ART offerings are changing the way institutions are providing financing products.
Without clients buying insurance, insurers do not need to buy reinsurance. So reinsurers need to take a healthy interest in the continued survival and success of the primary insurance industry, and to provide the protections that enable insurers to sustain and grow their own insurance businesses.
Insurance exists to meet clients' risk needs. Unfortunately, corporate clients do not always see their risk needs in terms of single and separate perils over single year periods – and not all of a client's risks are regarded as insurable (some US research has estimated that insurance covers only 20% or less of corporate risk exposures). However, insurance has traditionally been primarily supplied on a single peril, single year, fixed premium basis. Over time, some perils have been packaged together, and the range of insurable perils has gradually been extended (although at the same time some exclusions have also crept into standard policy language). Nevertheless, the insurance industry is still some way from providing its clients with flexible, inclusive corporate risk financing products. This is one of the main driving forces behind the development and growth of alternative risk financing or transfer (ART) programmes.
Question of definition
There is no clear line or static definition determining where traditional insurance stops and where ART starts; often features first introduced in ART programmes subsequently become adopted in mainstream or more traditional programmes. But the features that characterise alternative risk transfer combine to deliver greater flexibility and inclusivity. ART programmes are usually multi-year, often multi-line, and sometimes include risks that are not normally insurable on a stand-alone basis, as well as displaying other innovative features.
These elements of non-standardisation have several important consequences for the writers of such ART programmes. First, each ART transaction is custom designed and so requires more time for the detailed analysis and negotiation to structure a transaction that meets the requirements of both parties, and often requires additional professional opinions on accounting and taxation issues. Secondly, a custom-designed programme is unlikely to fit into the writer's reinsurance treaties, and so may require some additional facultative reinsurance, or more likely, will need to be written on a net basis. Nor are ART deals often syndicated, but again because of their unique structures, one carrier usually writes them 100%. Thirdly, ART transactions tend to be a low volume, medium-to-high limits book of business, and since each deal is distinctively different, there is little or no ‘portfolio' effect across the overall book. These latter two conditions narrow down the field of carriers which can offer meaningful limits on ART business, and are also the reason why many of the major corporate ART players are in fact the larger reinsurance companies, often with units dedicated to writing ART business.
Developments in ART over past years have included self-insurance, captive insurance companies, finite insurance, multi-line multi-year aggregate programmes and most recently insurance-linked securitisation. Captives formed by industrial companies are still often quoted as examples of ART, but the first captives were established in the 1910s and 1920s, and with around 4,500 captives now in existence, they can hardly be regarded as ‘alternative' any more. But it is only in the last decade that some of the more traditional reinsurers have come to terms with captives and been prepared to deal directly with them.
When corporate clients are asked what risks they are most concerned about, the top answers in recent years have included business interruption, product liability, and more recently, loss of reputation (from the Aon Risk Services Biennial Risk Management and Financing Surveys, 1995 to 2001). When asked further about the risk areas in which the purchase of adequate insurance cover causes concern, the top answers given for several years by corporate risk managers have included environmental risk, business interruption and loss of reputation and brands. These results highlight that there continue to be areas of ‘real' risk for which the insurance industry does not have well-developed product or meaningful capacity to offer.
Gross premiums on traditional property/casualty business have hardly grown in recent years, and so if the industry is to achieve real premium growth, further innovation in the lines of risk covered offers one way forward. At the same time, it certainly seems there are risks that corporate clients acknowledge they face but find current insurance industry offerings are inadequate.
Surmounting the challenge
Another challenge to the traditional insurance industry is that companies will increasingly find alternative risk financing solutions in the banking or capital markets. As has been widely reported, the insurance and banking/capital markets are converging. So far this has been two-way traffic. Some financial risks (such as interest rate, exchange rate or commodity price exposures) have been incorporated within multi-line aggregate insurance programmes or double trigger structures. Recent years have witnessed a very significant volume of credit risk placed into insurance markets by banks seeking to manage their exposure to specific corporates or seeking arbitrage opportunities. In contrast and more significantly, some insurance risks have been placed directly into the capital markets, a process called insurance-linked securitisation (ILS) – by which process a total of over $9bn in limits has been arranged. This has been particularly the case for property catastrophe exposures (mainly earthquake and windstorm), using contingent capital or catastrophe bonds structures; about $6bn of insurance limit has been securitised so far in this way over the last six years. Best estimates indicate that this level of securitisation represents about $250m of premium lost to the traditional market (and on risks that have incurred very few or no losses).
Potentially more important and ultimately more threatening than any long-term loss of premium is the pace of innovation exhibited in these ILS deals. They have introduced new techniques for setting attachment points and limits in multi-year deals, and clearer definitions of the events that can trigger claims. Two examples of these features are the ILS transactions undertaken on behalf of Yasuda Fire & Marine and Oriental Land.
Yasuda Fire & Marine issued a catastrophe bond, through a special purpose vehicle (SPV) called Pacific Re, with a limit of $80m over a five-year period to cover its exposure to typhoon losses on its underlying book. However, the size and composition of Yasuda's primary property book will naturally evolve and change over the five-year period, and so if there was the same fixed attachment point for each of the five years, the risk posed to the bond investors would change and therefore would need to be reflected in the pricing. The neater solution adopted here was to fix the risk to the bondholders, and hence the annual pricing, by making the attachment point of the bond resettable each year. Each year, using Yasuda's latest exposure data, the attachment point is recalculated, using Risk Management Solutions' Japanese typhoon model, to maintain a consistent risk-return ratio to the bondholders.
Oriental Land is the company that operates a Disney theme park near Tokyo. Oriental Land has outstanding loans to finance further development of the site and any disruption to gate receipts on the existing site would impair its ability to service this debt. As a consequence Oriental Land has issued a catastrophe bond, through a SPV called Concentric Re, that pays up to $100m in the event of an earthquake anywhere within a series of circles drawn on a map (hence ‘concentric') up to a distance of 100km away from the centre of the theme park. The actual size of any payment is determined by a pre-agreed formula containing just the epicentre and magnitude of the earthquake – the closer to the theme park and/or the more severe the earthquake, then the larger the payment, up to the maximum of $100m. (There is also a separate $100m loan facility available under more or less the same conditions.) The bond payment is triggered purely on occurrence of a qualifying earthquake, regardless of whether any of the facilities within the theme park are actually damaged; the rationale is that any significant earthquake anywhere in the region of the park will frighten off future visitors and consequently adversely impact revenues. Therefore the cover is by nature of a contingent business interruption, but without the need to demonstrate actual physical damage or produce worksheets to estimate the increased cost of working and/or loss of revenues.
The trigger event is ‘black and white'; financial settlement can be immediate and without dispute or adjustment, as soon as the epicentre and size of the earthquake are confirmed by the Japanese Meteorological Agency.
The lessons to be learnt from these two, similar, ART and ILS deals are:
1) traditional approaches to programme design and pricing will have to be updated to make use of the greatly increased power of the computerised catastrophe and financial models now available. Financial models can be used to evaluate multi-line programmes, even when one or more of the risks are not traditionally insurable. So programmes that combine investment assets and underwriting liabilities can be structured and priced using models such as dynamic financial analysis (DFA);
2) corporate clients are more concerned about the economic impact and consequences that any fortuitous loss has on their company, rather than on the pure causality. This point is also supported by the changing balance between physical damage and business interruption exposures; businesses these days are ever more dependent on their suppliers and customers for production processes to run as planned. Companies increasingly outsource component supplies and maintain minimal ‘just-in-time' inventories of their own. Any disruption anywhere in the production chain, even at a supplier several links removed, can have a more or less immediate and significant impact, resulting in the loss of production and profits, many times larger than the cost of the original physical damage giving rise to the problem;
3) the world of risk faced by corporates is much wider than that encompassed by traditional property and liability perils. The Oriental Land transaction probably lies outside even the most liberal interpretation of ‘insurable interest' and certainly does not conform to the principle of ‘indemnity settlement'. But it addresses a valid business risk in an effective and transparent manner. Although not structured as an insurance policy, it would actually be easier for an underwriter to price and adjust than any property damage policy with some form of contingent business interruption extension.
One accusation levelled against ART in general, and ILS in particular, is that it often appears to be more expensive than the nearest equivalent conventional insurance programme (although you can rarely compare on a strict ‘apples to apples' basis). However, any such perceived pricing differential is now being eroded by the significant rate hardening across most sectors of the traditional insurance market experienced since late 2000: ART and ILS can only become more attractive to clients who find that conventional insurance is not fully or effectively meeting their risk financing needs.