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ZURICH, Switzerland-Swiss Reinsurance Co. has made its first foray into transferring catastrophic risk to the capital markets with a bond deal tied to its purchase of $112.2 million in California earthquake reinsurance coverage.

Much like the deal United Services Automobile Assn. used in June to acquire high-level Florida hurricane reinsurance (BI, June 23), the Swiss Re deal involves the use of a Cayman Islands facility in issuing the catastrophe notes.

SR Earthquake Fund Ltd., a Cayman Islands reinsurance facility that Swiss Re created recently, sold the notes to investors, then sold Swiss Re $112.2 million in single-event, high-level California earthquake reinsurance coverage.

Officials at Swiss Re declined to provide details on the arrangement.

Newly formed Swiss Re Capital Markets and Credit Suisse First Boston were the deal's placement agents, structuring and selling the privately placed securities.

In contrast to the USAA hurricane deal, which was based only on losses to USAA's book of business, investor repayment of the $137 million worth of two-year SR Earthquake notes is tied to the index of industrywide California earthquake losses developed by the Property Claims Services division of the American Insurance Services Group Inc.

None of the deal's three tranches provides investors full protection of principal, and Swiss Re officials believe the deal's senior tranche is the first such catastrophe-linked deal to get an investment-grade rating without full principal protection.

That first tranche, which included $42 million in floating-rate notes and $20 million in fixed-rate notes, received an investment grade Baa3 rating from Moody's Investors Service Inc. and BBB- from Fitch Investors Service Inc. The second tranche of $60.3 million in fixed-rate notes was rated Ba1 by Moody's and BB by Fitch.

The third tranche was not rated and was tied to lower trigger points. "We presume it was structured for one or two particular investors," said Isaac Efrat, vp and senior analyst in the derivatives group of Moody's in New York. The only differences in the structure of the first two tranches is that investors in the first can lose no more than 60% of their initial investment, while investors in the second tranche could lose all their principal.

Each of those two tranches has trigger points at industry losses from a single California earthquake of $18.5 billion, $21 billion and $24 billion. Investors lose one-third of their principal at risk at each of those trigger points. Those trigger points are considerably beyond the $12.5 billion in insured losses caused by California's 1994 Northridge earthquake.

"In essence, the losses would have to be notably higher than the Northridge losses in order to have a default event," said Dan Moyer, a senior director and manager of the insurance group at Fitch Investors Service Inc. in New York.

As with the USAA deal, investor demand was considerable, with the deal upsized to its final $137 million size from a planned $115 million because of that demand. The notes' buyers included both U.S. and European investors, among them financial institutions, life insurance companies, money managers and investment brokers.

Rating the earthquake notes was particularly challenging, Mr. Efrat said.

"This was the hardest we've worked on any deal," he said. "It's the first earthquake deal that's ever been rated, so needless to say, we had to know a lot about earthquakes."

"We certainly have to know much more than perhaps what the average investor would, because they certainly look to us in this very new market," Mr. Efrat said.

Rating last month's USAA deal was "a similar sort of thing," Mr. Efrat said. "We had to learn a great deal about hurricanes."

"It would be fair to say that when these deals were first brought to us, we weren't sure whether we would be able to rate them because we hadn't analyzed the data sufficiently yet," Mr. Moyer said.

Actuarial research firm EQECAT provided assistance in quantifying investor risk in the earthquake deal, and the rating agencies also relied on internal analysis and additional independent research in rating the notes.

Mr. Efrat emphasized that Moody's Baa3 rating on the earthquake notes' senior tranche is comparable to a similar rating on a more conventional investment. "It's not a Baa3 rating with 'earthquake' attached," he said