Alternative risk transfer, or ART, is an umbrella label for a range of products, other than the conventional annual insurance or reinsurance policy, which handle financial risk. Rather than try to pigeonhole ART, I prefer to describe it as a set of products using techniques, attitudes and language borrowed from corporate finance and the capital markets and imported into areas traditionally dominated by insurers. To begin, let us consider some types of products currently being sold and then talk about how they can be used in the Lloyd's context.
Finite risk products - Finite risk products are usually multi-year contracts in which the buyer's loss experience and the time value of money are explicit in the contract, and the interests of the client and insurer are, thus, effectively aligned through a profit-sharing arrangement. Accordingly, additional premiums may be paid for high loss experience and, conversely, profits redistributed to the insurer in good years.
There are two principal effects of finite products from the point of view of the buyer. The first is that the volatility of the buyer's loss experience is suppressed. The second effect is that the insurer may get a higher return than the insured on invested premium and can give back some of this higher return to the buyer at the end of the contract. Finite products started in the reinsurance market but the technology has transferred to the direct market and corporate clients now routinely buy products which incorporate these features.
The principal commercial effect for the corporate client is that the usual benefits of a higher deductible or captive-based product are extended over a number of years to smooth corporate earnings.
Securitisation - Securitisation was developed in the mortgage market: the original lender passed on a group of mortgages to another institution and, in return, this business bought the rights to the income on the mortgages. How is this now being applied to the insurance world? Conventionally, a portfolio of insurance liabilities is passed on to a reinsurer for a premium. Securitisation techniques allow the insurer to pass on this portfolio risk directly to the capital markets without the interposition of an intermediary reinsurance company.
Many risks may be transferred, from single catastrophe exposures (for example, a Californian earthquake or European windstorm) to multiple exposures such as trade credit risks. These techniques became popular in the early 1990s as a means of tapping into alternative sources of catastrophe capital and, hence, are now often called CATbonds. Currently, they are significantly more expensive than conventional products available on the over-capitalised insurance market.
Securitisation techniques are also of interest to large multinational corporations who may wish to issue bonds as alternatives to catastrophe insurance protection. For their part, the capital markets are attracted by the high yield on these bonds but what they lack is pricing expertise, which is supplied by insurance and, more particularly, reinsurance modelling businesses.
Insuratisation and enterprise risk - As well as representing alternative methods of transferring conventionally insurable risk, ART is often about conventional methods of transferring traditionally non-insurable risk. This is known as enterprise risk, holistic risk or insuratisation. It allows insurable and traditionally non-insurable risks to be bundled up in a single insurance package.
For example, a business's risk of loss due to currency fluctuation may be packaged with insurable risks such as currency inconvertibility and conventional risks, such as fire and the failure of sub-contractors. In this way, the insurer uses its balance sheet to assume all the risks incurred above an aggregate deductible retained by the client. The risk associated with fluctuations of financial indices may then be hedged out from the insurer's books.
Although the frictional costs of this sort of transaction may appear to be lower, so making them an attractive alternative to traditional cover, the current softness of the world insurance market has meant that most clients continue to buy a bespoke range of insurance and financial derivative products rather than a single packaged offering, and the large reinsurers developing these products have managed to sell only a handful. However, contingent risk capital in the form of insurance should in the long run be cheaper than equity and we therefore expect insurers to continue to seek to accept risk that has traditionally been left in the hands of shareholders or debt providers.
Captives - Finally, we should not forget that many people regard the well established field of captive insurance as ART. Indeed, the development of holistic insurance products sold by major insurers will probably lead to an increase in the use of captive insurance companies to transfer these business risks. The inclusion of captives in ART also serves to remind us that not all that is alternative in risk transfer is necessarily new.
Lloyd's and ART
In the changing world of risk management, Lloyd's believes its traditional strengths, many of which are direct results of its market structure, place it in a strong position to develop in the ART market. These include:
Lloyd's is increasingly appropriate for consideration as a venue for ART deals as a number of technical and regulatory obstacles are being overcome and preconceptions challenged.
One of the principal developments is the liberalisation of regulation of financial guarantee insurance. Defined by Lloyd's to include insolvency, insufficient sales, interest or currency rate changes, asset value changes and financial index risk, financial guarantee insurance has been prohibited at Lloyd's since the early 1920s. This prohibition stems from an outdated notion of the risks involved and concerns for the security of the market as a whole. Steps are being taken to ensure that Lloyd's syndicates who offer these products have the right risk control mechanisms in place.
There is a preconception among some commentators that only a triple-A rating is sufficient to write ART products. Certainly, a high security rating is a significant factor when considering deals over a period of ten years or more where investors naturally want assurance as to the institution's longevity and staying power. However, many non-triple-A rated companies have achieved considerable successes on long-term policies and Lloyd's is writing a significant number of them.
Many commentators see Lloyd's current rating of A+ (strong) by Standard and Poor's, which was recently reconfirmed, as more than acceptable, as they recognise that it is partly due to the unique structure of Lloyd's financial base, which complicates the ratings process. If the structure were conventional, Lloyd's financial strength alone would arguably be sufficient basis for the assignment of a higher rating. This makes comparison of Lloyd's with its competitors in terms of ratings difficult as essentially it is not possible to compare like with like.
The use of securitisation techniques to transfer catastrophe risk out of the market will be of increasing interest to Lloyd's customers. The present extreme cheapness of the conventional reinsurance market due to over-capacity, coupled with the relatively high legal and other advisory costs of securitisation issues, have so far dampened the attractiveness of securitisation deals. Neither of these factors is likely to remain constant; therefore, the potential advantages of ART structures for syndicates and their clients alike will be considerable. The likely principal benefit of securitisation deals will be the lack of reinsurer credit risk, as the bond proceeds used to pay a catastrophe claim will effectively be under the control of the reinsurance buyer.
Furthermore, in the long-term, it is expected that the cost of these issues will reduce below the cost of cyclically priced conventional reinsurance due to the use of standardised models to price catastrophe risk rather than a bespoke analysis of a reinsurer's book. As securitisation deals increase in frequency, the regulatory mechanisms will be in place to allow Lloyd's to build on its vast existing skills base in the pricing of risk. In fact, a securitisation has recently been completed for a Lloyd's syndicate by the broking firm of R K Carvill and the investment bankers Lehman Brothers
Similarly, Lloyd's is working to permit the use of derivatives and derivative instruments within the market. These tools are regularly used by insurers to hedge their invested assets but are not widely used to hedge the liability side of the balance sheet as a replacement for conventional reinsurance.
Finally, there is now an extremely competitive Lloyd's captive product, which is also generating increasing interest. It provides the opportunity to establish a flexible insurance vehicle capable of issuing direct rated paper in 60 overseas territories, leading to savings in fronting fees, greater central risk management control and improved cash flows.
Lloyd's believes the added flexibility, greater cost efficiency for the client and wider spread of risk for the insurer are likely to enhance the ART deal flow generally in the medium-to-long term. As this happens, developments at Lloyd's in respect of financial guarantee insurance, securitisation and the use of derivatives will increase the opportunities for ART buyers at Lloyd's.