Against certain expectations, the alternative risk transfer market has not had the kick-start anticipated from the hardening of the conventional market.

Word on the street about alternative risk transfer (ART) has remained pretty constant for the past few months; it's out there, but it's keeping a low profile.

Back a year or more, when the business was facing a potential capacity crunch in the property/catastrophe (p/c) market, ART was viewed as a possible salvation for the buyer. In the event, the shortage of more traditional forms of capacity was not as bad as some had anticipated, but (p/c) re/insurers still will need several years of sustained profitability if they are to breathe life back into their balance sheets, and ART remains on the agenda.

Market hardening

In a recent sigma study, Swiss Re noted that there had been a change in the ART sector as a result of the hardening traditional market. "During times of tight capital funds, there is a need for extra capacity and hence the ART products developed during this phase tend to make better use of insurance capacity," commented the report, sigma 4/2002 (available for download from www.swissre.com). In particular, this hardening market has been increasing demand for finite risk products, according to the report, for example to manage the higher deductibles now typical within the market. In addition, finite products can be used for lower layers in circumstances where there is a high probability of a loss over a multiyear program. And this interest remained despite the "increased regulatory scrutiny and tighter accounting rules for corporate clients," sigma commented.

That regulatory scrutiny has hit the headlines in Australia, where the HIH Royal Commission has been asking questions about the validity of finite risk or financial reinsurance contracts. In a request for submissions issued earlier this year, the commission asked the following questions:

  • is there a legitimate role for the products variously known as alternative risk transfer products or finite risk reinsurance or financial reinsurance? If yes, what is that role?

  • to what extent do the advantages of such products depend upon their being accounted for as insurance contracts rather than as some other form of funding mechanism? Is such a distinction in accounting treatment justified? If not, how should it be addressed?

  • is there a potential for such products to be abused? If so, what safeguards would be desirable and effective to prevent abuse?

    These partly echo the feelings of the UK regulator, the Financial Services Authority (FSA), which has recently closed consultation over its proposals for a new approach to financial engineering in the insurance sector. In its consultative paper, the FSA noted that "improper use of financial engineering has contributed to the difficulties seen in several insurance companies in the UK and overseas," though it did note that financial engineering is a "valid method" of strengthening a company's solvency position, in cases where there is "genuine and material" risk transfer to an unconnected counterparty, and where it can allow life insurers to access "overly prudent economic reserves".

    Recognition quality

    It may be the less readily recognisable nature of such products that currently worries the regulators. Unlike certain financing mechanisms such as debt and equity, financial reinsurance and other ART products - as risk transfer products - are off balance sheet items, and therefore not readily identifiable in the same way. As Swiss Re pointed out in its submission to the HIH Royal Commission: "An essential difference between non-traditional reinsurance and traditional reinsurance is that the former covers risks that may otherwise be uninsurable using traditional reinsurance...

    "Over time, uninsurable risks often become insurance as long as conditions remain stable - ultimately, it becomes a matter of experience."

    The same could be argued for ART products as well - that time will breed familiarity. Catastrophe bonds, developed in the wake of hurricane Andrew in the early 1990s, appear to be having a bit of a comeback as buyers are finding traditional capacity more difficult to access. According to reports, interest in cat bonds has doubled over the past year, and this surge of attention fits in with the model that it generally takes more than one cycle for new solutions to become successful. The sigma report into the global capacity shortage noted: "Structural change occurs in waves....

    Sometimes, by the time a new product develops in response to a phase in the cycle, the market reverses and the conditions that led to the emergence of the product no longer support it.... In the long term, however, evolving client needs and industry knowledge will drive the development of new products and the insurance industry's move into financial market solutions."

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