Wilde Sapte ART Research Report
July 1999
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An Introduction
– An Introduction –
The world of financial services is in the midst of restructuring. A critical influence is new competition between retail banking and insurance. Retail banks and insurers are eating into each other's territory by marketing new products and cross-selling. These distribution-based strategies are known alternatively by the French expression bancassurance or the German expression allfinanz.
However, change in the wholesale arena – evolving patterns of competition and co-operation between investment banking and re/insurance – is even more dramatic than in bancassurance markets.
What is at stake goes beyond the marketing of new retail products or finding new channels of distribution. Traditionally, insurers and reinsurers have managed their capital according to their core business of taking on and financing risk. But the old rules of the game are breaking down. For the first time, the banking sector and the capital markets are playing an active role in providing what are, essentially, new capital management solutions for both insurance and reinsurance companies.
The most dramatic innovation has been catastrophe securitisation – issuing catastrophe bonds to capital markets investors, who take the burden of the risk in return for a healthy premium.
The insurance industry faces overcapitalisation, declining underwriting opportunities from commercial clients and the prospect of poor future profits. A new solution promises to be securitisation, albeit in a different guise – the transfer of risk to the capital markets so that firms can restructure balance sheets, manage capital more efficiently and write more business.
The other dimension of the convergence process is that the corporate client base of the re/insurance and banking industries is demanding a more sophisticated, multi-industry approach to risk management and risk financing. This is radically changing how the re/insurance industry addresses client needs.
Finally, this convergence has created new markets. New products and tools combine banking and insurance elements. So far, many of these have gone under the heading of alternative risk transfer (ART).
Although ART is an extremely malleable concept as part of the vocabulary of certain commentators, it has, to date, comprised two distinct waves. The first involved the establishment of captive vehicles and greater self-insurance on the part of the world's largest corporations.
Our interest in ART is in the more recent, secondary development of hybrid products which cross the regulatory divide between the two industries. These are highly sophisticated products developed for major buyers of risk management products, whether they be insurers, reinsurers or large corporates.
At present, many of these new financial techniques and markets remain marginal to mainstream re/insurance, investment banking and corporate risk management. Research into the possible drivers of their use has so far been lacking. As a result it has been difficult to make projections of their future success.
The following report concentrates on four areas:
- New forms of financing catastrophe risk for re/insurers
- The potential application of non-catastrophe securitisation for insurers
- The changing risk financing and capital management needs of corporations
- New products and new markets
These capital management solutions may become vital for the future success of re/insurers. But, as their clients – the world's major corporations – demand these as well, re/insurers will need to change the nature of their service offerings. In particular, they will need to incorporate financial engineering techniques more commonly found in banking. Some of the largest reinsurance and insurance companies are already well advanced in this field.
The success of many of these tools depends partly on the appetite of the capital markets to take on risk. Evidence in this survey suggests, however, that investors are more than willing to accept re/insurance risk in the form of an investment in bonds or derivatives. So far, securitisation has played a complementary role to the traditional model. Whether it will expand its role remains an open question. We suggest that the critical issue will be the willingness of issuers – players in insurance and reinsurance – to embrace the new technology.
The main findings of the survey can be summarised as the following:
- In the short-term, the most likely originators of securitisation are likely to be reinsurers; but in the long-term the largest and most liquid market is likely to be non-catastrophe bonds issued by primary insurers.
- Securitisation in the non-catastrophe area could have more dramatic effects: it could lead to major restructuring in the insurance industry, since insurance companies would transfer risk directly to the capital markets.
- The main barrier to the further development of the market is not lack of acceptance on the capital markets side but the unwillingness of issuers to innovate with the new capital management techniques. More specifically, in the non-catastrophe securitisation area there are barriers of moral hazard and risk disclosure to overcome.
- Corporates are increasingly demanding new risk financing techniques which are balance sheet driven.
- Corporates should become issuers of insurance-linked bonds through their captive insurance companies, but, again, the main problem lies in the area of adequate risk disclosure.
Overall, the findings led us to the conclusion that:
New pressures on the insurance industry – pressure to manage the cost of capital more efficiently and pressure to adapt to changing needs of clients – will lead to the increasing incorporation of financial techniques to manage capital and to finance risk. The extent to which this happens will depend more on insurers' willingness to innovate than on investors' appetite for risk.
The most dramatic expression of the introduction of financial techniques into the insurance industry would be the virtual insurance company – an entity which transfers risk directly to the capital markets.
Wilde Sapte ART Research Report – Executive Summary
Financing catastrophe risk through the capital markets
In the absence of very large catastrophes, the rationale for securitisation has switched from an industry-wide concern with extra capacity to the need for greater security or credit quality on the part of the originator. The initial concern that securitisation would disintermediate re/insurers has faded, not least because the industry has not suffered a large enough catastrophe to spark restructuring.
Although swaps of portfolio risk are viewed as favourable in the short-term because of cost and speed advantages, in the long-term, the case for securitisation is stronger because of credit advantages, widened investor access and the ability to raise more capital.
The exchange-traded product in the form of the catastrophe (cat) option emerged historically prior to the over the counter (OTC) market, a rare reversal of the normal development seen in derivatives markets. The argument for the exchange-traded product is strong (more security and cheaper than an OTC product) but its success will depend on greater issuer involvement.
Long-standing relationships between insurers and reinsurers may slow the move towards securitisation, but will not stop it. According to respondents, these relationships, although important, have been eroded anyway because of changing price/market conditions.
From the investor perspective, the impact of turmoil in the financial markets is likely to strengthen the case for purchasing cat bonds.
Barriers to the further development of the market are greater on the issuer side than on the investor side.
The potential applications of non-catastrophe securitisation for insurers
Many respondents identified this area as the future of the re/insurance securitisation market.
Respondents identified that, while reinsurers are likely issuers in the short-term, in the longer-term insurers represent the most likely issuers. The potential size and liquidity of an asset-backed bond market is greater.
The most likely non-cat risk that could be securitised, according to respondents, is auto insurance.
Long-tail risks are viewed by respondents as least susceptible to securitisation.
The barriers to securitisation in this area are, on the investor side, moral hazard – the possibility of manipulation of figures by the originator – and, on the issuer side, the unwillingness to disclose intimate business risks.
Financing corporate risk
The current low price of commercial insurance is the main barrier holding back corporates from issuing a cat bond. In addition, the unwillingness of corporates to part with detailed information about their business was cited as a significant barrier.
However, a majority of respondents believed that captives could become future issuers.
Alternative risk financing (ARF) offers pricing benefits compared to conventional cover – but, more importantly, ARF gives insureds more financial flexibility and better ability to manage capital, in line with increasing shareholder value.
New products and new markets
The fastest growing product in the latter half of 1998, according to respondents, was finite risk.
Respondents expected credit products to grow the fastest in the coming period.
A majority of respondents believed that competition between the insurance and financial markets was exaggerated.
The US is seen as the leading market overall.
The future: the virtual insurance company?
A significant minority of respondents identified the emergence of the virtual insurance company, as an entity which would transfer risk to the capital markets, in much the same way as mortgage lenders developed in the mortgage-backed securities (MBS) markets in the 1980s. While there are barriers to this approach, the impetus could come from the chronic capital efficiency problems in the insurance industry, now much commented on.
Wilde Sapte ART Research Report – Methodology
Background
The fieldwork was carried out on behalf of Wilde Sapte by Brightwater Research & Editing. Telephone interviews lasted 45 minutes on average and were completed in March 1999. In total, 50 organisations participated: 17 reinsurers; eight investment banks; nine corporates (six treasurers, three risk managers); five re/insurance brokers; four insurers; three consultants; two accountancy firms; one Lloyd's syndicate; and one investment fund. Two fifths of respondents were based in the US; a fifth from Continental Europe; a fifth from the UK; and a fifth from Bermuda.
Objectives
Our objective was to interview those most involved in the new alternative risk markets. In many cases respondents hold senior positions in units devoted to these markets, set up recently by their institutions. Nearly half of all those interviewed had experience or were qualified in both finance and insurance. Many are considered leading innovators in the marketplace.
We wished to solicit the views of market leaders on a range of subjects relating to insurance securitisation and alternative risk transfer. In particular, we wanted to clarify the rationale for the supply and demand of new risk products and solutions and gauge the future direction of the market. The report is intentionally qualitative in style, but we have included quantitative data where appropriate.
The report is divided throughout into three main parts: scene setting, main findings and comment. The scene setting will introduce the reader to technical subject matter and explain the reasoning behind the questions asked.
Wilde Sapte ART Research Report – Catastrophe risk securitisation
Background
Securitisation originally emerged as a tool for lenders to refinance mortgage loan repayments, credit card receivables and other income streams, in the US capital markets. Asset-backed securities were issued and, before long, a liquid secondary market developed. Later, the re/insurance industry became the beneficiary of this new technology when it began to securitise catastrophe risk with the aid of banking expertise.
Conventional securitisation involves refinancing payment streams. This income may be more or less predictable. Insurance securitisation, by contrast, involves financing risk – or more precisely, event risk. Essentially, it is the financing of risk exposure that traditionally would be transferred to the re/insurance markets. It is also the financing of something more unpredictable – which is why it is also labelled risk securitisation. Unlike other securitisation transactions, there is the possibility that investors will lose their principal upon the occurrence of a defined event (principal is at risk).
Since securitisation in this area has the potential to disintermediate the re/insurance industry, there has been debate on whether it will substitute or complement traditional cover provided in the re/insurance markets. To get closer to an answer, we asked respondents for their views on a number of topics: advantages of securitisation over traditional cover; the strength of existing, traditional relationships; and investor appetite.
An emerging derivatives market has accompanied the catastrophe bond market. This comprises swap transactions which have raised less capital but clearly have been easier and speedier to conduct, and the catastrophe options traded on exchanges (such as the CBOT – Chicago Board of Trade and the BCOE – Bermuda Commodities and Options Exchange). The exchange-traded products were the first examples of transferring insurance risk to the capital markets. However, since then, liquidity in the markets has been poor, leading many to question their future.
Main Findings
What are the top three advantages of risk securitisation over traditional re/insurance cover?
The most popular first choice was that securitisation offers better security, or better counterparty or credit risk to the issuer, than conventional cover. As one insurance broker put it succinctly, 'upfront cash is better than a promise' .
The second most popular view was that securitisation offers a route to'greater capacity' in the form of the capital markets.
'The main advantage is a large capital base, of trillions rather than billions of dollars. Connectedly, there is much liquidity in the capital markets, which means there isn't as much hand-wringing in the event of a big loss. The capital markets don't punish you for handing them a loss, they forget about it and move on. Because it is such a liquid market, there is none of the moralising and back-stabbing that still goes on in insurance circles after a major loss.' – a broker
In third place was 'price stability': issuing a bond offers a price over the long-term that is fixed and not subject to fluctuations in the reinsurance market. Some respondents drew attention to the 'upfront price' – the initial transaction costs of setting up the special purpose vehicle (SPV), advisory services, etc – which has been high so far.
What has been the most important innovations in the securitisation of cat risk since the first cat bond deal was placed in the market?
The most frequent response was the parametric trigger, followed by the involvement of ratings agencies and then the use of reset mechanisms.
There are three major ways in which the default of a bond may be triggered: (a) the specific underwriting loss of the insured; (b) an independent index of insured events; or (c) a non-insurance, physical index (such as the Richter scale).
Of late, there has been a growing belief that the third trigger form of reset mechanisms represent the future of the market and the best possible option for investors attempting to quantify the risks (although some investment funds specialising in cat bonds have argued to the contrary).
There are two main reasons. First, an index relating directly to natural disaster removes the risk of moral hazard – in this context the possibility of the manipulation of figures by the insured – and aligns the insured and investor in their knowledge of the risk. Second, from the investor perspective, a security tied, for example, to a meteorological index may represent the closest it can get to portfolio diversification, since a trigger linked to a pure weather risk offers more complete non-correlation with fluctuations in the financial markets.
This thinking was encouraged by the Parametric Re transaction, the first security issue tied to the occurrence of a physical event and not directly indexed to insured losses. In this deal, arranged by Goldman Sachs and Swiss Re (insuring Tokio Marine & Fire, a major Japanese insurance company), a US$100m bond issue was placed in the market in two tranches, both with a 10-year term. The trigger was related to magnitude level, location and depth of an earthquake as announced by the Japan Meteorological Agency.
The second most popular innovation mentioned was the involvement of the ratings agencies. Since the evaluating of pricing and credit risk of catastrophe bonds is far from straightforward, the success of the agencies in rating the bonds is seen as a major step forward.
The third most popular choice in this section is reset mechanisms. These allow for the alteration of the risk/return ratio if a catastrophe occurs. Effectively, the price is reset if a catastrophe occurs during the term of a bond, because the probability and modelling for the original price of the bond has been altered.
Re/insurance relationships
Will long-standing relationships between insured and insurer (in both reinsurance and commercial markets) be likely to prevent a move away from insurance-based products to capital markets-based products?
The most common response was that relationships would not be strong enough, but could be 'a drag on the process' or 'slow the process down'.
Some respondents identified relationships as existing only because of tough times, which could be important in the future. Others mentioned the importance of relationships even in the capital markets – bondholders need to be comfortable with the creditworthiness of companies, for example. One respondent made the point that long-standing relationships exist only because of inefficient markets and 'deep structural problems in the industry'.
A number of respondents commented that many long-standing relationships had been destroyed by recent low reinsurance prices, enabling greater choice in the market. Others mentioned that relationships are coming under attack because of a changing ethos in the re/insurance industry; managers are under more pressure and do not have the 'perks' of going beyond purely market relationships with clients.
What impact will turmoil in the financial markets have on investor perceptions of buying insurance risk paper?
Respondents veered more to the view that turmoil only served to point up the diversification benefits. One pointed out, for example, that a recent hedge fund in trouble bought cat bonds and out of its entire portfolio only these securities held their price. Some respondents stressed the importance of seeing a distinction between a 'flight to quality' and 'buying cat bonds for diversification', even though they may be considered 'exotic instruments'.
'Now is an opportune time for grooming the investor base, because cat bond investors have weathered the financial storm better than other investors. Now is the time to hammer home the idea that they should have 5-10% of their portfolio in these securities, not just 1% or 2%.' – a reinsurer
Has getting investors interested in insurance risk paper been difficult?
Many respondents identified a high level of education amongst those investors who have bought insurance linked-notes but recognised that this represented a tiny fraction of the global institutional investor population.
Interestingly, we found that respondents were more willing to criticise the lack of issuers' willingness to issue, rather than investors' readiness to buy. Many respondents pointed out that all deals to date have been oversubscribed. Some respondents made the point that investors will invest in anything where lack of market correlation increased portfolio diversification.
'The problem is not enough deals around. All the deals so far have been oversubscribed.' – a broker
The swaps market
Hot on the heels of securitisation deals have been an increasing number of catastrophe swap deals. Swap deals offer a number of price advantages over cat bond deals and are easier to conduct.
What are the advantages of OTC derivative instruments over securitisation deals?
Respondents mentioned: cheaper cost; simplicity; greater speed to market; less need for rating, risk modelling and documentation; and greater standardisation.
Will catastrophe swap deals become more popular than cat securitisation?
The majority of respondents answered in the affirmative, but most qualified their answers. The overall message was 'yes, but only in the short-term'. Many problems were associated with swaps. First, they lose the security and credit advantages of securitisation. Second, there are regulatory constraints – in some jurisdictions only 'indemnity-based' swaps are permissible and there are constraints on the investor type who can enter into transactions. Third, and related, the investor base for buying bonds is much bigger. Fourth, swaps cannot raise the capital amounts seen in securitisation deals. Fifth, swaps are less tradeable.
Many respondents said securitisation and the swaps market are complementary. A few warned against writing off securitisation especially in the longer-term.
Exchange-traded derivatives
Are OTC insurance derivatives seen as more favourable than exchange-traded contracts?
The vast majority of respondents replied yes. Some made the point that the order
in which OTC derivatives and exchange-traded instruments had developed in this particular market had bucked the trend of other derivatives markets. That is, counterparties normally enter into OTC arrangements, through which contracts stumble towards a standardised format and can then trade on an exchange. In the catastrophe risk securitisation market, however, exchange contracts were established early on and were followed by OTC markets at a later date.
Respondents were divided between those sympathetic towards attempts to develop exchange-traded contracts and those dismissive of them. Points in favour were: contracts are cheaper and security is guaranteed through the clearing mechanism. Some respondents commented on the illegality of swaps in many jurisdictions.
On the other side of the argument, some questioned whether insurance contracts could be fungible in this form; others said that basis risk continues to put off many potential re/insurers.
One respondent made the key point that cat options would be more successful in a mature market comprising 'thousands of players'. Again, others suggested that the two markets should be complementary.
Which area is most likely to grow over the next five years – OTC derivatives; exchange traded derivatives; or insurance securitisation?
44% mentioned the OTC market as their first choice; 26% securitisation; and 7% exchange-traded products. 23% declined to give an opinion.
Comment
The high importance ascribed to mitigating counterparty risk as the main reason for issuing a catastrophe bond, may reflect a combination of current, as well as long-standing, concerns. Historically, the high number of insolvencies after the major US catastrophes in the early to mid-1990s, and the Lloyd's crisis in the UK, may have dented the re/insurance industry's reputation for honouring commitments. More recently, the perception of increasing competition, increasing pressure from shareholders, pressure to improve capital management and cash-flow stability, may have attracted many organisations to the security offered by capital held in an SPV.
The higher credit quality offered by securitisation comes at a price. However, securitisation is suited to the current climate, where institutions are cash-rich but are more concerned with credit quality. As a result, they are likely to be comfortable paying a higher price for higher credit quality. The demand for securitisation should continue to be healthy in the medium term, with steady, rather than explosive, growth.
We found that there is a perception that investors are keen to invest in cat bonds, even given turmoil in their traditional markets. The barrier seems to be greater on the supply side – the reluctance of issuers to experiment.
While catastrophe securitisation remains at present a cumbersome process, it is realised that it offers a more comprehensive and ambitious capital raising solution than hedging in the catastrophe derivatives markets, although ideally the two markets should be complementary.
The success of the exchange-traded derivative will be, to a large extent, dependent on the maturity of the market. While it remains underused, the arguments in favour are strong and in time it should develop into a valuable hedging tool for those in the re/insurance industry.
Wilde Sapte ART Research Report – The potential applications of non-catastrophe securitisation for insurers
Background
So far, securitisation deals have mainly either provided retrocessional coverage for reinsurers or have 'reinsured' insurers' property-casualty risks. But it has been unclear whether the greatest market lies with reinsurers or insurers. We asked respondents for their opinions.
Although insurance securitisation developed first to provide capacity for catastrophe risks, there have now been a number of deals that have securitised conventional risks, such as life assurance and residual value. Although it is realised that these deals are closer to the conventional financing of an asset-backed deal, there has been increasing discussion on whether conventional insurance classes such as auto insurance, may be ripe for securitising. Indeed, the securitisation of such classes would lead to a larger, more liquid market than that for catastrophe risk.
Who is likely to securitise?
Do you expect reinsurers or insurers to make greater use of capital markets risk financing over the next three years?
Two thirds identified reinsurers as being more prepared to go down this route. The top reasons given were that: 'they are more financially savvy'than insurers; they are able to package risk better; offer more diversity to the capital markets; and are faced with fewer regulatory barriers.
However, a number of respondents in both camps qualified their remarks by observing that, in the long run, insurers would be more likely to turn to the capital markets. This is because there is a bigger potential market for issuance and secondary trade: insurers are more numerous and there is more premium volume in the insurance markets. However, some respondents also suggested that securitisation techniques would need to extend to non-cat risks or insurance classes. As some commented, if this occurred reinsurers would face the threat of disintermediation and would have to take on new intermediary roles (such as issuing and trading securities).
Which are the three developments most likely to spur more risk securitisation?
Somewhat predictably, the top choice was 'a large catastrophe' which could force further restructuring in the re/insurance industry. More interestingly, 'non-cat securitisation' was mentioned in joint second place with 'increased investor interest' as the most likely development to spur more securitisation. This supports the earlier finding that in the medium to long-term, securitisation by primary insurers may represent the future direction of this market.
Which two non-cat insurance risks are most likely to be securitised?
Auto insurance was mentioned as the most likely insurance class to be securitised, followed by (in no particular order) life, healthcare, homeowners, workers compensation, satellite and aviation and residual value. Some respondents mentioned risks that could be securitised outside the mainstream insurance arena altogether. These were: technological obsolescence, product liability, industrial disaster and hedges linked to changes in GDP (gross domestic product).
A significant number of respondents stressed that liability risks could not be securitised. This is because of the long-tail nature of the risks and the unpredictability of cash-flows, which runs contrary to a fundamental requirement for a successful securitisation.
'All risks except long-tail liability can be securitised. Investors want to be out of the transaction, so there has to be a cut-off point. They buy bonds that have a maturity and so they want to be paid back. Because of this, the easy classes to securitise will be the short-tail risks.' – a banker
Barriers to non-catastrophe risk securitisation
What are the factors holding back securitisation of non-catastrophe risks?
A number of respondents mentioned that securitisation in this form was more susceptible to potential manipulation by the cedant than catastrophe risk, which is only dependent on 'mother nature'. Others questioned the economics: 'Why would it make sense for insurers to go down this route if they are underwriting profitable lines?' Finally, a number of respondents pointed more generally to the lack of innovation in the insurance industry.
'There has to be greater market acceptance of a statistical methodology and approach to these risks. It's a very different argument that you pose to investors compared to cat bonds. The nature of the risk is very different. You may have a portfolio of 10,000 risks as opposed to waiting for one risk, in one zone. The risk-return relationship is far more intertwined with the underwriting standards of the insurance company: if they are lax with policies, ie they misjudge the mortality risk, the risk-return profile will change. So with these risks investors have to lean more heavily on the cedant company than cat risk.' – a reinsurer
Comment
A number of findings seem to suggest that insurance securitisation in the non-catastrophe area could represent the future of the market. At the level of individual deals, the issues of moral hazard and issuer discomfort with detailed disclosure of risk are the most critical potential barriers. The industry-wide barriers are discussed in the final section, 'the virtual insurance company'.
Wilde Sapte ART Research Report – Financing corporate risk
Background
One discussion point in the last few years has been whether corporations will issue a catastrophe bond to insure against industrial disaster.
Much of the discussion on innovative risk financing has centred on a company's captive vehicle. More recently, there has been some debate over whether captives could be potential issuers of cat bonds for industrial corporates. We asked respondents for their views.
The move away from using the insurance markets to finance risk has been much commented on, as captives continue to be set up, corporates increase their levels of self-insurance, become more sophisticated in their risk management and find new ways of financing risk. We asked respondents for their views on the insurance markets and where they find them lacking.
We also asked respondents for their views on the related subject of alternative risk financing (ARF). Although a subset of ART, the definition of ARF differs in that risk is not being transferred to a third party who is obliged to pay an agreed sum. Rather, ARF usually involves a balancing out of payments over time between insurer and insured. Finite risk solutions clearly fall into this category, as do other techniques which give the insured more flexibility (such as multi-year, multi-term cover).
Main Findings
What are the main barriers holding back corporates from issuing an insurance-linked note?
The principal barrier was seen to be price. Catastrophe insurance is cheap in the current soft market, although it was pointed out this could change unexpectedly.
The complexity of doing such a deal was cited as a barrier. Other respondents mentioned that investors would require a high degree of transparency and disclosure, but corporate issuers might be very reluctant to part with very detailed information. A related point was the suggestion of a fear that figures could be manipulated, with the moral hazard of the corporate issuer knowing more about its risk profile than investors could find out. Finally, internal company divisions – and the difficulty of winning buy-in from the board – were perceived to be important barriers.
'Corporates need a better understanding of their risks. Risk managers have not always been part of the corporate financing chain. There is a need for greater unity of risk awareness in corporates.' – a reinsurer
Captives and innovation
Can captives increase the chances of corporate securitisation?
A majority answered 'yes' (51%) or 'perhaps' (12%). This compared to 21% who, outright, said 'no'.
A proportion of respondents made the case in negative terms: captives show that 'risk management is more developed' or 'they show a step up the sophistication curve'. Others answered in positive terms: they were encouraged by attempts in Bermuda to develop new transformer vehicles that accommodate bond issues through separate accounts in a cell structure, seeing this as a model for potential captive issuers.
Those who believed captives would not increase the chances of corporate securitisation saw captives as primarily bringing tax and accounting benefits to the company concerned, and did not think this role could be extended.
Perceptions of the insurance markets
Do you see inadequacies in the insurance markets?
The most common answer was 'lack of customisation'. Corporates have specialised risks connected to their business, and the insurance industry is failing to find cover for them. The organising principal of the insurance industry has, traditionally, been the 'law of large numbers' – the'socialisation of risk' which depends on identifying common risk factors. In this role, however, the industry is often unable to provide cover for individual risks that do not fit into this actuarial framework.
Interestingly, we found that many respondents were prone to judge the insurance industry by the standards of the financial markets.
One made the point that, unlike the financial markets, which innovate on an on-going basis, the insurance industry is loath to change. In addition, others mentioned 'the absence of tradeability' and 'low awareness of the cost of capital'.
'There is a huge fixation with segmenting risk by cause, instead of effect. The finance director of corporate X doesn't care about fire: he thinks about a basket of risks that would limit his ability to do something else. So the causation is irrelevant. Of course, we need expertise in understanding risk, but this should be a back-office not a front-office activity.' – an insurer
'It's not a dynamic market. Corporates are wanting more dynamic hedge exposures. There is a need for simple, robust hedge triggers. How many insurance contracts have put options in the market?' – a broker 'The failure to recognise the needs of buyers. From a relationship point of view, corporates want more than a piece of paper with an exclusion list. They want more sophisticated financial planning with a group that can also understand pollution and Y2K.' – a reinsurer
'Amending an insurance contract mid-year is difficult; whereas if you have different views on the weather during the year, with a liquid trading market you can trade out, get back the premium and use that money for more pressing concerns. Re/insurers do not have a trade perspective, but have a risk retention or risk assumption perspective.' – a reinsurer
ARF
What are the main reasons ARF is favoured over insurance purchase?
The majority of respondents identified price as the main benefit. ARF offers cheaper risk financing especially over the long-term.
Some pointed to the fact that users are tired of one-year terms, 'the annual venture', 'the adversarial nature of insurance', or 'the win-lose situation'. Others pointed out that ARF has balance-sheet restructuring benefits, in line with financial goals. As a result, it can lead to income stability, smooth cash-flows and protect earnings per share.
Corporate treasurers identified shareholder value as the underlying rationale for using ARF, which is viewed as reducing cash-flow volatility. Some suggested that with new risk disclosure rules coming into force, shareholders will be more keen to compare companies by their risk management credentials. This was viewed as a driver of alternative techniques in the near future. Secondly, corporate treasurers are looking at raising capital more cheaply through ARF, compared to the banking or bond market. This could be through issuing a cat bond but, as the survey found, there are substantial barriers to this approach and many are still in the process of reviewing these alternatives.
'With ARF, there is a good counterparty risk over a longer period, rather than riding a cycle in a one-year market. In the short-term, say up to five years, traditional insurance comes top because there is a lower probability of loss, but over, say 25 years, financing looks superior because there is the ability to amortise over time.' – a broker
Comment
For some time, captives have been viewed as inefficient and in need of innovation. Already, they are being used in conjunction with the multi-line, multi-year insurance programmes of their parents. There does seem to be a case for corporate issuance of cat bonds, although this remains a future possibility.
Corporate risk management and financing has, over the last few years, moved more into the arena of strategic capital management, in parallel with the general management focus on shareholder value. ARF – which may involve the commercial insurance industry, but in a new role – expresses the future of risk financing along these lines.
An interesting finding is that the insurance industry is beginning to be judged more by the standards of the capital markets and banking. There is a demand for more tradeability, innovation and a focus on the cost of capital. Clearly, these sentiments will further encourage the convergence of the insurance and financial markets, as the former reforms along the lines of the latter.
Wilde Sapte ART Research Report – New products and new markets – July 1999
Background
The convergence of the re/insurance, banking and securities markets has created new institutional forms, new markets and new products. For example, re/insurers and re/insurance brokers have set up structured finance departments and capital markets trading groups. Insurers have set up alternative risk departments. Investment banks have set up insurance products groups. These new units have enabled their parents to market a new range of products to adapt to their clients' changing needs.
Some of these units may dedicate themselves to serving particular markets or trading particular products. What they have in common, however, is that they combine cross-industry skills and expertise. As such, they are among the most innovative developers of new products that address the new risk management and risk financing demands.
Main Findings
Which products have experienced the fastest rise in demand over the last six months, bearing in mind that much of the market creates customised solutions rather than standardised product offerings?
The top answer was 'finite solutions' (23%), followed by 'weather derivatives' (16%), 'credit products' (9%), 'blended products combining insurance and financial risk' (9%) and 'multi-year programmes' (7%).
Which products will be more in demand in the near future?
'Credit products' came top with 12%, followed by 'weather products'(9%), 'non-cat securitisation' (7%), 'multi-year' (7%), 'blended' (5%);'finite risk' (5%).
Is competition between the re/insurance and capital markets exaggerated?
An overwhelming majority – 60% – replied that it is; 21% answered it is not exaggerated and 19% did not express an opinion.
Those who answered yes made the following points. Reinsurers and banks tend to have complimentary strengths: reinsurers are strong in the area of insurance risk analysis and underwriting, banks in the area of distribution to the capital markets. Both skills would take time to develop and establish critical mass.
Others pointed to the limited transaction volume and the immaturity of the market where, unlike the M&A market for example, players are not 'yet bumping into each other'. The idea that both financial and insurance industries were either 'adding to each other's experience', or that 'each was approaching the market with their own self-interest', was commonplace.
'The market is growing faster than any one particular company. We are not yet bumping into competitors. It's not like other finite markets, like M&A. We are helping to shift the border of insurable risk; we're expanding the pie.' – a banker
'No, competition is not exaggerated. Economics stress that important things happen at the margins. Although this area is not yet a major activity for either reinsurers or investment bankers, if you allow a marginal activity to develop, sooner or later important losses will occur to either one of them.' – a broker
Those who answered that competition was not exaggerated tended to elaborate less but pointed out, for instance, that 'competition is a fact of all new markets.' Some made the point that competition was strong but confined at present to niche areas: markets for weather derivatives, cat bonds and some credit products were singled out.
Are you attempting to win market share from competitors in parallel markets?
In line with the spirit of previous answers, only a fifth believed that they are.
However, whereas banks tended to downplay competition, re/insurance brokers felt more strongly that they were competing head-on with banks. Four fifths of those surveyed answered that they were attempting to win market share from their opposite markets.
Which market is leading the way in risk securitisation?
65% said the US, 19% said Bermuda, 9% Continental Europe and only 2% London (on a par with Japan with 2%).
How far is Europe is behind the US?
The majority answer was 'only slightly' (37%).
However, many respondents qualified their answers. Many said that the US is ahead primarily because of its greater catastrophe problem. For its part, Europe has led the way in other markets, particularly life securitisation. Others pointed out that Bermuda plays a major facilitative role.
'The Bermudian market has been an innovator. It has acted as a think-tank with its concentration of expertise. The reasons for its current eminence are no longer just tax-based.' – a reinsurer
Comment
Finite risk solutions move beyond the insurance mechanism for hedging risk by offering a more stable financing situation over a longer time period. As such, they are often balance-sheet-driven. The increasing pressure on companies to manage their risks and capital base more efficiently may be seen as a contemporary driver of these products.
The expectation that 'credit products' will become the most popular in the next six months expresses the general concern with credit, and the demand for new hedging tools following the aftermath of turbulence in the world's financial markets.
The finding that brokers expect to win market share from banks may express confidence that those on the re/insurance divide have gone far in developing structured finance and securities trading capabilities; investment banks, however, are prevented by regulation from underwriting insurance risk through traditional means. As a result, there may be more space for brokers to expand into traditional banking arenas, partly driven by the demand for a multi-industry risk financing approach by their clients.
Competition between banking and re/insurance is likely to hot up as the two industries converge. However, many of these markets are based upon the customisation of particular 'solutions' rather than products, and as such may be more amenable to collaboration between experts in re/insurance and banking. As a result, competition has tended to be confined to standardised products – such as weather derivatives and credit products – where there is a clearer pattern of market demand.
Wilde Sapte ART Research Report – The future: 'The virtual insurance company' – July 1999
Background
One alternative for the insurance industry could be to repeat the experience of mortgage-backed securities during the 1980s. As mortgage repayments became securitised, banks became conduits to the capital markets and did not need to hold capital on their accounts for loans. As securitisation in the insurance arena becomes increasingly acceptable, this may become a reality.
This model could result if the focus on capital inefficiency in the insurance industry increases, and companies come under more pressure to manage their capital bases more effectively.
Main Findings
The feasibility of the virtual insurance company was supported by our findings.
What are the current inadequacies in the insurance markets?
Some respondents pointed to the economic inefficiencies of the insurance industry, such as 'supply/demand imbalances' or 'over-capitalisation'. A few said, for example, that the 'distribution between insurers, brokers and reinsurers is not cost-efficient'.
'The question is, why would insurance companies want to securitise steady, profitable business? It is possible that they could become marketing companies rather than risk takers, in the same way that banks have become solely marketers of mortgages, with the capital markets providing the capital. In some ways, this is possible because many insurance companies are seen as sales agents. Also, this may be possible because insurance companies have established a brand name in certain lines.' – a broker
One respondent did not think this represented a logical path for the insurance industry to pursue.
'The industry is far too capitalised as it is, and securitisation, by its nature, is capital-raising. This is a contrasting scenario to banking and securitisation in the 1980s, where there were capital shortages. For the insurance market, it doesn't make complete sense.'– a banker
However, another respondent envisaged securitisation as 'supporting working risk' on an on-going basis, rather than being a means of capital-raising per se.
'The insurance industry should securitise, as a means of raising capital to support working risk over a much longer time frame. It would then be able to deal with a broader spectrum of risk. Often insurers want to grow without growing their capital base. Homeowners' insurers often want to diversify into new products, but run into solvency problems when writing premium with extra capital. A better alternative could be to securitise cash-flows of old products in order to free up the balance sheet to get into new ones. In the traditional model, insurers retain frequency risk and look to transfer severe risks. But the vice-versa model makes sense. This model would allow insurers to grow without growing their capital base.' – an insurer
Comment
Debate on the feasibility of the virtual insurance company for the insurance industry as a whole will intensify as more non-catastrophe insurance bonds are issued by individual companies.
Clearly, insurers must choose the most effective way of managing their capital bases. One method is share repurchases, allowing insurers to return surplus capital to shareholders. But with traditional relationships in the industry rapidly being superseded (for instance, large corporates now self-insure to a great degree), there is clearly a case for more radical restructuring solutions. Securitisation could be the key card in the pack.