Corporate finance is undergoing a revolution, resulting in increasingly efficient methods for financing risks. This is due to two major developments. One is the advance in technology that has enabled organizations to more accurately model their risks, regardless of the source. The other is the vast array of new financial products that allow organizations to easily hedge, or transfer, their various risks.
Current technology allows an organization to accurately assess its risks on both micro and macro levels. For example, an organization can examine the impact on its profits of risks arising from specifically-defined areas, such as commodity price changes or interest rate fluctuations. More importantly, an organization can examine the dynamics of how its various risks work together to impact its profitability. The results of these analyses provide an organization with valuable insight on its risk profile.
Financial institutions have responded to these technological developments with a large number of new capital market risk financing products, such as derivatives and contingent capital, that allow an organization to finance its various types of risks, even those that fall into narrowly defined areas. By selectively using these products to hedge its risks, an organization can justify reducing its traditional capital base (debt and equity), which is relatively expensive to maintain. Therefore, by replacing traditional capital with these non-traditional financing products, an organization increases its return on equity and its long-term prospects for growth.
An equally important benefit of these new financial products is that they enable an organization to engineer its overall risk, meaning that the organization can change its risk profile to suit the preferences of its various stakeholders. By analyzing the effect of the various financial products on its risk profile, an organization is able to choose a risk profile that best suits the risk appetite of its stakeholders while maximizing its return on equity at the chosen risk profile.
These new methods of financing risk can also be applied to risks that are usually transferred through traditional insurance (and reinsurance), such as the risk of loss arising from property and liability loss exposures. For centuries, the capital markets have financed insurable risk by providing capital (debt and equity) to insurance and reinsurance companies, which use the capital to underwrite their customers' risks. However, there are new capital market products, such as insurance derivatives, that enable an organization to finance its insurable risks directly without purchasing traditional insurance or reinsurance.
A primer on capital market products for financing insurable risk
Financial institutions, including insurers, reinsurers, insurance brokers and investment banks, have recently developed new products for financing insurable risk. These products can be categorized as insurance-linked securities, insurance derivatives and contingent capital arrangements.
Insurance-linked securities are financial investments (usually in the form of bonds) that have insurable risk embedded in them. The investor receives a return that is higher than it would receive if the insurable risk were not embedded in the security. However, in the event of a loss, the investor forfeits interest, principal or both. The organization that issued the security is able to use the investors' loss to offset its insurable losses. An example of an insurance-linked security is a catastrophe bond, which is specifically designed to transfer insurable catastrophe risk to investors.
Insurance derivatives are financial contracts that are valued based on the level of insurable losses that occur during a specific time period. An insurance derivative increases in value as specified insurable losses increase and, therefore, the purchaser of the derivative can use the gain to offset its insurable losses. The seller of an insurance derivative accepts insurable risk and receives a commensurate return for doing so.
An example of an insurance derivative is an insurance option, which has the same cash flow characteristics as an insurance policy. The buyer of an insurance option pays a premium and receives funds when the value of the insurable losses exceeds the strike value (similar to a deductible or a self-insured retention level for an insurance policy) during the period of the option (equivalent of the policy period). The option seller (the equivalent of the insurer) is in the opposite position because it receives the premium and must pay funds if the value of the insurable loss exceeds the strike value.
A contingent capital arrangement is an agreement entered into before losses occur and enables an organization to raise funds by selling stock or issuing debt at prearranged terms following a loss that exceeds a certain threshold. The agreement can be designed so as to respond to a loss arising from insurable risk, such as property damage resulting from an earthquake. The organization agreeing to provide the contingent capital receives a commitment fee.
An example of a contingent capital arrangement is a catastrophe equity put option, which is a right to sell equity (stock) at a predetermined price in the event of a catastrophic loss. The purchaser of a catastrophe equity put option pays a commitment fee to the seller, which agrees to purchase equity at a pre-agreed price in the event of a catastrophic loss, as defined in the put agreement. A catastrophe equity put provides an organization with instant equity at a predetermined price, which helps an organization regain its capital following a catastrophic loss.
It takes a large commitment of resources to implement these new products. To date, only a small number of large organizations, mainly insurance and reinsurance companies, have used them to finance insurable risk. In addition, the vast majority of these products have been used to finance risk arising from catastrophes, such as hurricanes and earthquakes.
Conceptually, these new capital market products can be used to finance any type of insurable risk for any type of organization. For example, in theory, an organization with a large number of property risks could embed the risk of loss to these properties in a security it issues.
These new products for financing insurable risk will grow in importance if a large market of buyers and sellers develops for them because market dynamics will reduce their cost and improve their liquidity, enabling investors to trade them. If these products are able to deploy risk capital more efficiently than traditional insurance (or reinsurance), they could replace many traditional insurance (and reinsurance) transactions, and their use will grow exponentially. The convergence of insurance with other financial services is driving the development of these new products, and many insurance and reinsurance companies, insurance brokerages, investment banks and other financial institutions are actively promoting them.
Because of the growing significance of these new products as a source of financing for insurable risks, the Insurance Institute of America recently published an educational monograph entitled Capital Markets for Risk Financing. The purpose of this 53-page monograph is to educate people on the mechanics of these new capital market products and their application to insurable risk. The monograph features a glossary, matching exercises, review questions and a 20-minute self-assessment quiz so that the reader can check his or her mastery of the content. It is geared for a wide variety of risk professionals, including reinsurers, risk managers, investment bankers, insurance brokers and commercial lines underwriters.
These new products have some inherent risks and disadvantages, so Capital Markets for Risk Financing covers the common concerns of both the organizations transferring the risk and the investors supplying the capital. It also discusses the regulatory and accounting issues involved with these products.
A sister publication, Finite and Integrated Risk Insurance Plans, is also available. Both of these educational monographs give risk professionals a firm foundation in the latest risk financing techniques.
The monographs are $25 each (plus shipping) and can be ordered directly from the Insurance Institute of America either online via its website, www.aicpcu.org, or by calling customer service at (800) 644-2101.
Michael W. Elliott, at the time he wrote this article, was assistant vice president at the American Institute for CPCU and the Insurance Institute of America. He directed the ARM, ARM-P and Introduction to Risk Management programs as well as the CPCU 9 (economics) course in the Chartered Property Casualty Underwriter (CPCU) curriculum. Currently, he is senior vice president and professional communications director with MMC Enterprise Risk, a division of Marsh Inc.