Dr Thomas Renggli provides an overview of trends on non-traditional risk financing.
The market for alternative risk transfer (ART) has grown rapidly over recent years as clients have increasingly looked to the non-traditional markets for risk transfer solutions. These markets have been subject to three main trends. Firstly, the range of investor categories has broadened to a degree that had not been anticipated by most observers. As well as insurers and reinsurers, other groups of investors such as pension funds, hedge funds, private investors and others have been entering the risk market.
A second trend has been the development of analytical tools for defining and pricing risks destined for alternative transfer. The traditional, actuarial, stochastic approach is being increasingly overshadowed by econometric, non-stochastic analytical tools using capital market methods. The analysis of time series, once considered difficult if not impossible, can nowadays be at least tentatively undertaken using new mathematical methods such as game theory. Weather derivatives are one example, as are insurance products which hedge stock market indices.
The expanding range of application for non-traditional risk financing may be seen as a third major trend. Ten years ago, only insurable risks were considered tradable. Now, the providers of ART models include non-insured or traditionally non-insurable risks in their projects. Imperfect, non-liquid markets are being so widened by the global networking of supply and demand that sufficient market participants can now be found to support a more or less thriving trade. In addition, the relevant data is made available and accessible to market participants practically in real time thanks to modern, efficient information technologies, with the internet as just one example of how new technologies have developed.
The traditional definition of ART as ‘alternative risk transfer' refers to securitisation, which has extended beyond what originally began as pure catastrophe risk transfer in the area of property insurance. Nowadays, both life and third party risks, as well as risks from broadly diversified portfolios such as motor third party liability, credit or weather, are considered suitable for securitisation. Furthermore, the uncertainty associated with such instruments is declining, along with the ‘novelty premium' which investors had to bear. This factor enhances the efficiency and effectiveness of these new instruments.
An increasingly important issue is that of efficiency. Will ART providers succeed in advancing the standardisation of ART processes to the extent that these might become profitable even for smaller transactions? At present, non-traditional financing solutions must be individually analysed and structured in each and every case. This constant ‘reinvention of the wheel' implies an inefficiency that allows only large transactions above a certain volume to be profitable for participants. However, once ART providers' sales channels, analytical tools and internal administrative processes become standardised, it will be possible for their marketers to systematically open markets even for smaller transaction volumes. This will allow even smaller companies to consider marketing ART solutions. The standardisation of ART products will inevitably lead to their becoming established, thus gradually losing their ART status.
Another problem facing ART providers involves accumulating know-how from different sources to underwrite and structure complex, integrated risk-financing solutions. This requires a combination of insurance, corporate finance and capital market techniques with the related knowledge of fiscal procedures, accounting standards and supervisory legislation. Medium-sized ART providers can scarcely afford to put together strong and effective interdisciplinary teams: this is where the sheer size and financial strength of an international concern certainly constitute an advantage.
Joint ventures, mutual co-operation and the suchlike are possible strategic approaches which might also enable smaller ART providers to acquire the necessary know-how. The increasingly complex global economy is compelling ART providers to step up the pace in developing new products, whereby integrated work and cooperation between widely varied disciplines have been shown to provide a crucial competitive edge.
Critical mass and the access to specialised ART know-how are thus major factors. An innovative provider who can offer either of these will have a competitive advantage ripe for exploitation until competitors understand and replicate its products. By that time, the innovator must have completed development – financed by the premium which it, as innovation leader, can command – that will allow it to expand on another level or to another area. Only in this way can it maintain its competitive position.
The need to keep pace with developments, however, makes it increasingly difficult for medium-sized providers to move assuredly in all market segments. Major advantages are enjoyed by specialised niche providers which have joined to form joint ventures, as well as major international financial concerns with the relevant in-house know-how at their disposal. In this way, diverse areas of know-how merge to form a new, comprehensive approach to risk management.
First of all, the catastrophe risk market is likely to show growth and development. The large number of ‘once-in-a-century' disasters such as earthquakes, storms and floods over the last decade and the somewhat pessimistic forecasts being voiced with regard to global warming are exhausting the traditional market capacity for extreme natural disasters. In addition, the desire on the part of policymakers to see economic risks that are traditionally non-insurable such as clearance of woodland and roads at public expense or damage-limitation measures (such as the construction of dams) transferred to the insurance or capital markets, is leading to a new understanding of how to handle such risks. This issue will challenge the major reinsurers and politicians in particular. Other catastrophe risks can be transferred to the capital markets as well: plane crashes and genetic engineering risks are two major examples.
Secondly, there have been visible signs of increased demand from banks seeking to make better use of their capital base by ceding part of their credit portfolio.
Thirdly, there is a trend for industrial concerns to cede a portion of their entrepreneurial risks to insurers or the capital market, for example residual value or weather derivatives.
Fourthly, there is a demand for restructuring the capital base of finance companies – insurers, reinsurers and banks – through the use of hybrid capital instruments.
A fifth area of demand comprises rating capital support for companies needing to keep a close watch on their rating (upgrade, downgrade, being on Moody's or Standard & Poor's watch list). In addition, mention should be made of weather derivatives for companies whose economic success is particularly dependent on the vagaries of nature, such as power suppliers, manufacturers of agricultural products and drinks manufacturers.
Three main factors most strongly influence the development of non-traditional financing instruments.
The first of these is less uniformity and weakening solidarity. The changing needs of clients are currently giving rise to risks which are ever more diffuse and individualised. At the same time, these clients, whether industrial concerns or insurance companies, are increasingly reluctant to participate in financing ‘poor' risks. However, risk managers have been following the constant changes in the risk landscape, and are generally much better informed as to the possibilities of risk financing, ART included, than they were ten years ago.
A second factor has been that the environment has changed markedly over the last few years due to competition and capital market globalisation. Strong, new competitors such as banks, major brokers or large international insurance groups are entering the field and generating much new capital looking for a place to be invested.
Finally, accounting standards, tax law and the supervisory authorities have changed radically to counter the new options. There is much insecurity with regard to fiscal and accounting aspects in countries such as Germany, given that there is as yet no clear legislative basis like the FASB standards in the US.
Of great importance is the client's business mentality and dynamism. The client must be willing to tread new paths if, in addition to the economic advantages, he is to acquire new knowledge and break new ground as a market-maker and shaper of opinion.
Other important factors are the client's decision processes and the degree to which he is influenced by external factors. The shorter the channels, the smaller the decision-making bodies and the less they are influenced externally by state and administrative authorities, for example, the simpler it will be to implement a non-traditional solution. However, other outside forces – active shareholder groups or the increasing influence exerted by rating agencies – might favour non-traditional risk-financing solutions.
A client's financial strength and creditworthiness are two further very important factors which define the pricing of a transaction and its financibility, and thus decide whether and to what degree the transaction will be economically viable for the parties involved.
Key external factors include the influence of the opportunity cost of capital on pricing, as well as the influence of capacity on the competitive climate and the provider's opportunities for arbitrage.
In continental Europe, capital markets are just beginning to converge and the various approaches to risk management just beginning to develop. The example of the US may also show the way for Europe's risk managers. They will need, however, to take up the challenge presented by such models with even greater zeal in the future.