much more granular." Calyon Securities managed the Pinnacle CDO while ABN AMRO managed Bay Haven, which has been classified as the first publicly rated CDO of natural catastrophe.

S&P analysts also said that now that reinsurance obligations are being included in portfolios, the market has huge potential. By using CDOs, insurers can mitigate the present and future credit risk inherent in reinsurance, which allows them to better manage certain risks and to obtain reinsurance from a wide and diversified panel of reinsurers. Transactions that successfully mitigate reinsurer credit risk would have benefits from an economic capital standpoint.

David Aubin, managing director and head of debt capital market insurance origination at SocGen, added that the Merlin approach could be tailored for other insurers and reinsurers. "Some will transfer the majority of the risk to the capital markets to improve economic capital; some will transfer only part of the risk, while others will concentrate on placing the super senior tranches as an alternative to cat bonds or systemic risk protection," he said. "It is therefore an extremely powerful tool."

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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