Alan Punter and Julian Roberts ask why alternative solutions have not been as widely used as expected following the recent market hardening.

Conventional wisdom has it that alternative risk financing is anticyclical and that it should prosper relative to the hardness of the traditional market. When the traditional insurance market is at its softest, and risk transfer premiums appear to be at or below burning loss cost, then there is little economic imperative for buyers to seek alternative solutions for mainstream re/insurable hazards. The activities of the alternative market at these times are more concerned with the financing of non-traditional risks on a non-traditional basis. Such programmes mostly fall under the generic heading of finite or financial re/insurance and display some of the following features: multi-year deals, covering multi-perils, aggregate basis of cover, and some sort of experience-adjusted additional premiums or profit commissions.

The conditions of the current hardening market have been caused by a combination of circumstances. Since the last hard market of late 1992 to early 1994, premiums have been falling in most classes, while losses have been increasing; re/insurers only survived because of the bull stock market from 1994 onwards from which windfall investment returns offset dismal underwriting results. But then it all started to unravel for re/insurers; 1999 was a particularly bad year for major losses, 2000 saw the start of a collapse in investment returns, and 2001 was another bad year for losses, even without the World Trade Center disaster. And underlying all this, re/insurers have been adversely impacted by the need to strengthen reserves, as liabilities from the past such as asbestos-related exposures continue to deteriorate. Overall, the capital lost to the insurance industry in recent times - due to incurred losses, investment write-downs and reserve strengthening - has greatly exceeded any new capital raised. The only possible consequence was for reinsurers to increase premium rates, often substantially, in order to achieve any prospect for an adequate return on their available capita. This in turn leads to insurers having to follow suit and raise premiums.

The alternative risk finance market can best be considered in two segments - that for corporate buyers, and that for insurance company buyers.

ART and the corporate buyer
Under such hardening market conditions, corporate buyers' interest in all forms of alternative risk financing increases, and this increase has been significant over the past year. While for some this may be Hobson's choice, the predominant reaction is simply to increase levels of self-insurance - in other words buy less traditional insurance. Most corporate insurance buyers have to work within some form of budgetary framework, and so in order to mitigate the increased renewal premiums being charged, they will increase the level of retained loss, reduce limits and may even drop some covers entirely. The second reaction is to finance more risk through their own vehicles, such as captives and protected cell companies (PCCs). Although the number of captives formed has been increasing year by year for some time, including all through the soft market, there has been even greater interest in capital feasibility studies during recent months. Of more significance, however, are the greatly increased volumes of premium being placed into existing captives.

Perversely, the level of activity in other forms of corporate ART, such as multi-line, multi-year deals, has tended to decrease. This is due to a combination of demand and supply factors, but mostly supply. With the currently hardening market rates, re/insurers are able to reach their premium targets (and solvency limits) writing traditional risks, without having to use relatively scarce and valuable capital to write more exotic risks or structures. This is an entirely rational reaction but has the unexpected consequence of reducing `alternative' capacity available from `traditional' sources at a time when arguably it is most needed.

Another reaction of corporate buyers to hardening market conditions has been to consider the formation of mutuals or pools. Although this time round there has again been considerable talk and study, few mutuals are yet up and running. Those that succeed are usually in areas where conventional cover has more or less disappeared altogether, rather than just become temporarily expensive. The highest profile attempt is that of the airlines (US and European) to address the withdrawal of the terrorist cover they need to keep flying, and the apparently temporary nature of most of the emergency government schemes currently in place. The oil industry mutuals, OIL and OCIL, have formed a new mutual sEnergy for business interruption coverage.

ART for insurance company buyers
The most visible area of ART for insurance company buyers in recent years has been that of insurance-linked securitisation (ILS). The term ILS broadly includes such structures as innovative contingent equity and catastrophe bonds.

The advent of catastrophe bond technology awkwardly coincided with the longest and softest insurance market yet seen, and, not surprisingly, the number of issues during that time were relatively small. However it is noticeable, perhaps even surprising, that the level of catastrophe bond issuance has remained relatively flat, and has not increased significantly during the hardening market conditions. One possible explanation for this is that the WTC incident, and appreciation of its full ramifications, was too late during the January 2002 renewal season for ILS alternatives to be implemented in time. However, experience of recent ILS issues, such as Agatha Re, has shown that there is still strong investor appetite for subscribing to new catastrophe bond issues. In one way this is not surprising, because cat bond investors have so far had a profitable run; none of the principal cat bonds covering US or Japanese earthquake or wind perils have yet incurred losses. Nor did the WTC catastrophe trigger any ILS structures, with the one possible exception of the LaSalle Re/Trenwick CatEPut.

As the possible persistence of and, in some circumstances, severity of the hard market becomes apparent, it is probable that insurers (and indeed corporates) will turn selectively to the ILS market for a genuinely alternative source of pricing and capacity. Prospects for further ILS transactions are arguably better now than at any time during the short history of the cat bond market.

Developing complexity
There is little doubt that that the breadth and scope of insurers' activity in the `alternative' marketplace has developed in its complexity, not to say, on occasions, its esoteric involvement.

If the convergence of activity between alternative insurance underwriters and the capital markets has illustrated anything, it is that the shared currency of both is capital. Some of the most innovative and advanced risk structures that have been completed have been in the area of contingent capital. In such transactions the inherent fungibility of capital is explicitly recognised and, as such, represents innovative combinations of risk management and corporate finance.

Whilst the conclusion may be surprising or reluctantly reached, there is indeed increased recognition that sophisticated insurance solutions can add real value and utility to corporate finance structures. But the participation of insurers in complex financial structures has not been without difficulty.

At the heart of the problem lies the challenge of converging the requirements, practices and indeed legal frameworks within which transactions are carried out in the banks and capital markets on the one hand, and the insurance market on the other. These challenges include the need for and the nature of `guarantees' that may be given to secure cash flows or asset values at some future point in time.

Concern has been expressed and perhaps even the impression given that alternative risk solutions are risk-bearing panaceas. Clearly this is not the case, as insurers, despite having sophisticated risk modelling and advanced analytical techniques at their disposal, do not possess greater insight or knowledge regarding future values or corporate credit qualities. For this reason, rational ART underwriting cannot present a consistent arbitrage business model.

Cause for concern
The role played by insurers, for example, in underwriting tranches of credit risk within synthetic collateralised debt obligation (CDOs) has given rise to concern that insurers may have naively assumed large amounts of mis-priced corporate credit risk. Whilst there is probably no smoke without fire, only time will tell whether this concern is reasonably attributed either in terms of the volumes involved or the extent of the mis-pricing. The massive growth in deal flow to insurers and the overall volume in the credit derivative market have, in themselves, attracted the watchful attention of regulators at the UK's Financial Services Authority (FSA) and observers at the Bank of England.

The insurance company balance sheet does provide a privileged environment in which to retain, diversify and re-package risk. Nevertheless, each of these processes requires `correct' pricing of the risk components and confidence in the correlation evaluation. Where disparate sources of risk aggregate to achieve offsets (an overall reduction in combined risk) again the insurance model may offer superior utility to purely funded or separately hedged alternatives.

By Alan Punter and Julian Roberts
Alan Punter (right) is managing director of Aon Ltd and Julian Roberts (below) is a director at Aon Capital Markets.