Since Risk Management Solutions (RMS) changed its hurricane model in March 2011, no issuers seeking coverage for wind storms have chosen the firm's model to use in their cat bond offering materials, but that doesn't mean investors haven't taken notice. RMS, a top risk-probability modeler alongside AIR Worldwide, routinely captured more than half that market prior to the model change, which increased the "one in 100 year" U.S. hurricane industry loss - the biggest component of the cat bond market - to $180 billion from $120 billion.
Such hurricanes are obviously rare, but should one occur, it could put investors on the hook for significantly higher payouts and prompt them to require issuers to pay much higher spreads. Issuers could potentially use RMS's baseline model, which employs a historical average of how many hurricanes have made landfall and assumes that the future will be like the past. That model changes little, and that stability aids investors evaluating and trading cat bonds. Issuers fear, however, that tapping RMS for the offering materials would draw rating agency scrutiny and require acknowledgement of the firm's new medium-term-rate model, introduced in March 2011. That model blends historical data with forecasted rates of hurricane activity that the risk firm sees rising due to warmer sea surface temperatures, which have been scientifically linked to a higher likelihood of hurricanes."The biggest driver of the increase in the industry loss hurricane risk was the change in medium-term rates," said Peter Nakada, managing director of risk management solutions at RMS. "We're the only modeling firm that uses this approach." Nakada said issuers are also concerned that tapping RMS would prompt investors to pay greater heed to the medium-term-rate model, except that concern is all but moot considering 25 of the largest investors already license RMS' cat bond portfolio-management platform, which includes the medium-term-rate model.
Luca Albertini, chief executive officer of London's Leadenhall Capital Partners, noted that either RMS got its hurricane modeling "phenomenally wrong" or some heed must be paid to it, and that even using the best models the market has to offer, there isn't one answer for the probability of hurricane risk. "The models are pieces of information, and it's healthy to show two different views on the world. They key is you need to underwrite these deals," Albertini said. Whether issuers eventually adopt aspects of RMS' medium-term-rate model in their offering materials remains to be seen. For its part, RMS has publicly acknowledged that there's merit to capital-markets participants selecting the baseline view, since stability over transactions' two- or three-year life spans is important. - John Hintze