The catastrophe bond asset class is used to tossing around big ideas that manage risk from huge storms. A planned $4 billion transaction from State Farm Mutual Automobile Insurance Co., however, might be the largest transaction that the sector has ever produced.

Aon Capital Markets, the underwriter, was said to be marketing the deal at press time, according to market sources. The transaction uses the capital markets to manage a portion of State Farm's risk of natural catastrophe losses in the U.S. and Canada, including hurricane, earthquake, tornado, hail, winter storms and brush fire, according to Fitch Ratings, which gave the notes triple-A through single-B ratings.

Market sources said that the transaction, planned as a 144A placement, is the largest of its kind. If all of the bonds are priced as expected, the deal would represent roughly the entire volume of catastrophe bond issuance completed in 2006, according to Fitch Ratings.

The special-purpose vehicle, Merna Re, will issue bonds and use the earnings to provide reinsurance to Oglesby Reinsurance, a subsidiary owned by State Farm. Aside from its size, Merna Re's noteworthy feature is its indemnity-based structure, a structure that was popular for catastrophe bonds in the years leading up to Hurricane Katrina. Under the indemnity trigger method, the sponsor's losses would have to breach a set threshold before receiving a payout from the trust, much like regular insurance. Damages from Hurricane Katrina, however, eventually led to heavy losses in the Campo Re cat bond, according to Donald Thorpe, a Fitch analyst. After that, cat bond sponsors preferred to put together their deals using the parametric trigger technique.

In parametric structures, triggers are based on an objective measurement of the severity of the insured event, which is something that does not always work to a sponsor's advantage, Thorpe said.

"If you have a deal with the parametric structure, then maybe you lost money but did not trigger the bond," he said, "or maybe you triggered the bond but did not lose any money."

Investors are sometimes apprehensive about investing in bonds issued by indemnity structures, because losses can sometimes take a long time to accumulate and identify. In the case of Merna Re, investors might have to wait for State Farm to settle claims before the losses become clear. Some transactions include a 24-month extension to settle claims, which adds extension risk to a deal. Indemnity deals also entail the so-called threat of moral hazard, which is the risk that the sponsor might change its underwriting practices and sell policies to people it would not normally sell to, and that it would be more liberal in settling claims than in the past, said Thorpe.

Still, the indemnity structure offers benefits to both the sponsor and the investor. The Merna Re transaction will operate as closely to traditional insurance as possible. Further, State Farm will retain a portion of the deal.

"They've got skin in the game," Thorpe said. "The purpose is to align State Farm's interest with the interest of the note holders."

Aon Capital Markets declined to comment about the transaction.

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

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