In the last year, alternative risk transfer (ART) markets and products have enjoyed a higher profile than ever before. However, confusion still reigns in some quarters about the products themselves, how they are defined and the motivations of end-users. One basic reason is that some products - most notably risk securitisation and insurance derivatives - employ contracts and structures unfamiliar to those within the re/insurance industry.
It would seem logical that, although a number of factors are at work here, an important reason why the volume of alternative transactions continues not to meet the expectations of proponents of ART solutions is the slower-than-expected pace of the growth in understanding on the part of buyers of ART products. All the evidence is that awareness is growing and it would be perfectly realistic to expect a time to arrive where the level of knowledge eventually matures into a situation where buyers understand and feel comfortable with at least seriously considering alternative solutions rather than shying away from them. When this point is reached, conditions will be right for an increasing number of alternative transactions to be completed.
When it comes to evangelising about alternative products, there is an inherent paradox which promoters of alternative products are compelled to live with: it is still the case that many alternative products are very specific to the purchaser's needs. Being bespoke in this way, the products require a considerable measure of resource and, therefore, expense in order for them to be brought into existence. It is, of course, ultimately the buyers who bear this expense and they would not wish other people, whether they be brokers, arrangers, originators or intermediaries within the product chain, to free ride on the development costs for their own benefit. Accordingly, there is great sensitivity about ensuring non-disclosure of transactions. Documentation frequently tends to contain extensive confidentiality provisions. Although some notable transactions have nevertheless achieved a high degree of publicity, it is still the case that a lot of the work done in the ART arena is shrouded in secrecy. It needs no explaining that a consequence is, at least at the detailed level, to hinder the spreading of the word. This in turn holds back the speed of development of the market.
It is nevertheless interesting to note from last June's Marsh annual ART questionnaire analysis that general awareness of the alternative market is undoubtedly increasing. The analysis shows that whilst in 1998/1999 46% of insurance buyers were offered alternative products, the position in 1999/2000 had taken a major step forward with 77% being offered ART services. This reflects the investment of the major brokers in ART and also the growth of some specialist consultants including the major accountancy firms. The survey also finds that 85% of respondents saw the capital markets and the insurance market converging, with the majority of respondents considering the development to be beneficial. In the words of the report, “the framework for convergence is being built in buyers' minds”.
With the passage of time there will undoubtedly be a tendency for alternative products to become more streamlined in various respects. Because the products are inherently complex, it is unlikely that more than a few will ever become fully commoditised. Nevertheless, the development content and therefore the expense of the products is likely to diminish as technology improves. This should in turn mitigate worries about confidentiality and sharing of knowledge. Following on, this should give rise to an acceleration in the knowledge base across the alternative market of the products and their capabilities. It will also involve growing economies of scale which will affect the pricing of the products and make comparisons much more favourable with rates in the traditional markets.
Whilst the process of educating the various links in the insurance market distribution chain about the new products has proceeded more slowly than expected, it is interesting to note the dynamics within the alternative marketplace itself. In October this year, Denton Wilde Sapte published research titled “The ART Survey 2000: Risk Finance for Corporations - The New Frontier”. This followed on from and updated the firm's original research report published in July 1999.
In 1999, respondents anticipated substantial further growth in the catastrophe bond market in which demand was found to outstrip supply. It was expected that in the wake of that growth there would be the start of non-catastrophe securitisation. The market was perceived to prefer bonds over swaps since bond proceeds in hand had the major advantage relying on unfunded covenants in the swaps arena. The fastest growth area was identified as finite products followed by credit products.
The October 2000 report re-appraised the current state of play in ART. Whilst it is the case, as predicted in the original report, that the fastest growth has indeed occurred in finite and credit products, our research and that of a number of other independent commentators indicates there has been a marked tailing off of issues of bonds. The predicted debut of non-catastrophe bonds failed to materialise and the volume of catastrophe bond issuance has diminished markedly. Derivative-based products have also made less headway than would have been expected 18 months ago.
The background here is that the expected upward trend in traditional insurance rates has been far slower to show itself than people expected. As a consequence, the possibility that traditional covers at sensible rates might not be available indefinitely has receded from the forefront of buyers' minds. It was largely concern about availability of sensibly priced future capacity which motivated the more sophisticated and more forward-thinking parts of the industry to look at alternative solutions. In doing so, it was recognised that the development of alternatives would be a time-consuming process involving teams of professionals examining the complex issues of (often cross-border) tax, regulatory and accounting issues. There was, and is, an awareness that should the current buyers' market for any reason suddenly become a sellers' market with the attendant consequences in pricing terms, it would be too late at that point to start attempting to identify the ways out of the problem.
While concern about future availability of catastrophe covers may have diminished, a particular area of growth at present is financial guarantee. There is evidence that a number of re/insurers view financial guarantee as potentially a profitable use of capital at a time when premium rates in a very substantial range of lines of business are extremely depressed. Indeed, this seems to be an opportunity which the Lloyd's market is particularly keen not to miss out on. Lloyd's is, however, adopting a cautious step-by-step approach to the expansion of its permitted financial guarantee business. It has rightly identified the need for syndicates to take on people with appropriate underwriting expertise. This is an important issue as this class of business requires an in-depth understanding of the underlying transactions and is not well suited to remote underwriting. Underwriters need to be at the table attending meetings and following the negotiation of the transaction in order to write their business. Lloyd's has rightly set attributable funds at Lloyd's at a high level. Some may say that the level of funds at Lloyd's has been set so high as to present a competitive disadvantage to the Lloyd's market. Presumably the intention is to see how a carefully managed expansion of this class of business performs and then to look at the possibility of introducing modest relaxation in terms of committed capital if experience shows that reductions can be justified.
There is no shortage of first-hand evidence of the strong growth in financial guarantee in terms of actual transactions being completed. This bears out the findings of the report. A financial guarantee cover has a remarkable capacity to provide the critical missing component in any number of diverse transactions which might not proceed on the basis of a traditional banking credit committee analysis. In filling in the gap, insurers would certainly not think of themselves as applying lower standards than banks. They would rather think of themselves as applying a different analytical approach which can open the way for a transaction to proceed. It is also the fact that insurers can take advantage of regulatory capital arbitrage when writing these covers. Whilst not in itself a major issue, this does mean that insurers can price financial guarantee covers more keenly than banks can price guarantees or letters of credit. This is because insurers have the advantage of a lower regulatory capital cost.
As predicted in the 1999 report, finite products have continued to prosper. In essence, these are multi-line multi-year products which balance risk financing and risk transfer. In an age of managing for shareholder value, large corporations value balance sheet stability more than ever before. In this scenario, they want more control and flexibility over cash flow management. The ability to finance losses on a regular basis, in partnership with an insurer, has become more appealing than the ultimate long-term uncertainty of a simple indemnity relationship, common in traditional insurance. The most tangible gain for buyers in this area is administrative efficiency. Corporations are able to move away from the bulk buying of diverse insurance programmes to customised, specifically-designed solutions. Annual renewals can often take up to a third of the corporate risk manager's time, time better spent on proactive risk management. In addition, finite programmes allow corporates to reduce the number of carriers and help facilitate a better relationship with a smaller group of insurers.
By bundling together various insurance lines and applying a portfolio approach, buyers can apply a higher degree of risk diversification before insurance comes in to the equation. This self-diversification may be a better foundation for establishing the deductible within the overall programme. In this way, buyers of finite products enable a more sophisticated integration of risk retention and risk transfer based on their own particular risk profiles.
The 2000 survey finds that there is evidence that the chief financial officers of major corporates are taking a closer interest in and becoming more involved with group risk management and insurance. Providers of alternative risk transfer and alternative financing products are aware that decisions to learn about and experiment with alternative products need to be taken by those responsible for financial management rather than by those with a more focused and tradition-bound view in risk management. The campaign to increase awareness of alternative products has therefore been focused in that direction. This is not by any means to say that risk managers need not know about alternative products; it is simply that within organisations, risk managers are no longer the sole focus for brokers and intermediaries.
Weather derivatives continue to be written in fairly substantial and steady volumes. The impetus here apparently comes mainly from the energy companies which continue to apply great inventiveness in identifying suitable counterparties for the products they offer.
The survey found a healthy demand for covers against product launch failure and associated lost research and development costs. This area appears to be fairly closely related to project-related covers guaranteeing minimum revenues based on expected usage of revenue-generating products such as toll bridges and roads.
The 2000 research shows that product launch failure covers are unlikely to extend to more general bottom line earnings protection. The moral hazard implications of such covers are obvious; there would be a huge assumption of risk without any corresponding control. The research found that shareholders should bear general or core risks and investee companies should finance or transfer non-core or non-specific risks in the context of the industry concerned. The insurance industry should play the leading role in delineating this frontier between core and non-core.
The picture we see is of financial guarantee and other credit products leading the field alongside finite. Catastrophe bonds have fallen back and other specialist products have taken root and look poised to move forward. Above all, appreciation and awareness of the products is spreading across a broad base. This improved knowledge base will be the foundation for the next advances in ART.
George Sandars is a corporate insurance partner at Denton Wilde Sapte. Copies of the 2000 research report are available from Amelia Knight,
tel: +44 (0)20 7320 6912,