Capital and derivatives market are no strangers to risk, but certain features of insurance risk are atypical to those with which these markets are familiar, John Walker explains.
An underlying demand for instruments which manage the risks associated with a volatile and increasingly global financial environment has driven the explosive growth of the world's capital markets over the last 30 years and, more recently, the use of derivatives.
Although originally fuelled by the pursuit of divergent monetary policies by national governments as a consequence of the abandonment of the fixed exchange rate system in the early 1970s, the capital markets have responded to demand for products designed to manage risks across a diverse range of economic activity. As well as the familiar foreign exchange rate, benchmark interest rate and commodity price products, similar techniques have been applied to manage more exotic risk exposures, including credit and default risk, volatility, natural disasters and, as recently as this summer, unexpected revenue loss from future World Cup competitions.
The demand for instruments capable of managing these risks has now grown to a level where they constitute a powerful sector of the financial markets, not merely in terms of total annual volume but also in their variety of participants. Almost every financial institution of any size has now made some commitment to these products by establishing their own group or department (often within the treasury function or a structured products group) to utilise such financing techniques as an intrinsic part of managing their commercial and business operations.
While the financial engineering developed by the markets often appears complex - not least as a result of the exotic terminology adopted - the products, nonetheless, have at their heart the same rationale as the insurance and reinsurance industries: namely, the allocation, transfer and management of different types of risk. As a result, insurers and reinsurers, too, have increasingly come to recognise the potential for applying these techniques as alternatives to the reinsurance mechanisms traditionally used to achieve such objectives.
Classic risk products include swaps, options and warrants in their various guises, numerous derivative forms and limitless underlying subject matter. The evolution of highly innovative new products based on these classic products has been a feature of the capital and derivatives markets. The process of creating new structures in response to market demands and opportunities has been most recently characterised by the growth of credit related instruments. A significant market has now developed in credit linked notes and credit derivatives. These instruments enable entities to buy or sell (and thus isolate) the credit risk inherent in, for example, a specific obligation of a particular borrower, specific obligations of multiple borrowers (portfolio risk) and sovereign risk.
Many different techniques are used in capital markets instruments to apportion risk between investors. Multi-tranching, for instance, provides a layered approach to risk with subordinated tranches absorbing first losses, thereby providing a measure of loss protection to more senior tranches. Different investors have different appetites for risk exposure. One way of meeting an investor's requirements is to limit loss to the income portion only of its investment or to a portion of the capital invested.
For example, the Swiss Re California Earthquake Bond underwritten by CS First Boston and issued into the capital markets in 1997 was structured into three different classes, each of which paid a different rate of return and provided varying levels of protection for the principal investment.
(Re)insurance risk contrasted
The capital and derivatives markets are no strangers to risk. However, there are certain features of insurance risk which are atypical of the risks with which these markets are accustomed to dealing. Perhaps the most fundamental distinguishing feature is that in financial markets, there is no requirement for the risk seller (that is the note issuer or derivative counter party) to have suffered any loss as a condition of the risk buyer making a payment. Nor does the risk seller need any interest in the underlying subject matter as a condition of receiving payment. It is the absence of the insurable interest feature that enables instruments such as credit linked notes to avoid being construed as insurance under English law. Because of this, market participants fall outside the regulatory regime for insurance.
Equally, not all types of insurance risk naturally lend themselves to a capital markets or derivatives solution. Instruments in these markets have, generally, a certain and final maturity or termination date. Consequently, for the risk transfer to be effective, any losses suffered in respect of the relevant risk need to be capable of quantification during the life-time of the instrument. Policies written in respect of losses arising from, for example, environmental pollutants are poor candidates for these markets.
A further contrasting feature relates to the mechanism used for determining the measure of loss in respect of a risk. The financial markets are accustomed to measuring loss or gain by reference to established and well understood indices. It is a relatively simple matter in the context of interest rates, currencies, equities and commodities. It is less so in the case of a claim in relation to a specific policy of insurance or reinsurance. Notably, though, the increasing volume of credit risk and credit default instruments is enabling investors to become more familiar with case specific loss measure mechanisms.
Classic ART structure
A common approach is to incorporate a special purpose vehicle (SPV) as an orphan company in an appropriate regulatory environment. The (re)insurer enters into a reinsurance contract with the SPV in respect of the risks being transferred, and the SPV issues bonds or notes to investors and/or enters into derivative contracts. These instruments absorb the risk undertaken by the SPV under the reinsurance contract and enable the SPV to meet its obligations thereunder. The premiums payable to the SPV under the reinsurance contract, together with the reinvestment of the proceeds of issue of the bonds or notes, service the "returns" payable by the SPV to investors.
Typical issues that arise and need to be resolved include:
* Solvency of SPV. The SPV needs to be bankruptcy remote. The counterparty under the reinsurance contract relies upon the SPV being able to meet its obligations if and when they fall due. Equally, investors rely upon the SPV being able to meet its obligations to them. Accordingly, an obligation to pay the counterparty must be mirrored by a decrease in the payment obligations of the SPV to investors.
* Regulatory position. This needs to be analysed both from the perspective of the SPV and the investors.
* Claims handling. This is critical to the determination of how losses are absorbed by investors. Of paramount importance to investors is the mechanism by which payments under the reinsurance contract are calculated. In the absence of an appropriate price source, index or other objective measure (such as a formulaic approach based on the severity of, for example, the subject earthquake or hurricane), the quota-share route is commonly adopted.
* Disclosure. To enable investors to make an informed investment decision, the risks being taken and the likelihood and quantum of loss need to be disclosed. If a price source index or other objective measure is used, attention will tend to fall on the quality of the historical data available in relation to the relevant source or measure. In other cases, data may be limited to that available from the relevant (re)insurers. This is more problematic since the quality of this data and the appropriateness of any related modelling will need to be tested. Moreover, from the perspective of the (re)insurers, this information may be commercially sensitive and valuable.
Participants in the capital and derivatives markets are well versed in risk transfer techniques. By all accounts, there is appetite in these markets for insurance related risk. Some insurers and reinsurers perceive these markets as attractive alternatives to classic reinsurance. Others argue that, in a market of adequate reinsurance capacity and softening rates, an alternative which does not offer material cost savings does not need to be embraced. Those entities currently investing time and resource in alternative risk transfer techniques hope to be best placed when, as surely will happen, reinsurance capacity shrinks and rates escalate. As with most things, time will tell.
John Walker is a partner at Cadwalader, Wickersham & Taft, London, and a member of the firm's capital markets group. He has extensive knowledge of capital markets, structured finance transactions and derivative products. He acted for Hannover Re on the innovative Kover I catastrophe bond transaction. Tel: +44 (0) 171 456 8500. Fax: +44 (0) 171 456 8600.