The other side of insurance and capital market convergence, transferring capital market risk to the insurance market.
When CFOs muse about the convergence of the insurance and capital markets, they tend to think in terms of either insurers ceding catastrophe risks or other traditional insurance risks to the capital markets via securities, or the cross-selling of retail services to bank and insurance customers. But what about the other side of convergence – transferring capital market risk to the insurance community (‘insuritisation')? While commentators give this side of convergence less attention, it may actually be more prevalent than the others.
Swiss Re New Markets (SRNM) recently put together several transactions ceding traditional capital markets risks to the insurance market. By doing so, SRNM is developing new, more cost effective methods of raising capital, and is rewriting the customary roles of insurers and reinsurers in the process.
Take the case of a recent transaction involving the fast food restaurant chain Arby's in the US and Canada. Arby's, Inc's parent company, Triarc Companies, Inc, was interested in refinancing its Arby's operations. Triarc had an idea. The company believed that future royalty payments and fees from Arby's franchises represented a stable and predictable cash flow stream based on the company's brand and reputation. Triarc turned to SRNM and Morgan Stanley to figure out how to use these intellectual property assets for a structured finance transaction. SRNM, working together with Morgan Stanley and Ambac Assurance Corp (a monoline financial guaranty insurer), crafted a strategy that equated Arby's franchise fees to an intellectual property asset having future value, ultimately permitting a newly formed special purpose subsidiary of Arby's to borrow against the revenue stream associated with this asset in the asset-backed market. The $290m private placement, completed in November 2000, is backed by the rights to collect royalties and fees from Arby's franchise owners in the US and Canada.
The inherent problem with accessing the asset-backed market directly was the novel nature of the asset. The average bond buyer can afford to spend only a few hours examining a circular and attending a road show before making a purchasing decision. Many times, however, buyers can look at the historical behaviour of the asset class as a guide to the analysis of a new issue – even if the issuer is new to the market. With a new intellectual property asset class in the Arby's deal that is certainly lacking in precedence, the typical bond buyer may not have been able to afford the time and resources that would have been necessary to become comfortable with the asset class and the expected behaviour of the cash flows associated with it. As a result, without any third party credit enhancement, bond buyers most likely would have demanded higher interest payments on the bonds.
To make investors comfortable with these securities, Arby's provided a financial guaranty, which, under New York law, can only be issued by a licensed monoline financial guaranty company. In order to provide the necessary guaranty, SRNM approached Ambac with the offer to support an Ambac guaranty through reinsurance provided by a AAA-rated Swiss Re subsidiary. This guaranty provided and supported by two AAA-rated risk takers ultimately helped to ensure that the securities were rated AAA by major rating agencies like Moody's, S&P and Fitch.
Before the guaranty was issued, however, Arby's needed to mitigate the risk that the assets backing the securities – the value of future franchise royalties – did not deteriorate, and needed to get its risk partners, Swiss Re and Ambac, comfortable with the remaining risk. As risk bearers themselves, Swiss Re and Ambac had the knowledge and devoted the resources to analyse the cash flow risks in a way that bond buyers could not. By identifying the underlying stability associated with the cash flow and putting their own capital (and, in the Swiss Re Group's case, its diversified risk portfolio) behind the risk, SRNM and Ambac were able to achieve the AAA seal of approval that the bond buyers wanted. The Ambac financial guaranty insurance policy, backed by reinsurance from a Swiss Re Group company, essentially protects bondholders against the possibility of a shortfall between the actual value of future royalties and the projected figure that was used as the basis for the securitisation (the metrics are proprietary). In other words, SRNM and Ambac underwrote the risk of a significant decrease in this revenue stream, absorbing the exposure on their own balance sheets. The insurance guarantees that bondholders are paid even if an adverse event affects the cash flow from the franchise operations.
How the risk takers split up the risk also was unique. A Swiss Re Group company took the first loss position on the asset risk, with Ambac taking an excess layer (though it wrote the entire program on its paper). This is a significant departure from traditional insurer-reinsurer business dealings. Typically, direct insurers are closest to the risk, in part because they are typically closest to the client. Direct insurers then spread their exposure through excess of loss or other types of reinsurance. In this case, however, Ambac's risk appetite was more closely aligned with the excess layer position, while Swiss Re Group's diversified book of business gave it confidence to play in the working layer. The atypical risk-taking positions of Ambac and the Swiss Re Group are one novelty in a deal that breaks ground in several areas. The deal also has proven that, in the right circumstances, the growth and stability of a cash flow stream driven by intellectual property can be measured and mitigated. By diverting the cash flow stream attributable to an intellectual property asset (Arby's royalty revenues and fees) from other traditional operating cash flows, the transaction isolates a new asset class. SRNM is confident it can use this structure to launch similar future cash flow securitisations, further expanding the asset class potential of intellectual property.
The novel structure can be replicated for other franchise and licensing cash flows that were previously forced to raise capital only in the high-yield bond markets, demonstrating that a new, more cost effective approach to corporate financing is at hand. Issuers are continually looking for alternatives to issuing straight debt, particularly given the difficulties in the high-yield markets at present. Evidently, the new tool comes at the right time.
Who's on first?
Perhaps most compelling from an insurance industry standpoint is that the Arby's deal (and several additional SRNM transactions) represents the placement of a capital markets risk in the insurance/reinsurance markets. Up to now, the attention devoted to the convergence of the capital and insurance markets has focused to a large extent on two scenarios.
The first is the ceding of catastrophic insurance risks in the form of bonds and derivatives (so-called cat bonds) to the capital markets. The Arby's initiative represents the complete inverse, of course. The second scenario derives more from the origination side of the business – commercial retail banks delivering insurance products to bank customers and vice versa à la Citigroup (the Citibank and Travelers Insurance Cos merged entity). While this structure has taken root in Europe as so-called bancassurance, it is not as prevalent in the US.
Now there is a third scenario; ceding securities-based risks to the insurance and reinsurance markets. This most recent evolution of convergence is still in its formative stages. Yet, there are growing expectations that exposures to capital markets or insurance risks can be syndicated successfully to both banking and insurance-based investors. Recent SRNM transactions involving the Royal Bank of Canada and Michelin demonstrate the interest of banks and insurers to provide capital support to their major clients. The $1,075m Michelin capital facility set a benchmark upon which Swiss Re and other insurers are building committed capital solutions to the corporate sector.
The Michelin transaction was built around the client's interest to have the right to issue long dated subordinated debt during a period of economic decline. SRNM structured a solution which allows Michelin to call on a syndicate of banks and insurers to provide 12-year subordinated debt to Michelin if the rate of growth in GDP declines. SRNM joined with Société Générale and Winterthur to syndicate the facility to a high quality group of banks and insurance companies.
The Royal Bank of Canada deal represents a similar solution, structured to meet the capital efficiency requirements of SRNM's banking clients. Working together with Royal Bank of Canada, SRNM structured a five-year commitment to purchase preferred shares which would be issued by the bank to replace capital in the event of a significant deterioration in its loan portfolio. Basically, a Swiss Re Group company has agreed to buy up to C$200m in Royal Bank preferred shares should the bank's loan portfolio be hit by losses.
The competitive cost and quality of an off balance sheet capital commitment was the key corporate finance driver in both Michelin and RBC. Important too was the favourable response of both banks and insurers to sharing in the risks.
The Arby's, Michelin and Royal Bank of Canada transactions broadly exemplify the potential for structuring solutions which combine the risk transfer and risk absorption capabilities of banks and insurance companies in a far more efficient manner than the ‘faceless' public markets. As similar transactions are consummated and disclosed, confidence in the strategy will blossom, enticing greater risk bearing participation by the insurance and reinsurance communities.
In these competitive times, with decreasing need for more traditional reinsurance products and growing consolidation within the industry, these risk assessment opportunities can produce a significant new and diversifying revenue stream. At the same time, these products augment customary programs offered to clients and enable them to implement a more efficient capital strategy. These and other insuritisation transactions that transfer capital markets risks to the insurance markets also demonstrate that the convergence of the capital and insurance markets really are two sides of the same coin.