Nick Jones reflects on the growth of alternatives, and their long-term impact on London.

About ten years ago, in the early days of Global Reinsurance magazine, I wrote: “The disintermediation of reinsurance ‘manufacturing' has probably already commenced through the financial or finite reinsurance market ... the recent, although as yet unsuccessful, attempts at developing insurance futures contracts and catastrophe derivative policies built around the Swiss Re catastrophe log would appear to represent further possible avenues for profound and revolutionary change.”

What a lot has happened since 1991. Lloyd's has been through its crisis and re-emerged in a different form, there are now really only two UK-owned composites, LIRMA and the ILU have merged to become the IUA, National Indemnity is the largest reinsurer in the world, the Japanese government has been downgraded to AA, the banks are in direct competition with the reinsurance industry, the broking sector has shrunk to a very high level of concentration, and the LUC is virtually full. What are we to make of these changes, and where will they lead on the road to managing risk?

The unremitting growth of the ‘alternative' market – here broadly defined to include captives, risk retention groups, self-insurance mechanisms, finite reinsurance, derivatives, index trading, catastrophe bonds and embedded risk options – since the late 1950s, when the first real captives started to be formed, is a cameo of economic rationality.

Over this half century, financially savvy companies and individuals have sought to manage their risk exposures at the best price. Not necessarily to find the cheapest cover, not to transfer all risk, nor just to find innocent capacity, but to manage with stability and transparency their total cost of risk, including voluntary and involuntary deductibles, fronting charges, captive management costs, broker commissions and the pure risk transfer costs. Indeed, these three forces – transparency, cost and capacity – are inextricably linked. They give us an explanation of why the alternative market has developed the way it has, and suggest where the future might lie.

Let us first look at transparency. For the risk manager to optimise his management alternatives of retention, transfer, avoidance or minimisation, he must be able to make direct, undistorted comparisons between the various choices at his disposal. What percentage of his involuntary deductibles or uninsurable risks should be handled by his captive? Is it feasible to fund these risks after the event, or take a charge to operating earnings now?

Put in this way, the need for transparency is absolutely critical. Without a clear picture our customer, the risk manager, cannot make proper economic decisions. Opaque and cloudy products merely magnetise the drive to find alternatives that look reasonable, even in conditions of imperfect information. No wonder some estimates put ‘alternative' mechanisms at some 25% of the traditional market in the OECD, and no wonder there is a voracious appetite to explore other institutional or conceptual mechanisms.

Let us turn to cost. Here it does not mean merely the vulgar comparison of one insurance premium quote with another, even with a feel for the quality of policy wordings. What the risk supervisor wants to evaluate is the return on equity, cost of capital and share price effects of each potential option. Is the total cost of risk the best by using retrospective coverage, a weather or pollution derivative, or a pussycat bond? (Thanks go to The Economist for this quip deriding the small growth of the cat bond market.) With transparency, several institutional options and alternative markets, he can now start to make sensible economic decisions.

Finally, we come to the mirror images of capacity and stability. If the price, policy terms, mix of risk transfer, cost of capital, etc, all work, but the capacity is so volatile that it could disappear at the following renewal date, then it is unlikely to be viable, except under the most extreme conditions. Indeed, the various capacity crises of the 1970s, 1980s and 1990s are all testament to our chronic tendency to organise around the product rather than our customer.

Is it any wonder that multi-year policies are the vogue, that alternative mechanisms grow during a soft market, and that investment banks are usurping the role of the broker in the alternative market? In discussions with the ‘leads' in the alternative market it is clear that investment banks now dominate the flow of business on a 70:30 basis. It remains to be seen whether they have the proper legal and regulatory authority to operate in this market.

Are we really surprised that the London subsidiary of a French bank is writing a large weekly flow of weather derivative contracts? That most of the major ‘firsts' in the alternative market have come from the banking industry (Citibank, for example, organised the first capital market put for Hannover Re, and developed the single-cell legislation for Lloyd's)? That convergence and the jargon of the capital markets are the lingua franca of executive lunches?

Gone are the days of talking about capacity problems in the Bavarian triangle. In are the discussions of the higher cost of capital in the chemical sector because of the volatility of the total cost of risk. This is a world of corporate finance, business school lingo and technique, and barbarians at the gates of Mincing Lane and Lime Street (and my apologies to the book's authors for this crude allusion).

So where will the alternative market go from here? Let me say straight away that this is not a cynical treatise on the failings of the insurance industry. After 26 years working with the industry I have come to respect the institution known as the London market. It is no accident that the international manufacturing of insurance takes place in London. Bavarian, Bermudian and Baltimore capital and capacity is located here because, like Silicon Valley for software or Lake Como for ties, the transfer and transformation of risk still gets done in the Square Mile (apologies to Canary Wharf) more than any other centre in the world. The point is, however, that the fortuitous combination and convergence of the insurance and banking industries is supporting this continuation of specialisation.

And it is precisely because of this co-location that the future bodes well for the centrifugal focus of the risk-taking market. Tomorrow's world will see a collection of indices, sponsored by the IUA and domiciled in the LUC, which trade the price volatility of those risks that are the most volatile (aviation and product liability, political risk, pollution credits under a new world protocol); where major multinationals – those that have hitherto run shy of risk transfer to a BBB market – start to participate, on both sides, in the atomisation and distribution of risk because of the three forces of transparency, economic rationale and stable capacity.

We will be in a world where wysiwyg regulatory and accounting arbitrage will level the cost of risk-adjusted capital between the banking and insurance industries; and transformer vehicles will expose the folly of such regulatory gaps; where finite risk covers combined with global aggregates will be underwritten in both markets; where AIRMIC off-sites will be as popular as those of the Association of Corporate Treasurers; and Lloyd's and the LUC will have joined forces in one building. What a brave new world!