Chris Allen and Christophe Létondot explore the manner in which insurance can be used to facilitate financing activities.
Over the years, much ink has flowed in writing about alternative risk transfer (ART). The purpose of this article is not to add to the significant existing body of ART literature, but rather to elaborate on recent trends. More specifically, we will explore an area of the convergence of the insurance industry and the capital markets which has immediate application: the use of insurance as a means to facilitate financing.
As the ART market has matured over the last few years, distinct features have appeared. In particular, the field of ART has redefined itself into sub-specialities within its broader scope. A distinction can today be made between traditional ART and a more financial approach to non-traditional insurance, generically referred to as alternative risk financing (ARF).
The more traditional portion of the ART spectrum is comprised of risk financing tools such as captive (re)insurance companies as well as multi-year/multi-line and finite risk programmes. Captives were developed over the last four or five decades primarily to address fiscal and price inefficiencies. Multi-year/multi-line and finite risk programmes were once considered cutting edge ART techniques and are today mainstream alternative products. These risk financing solutions were developed primarily as cost cutting and loss smoothing tools and are based on principles of risk mutualisation and risk spreading.
The newest and fastest growing area of the ART spectrum is alternative risk financing. The ARF arena is ever changing and encompasses financial solutions ranging from residual value insurance to credit enhancements, and financial guarantees to securitisation.
Certain ARF solutions are the result of the convergence between insurance and capital markets. One of the more tangible aspects of the convergence of capital markets and insurance has been mutual sharing of capacity from each market. For example, the capital markets provide capacity for insurance related exposures (i.e. through securitisation). Simultaneously, the insurance market has started to provide capacity to introduce certainty for specific capital markets related issues (i.e. the use of insurance-backed financing).
In traditional financing structures, there are two participants, the lender and the borrower. The use of insurance in financing structures introduces a third participant: the insurer. The premise of this article is to explore from the perspective of the participants the manner in which insurance can be used to facilitate financing activities. Insurance contracts have been used to guarantee future revenue streams, protect against counterparty default, and used to guarantee structured finance arrangements for the purchase of large revenue producing assets.
One of the factors which has led to the convergence of capital markets and insurance has been the introduction of more stringent control mechanisms. As a result, lending capacity and underwriting guidelines have become increasingly strict for many assets classes. More often than not these restrictions on lending clash with the borrower's balance sheet management plans. Today, many quality borrowers are forced into the decision of using expensive sources of debt or potentially more expensive equity positions.
The financing of assets ranging from aircraft, to rolling stock, to vessels and property has been affected. The desire to avoid excessive balance sheet leverage and expensive sources of funding has led to innovative off balance sheet financing. Common examples of such financing schemes are sale and lease back arrangements. However, due to the inherent asset risk, these off balance sheet mechanisms have limited the ability to borrow funds at desirable rates.
As an example, we can examine the financing of a generic asset and the use of insurance to facilitate this financing. Aside from the typical business risk and credit risk, these arrangements introduce structural risk.
As mentioned the typical insurance-backed transaction will include a series of indirect relationships between several parties including the lender, the borrower and other participants such as owners and operators. Each party has a direct relationship with at least one other party that results in the profitable operation of the asset and subsequent repayment of the debt. The relationship between many of the parties, while indirect, is linked through a series of contractual arrangements. Therefore, because the facility depends on the performance of each party, the structural risk becomes difficult for lending institutions to assume high loan-to-value ratios. This leaves the purchaser in the aforementioned dilemma of either seeking an expensive source of debt or injecting precious equity into the purchase of the asset.
Most insurance companies do not wish to compete with the mezzanine finance market. However, there are often structures which include high quality participants which justifies the use of insurance capacity. In the case where a solid counterparty risk would be employing the asset, it would protect future revenue stream, which indirectly secures the repayment of the debt (i.e. a ship charter secures revenue to the ship owner which in turn uses these revenue streams to repay the lender). Therefore, a guarantee on additional lending (the mezzanine layer) can be the answer. Under such an arrangement, the insurer issues a commitment to the lending institution to make good that portion of the lending in the event of borrower default. As in all business transactions, insurance-backed finance is structured to address each participant's requirements.
The lender seeks to forward funds at the highest loan-to-value ratio at which it can confidently expect repayment. The lender would also like to maximise income through arrangement and syndication fees, while at the same time minimise the long-term credit exposure to the arrangement. The purchase of insurance-backed finance can help accomplish both these goals.
Competitive advantage over other lending institutions is gained through higher lending capacity. This enables a lending institution to secure attractive arrangement and facility fees. Furthermore, due to the attractive loan-to-value ratio, the institutions are then able to syndicate portions of the facility without concern over the residual value of the asset. Effectively, the lending institution views the guaranteed portion of the facility as a credit commitment of the insurance company. Therefore, the credit quality of the insurance company becomes the important factor in the banks' credit decision.
The borrower wishes to minimise the use of equity and maximise the use of inexpensive debt. With limited equity, a borrower would prefer to use half the equity on two assets as opposed to all available equity on one asset. This allows the borrower to leverage assets in the most efficient manner and generate greater overall returns.
The use of standard first mortgage bank financing is the cleanest, and in most circumstances, the cheapest method of finance. However, this is not always available for high loan-to-value ratios and the use of mezzanine finance often involves much higher interest rates as well as forfeiture of part ownership in the asset. Finally, the use of equity reduces the ability to employ multiple sources of income production. Therefore, the use of insurance-backed finance can enable the completion of the structure in an efficient manner.
The perspective of the insurer is simple: if an opportunity presents itself to receive a payment which exceeds expected losses and expenses, then the opportunity should be considered. In the case of insurance-backed finance, the insurer's risks are: (1) credit default, coupled with (2) a realised loss on the value of the asset.
For traditional insurance companies, credit risk is generally not an area for which established expertise exists and credit risk is taken as a necessary evil to doing business. Insurers are increasingly recognising that a significant portion of their risks lies in credit obligations. These obligations are either through exposure to long-term premium payments or to the use of reinsurers as support for traditional business.
However, in the case of insurance-backed finance, credit risk is the primary component of the structure (the secondary risk is on the residual value of the asset). In these structures, the combination of the two events must happen concurrently for the insurer to suffer a loss. For example, a decline in the value of the asset has no effect on the insurance policy unless accompanied by a default of the borrower.
Besides credit and asset risk, there exists a third type of risk in insurance-backed finance, namely: liquidity. In general, the less likely the opportunity to divest from an financing structure, the higher the required return. Insurers have an advantage over other participants as they traditionally take a longer-term view of risk. While they are certainly concerned with liquidity, they may not charge as high a premium as lending institutions.
We have seen in this example the use of insurance capacity respond to a need which the capital market has created, but what about the future of insurance companies in this domain?
The direction of insurance-backed finance is certainly a great unknown to insurance companies. The principle forces behind the growth of the market are the availability of credit coupled with the internal control mechanisms placed upon banks. Trends would suggest that as lending controls tighten in certain areas, they may weaken in other areas. Therefore, the focus of insurance-backed finance may shift from one asset class to another as time passes. So long as insurers look to capitalise on these situations, for the most part they are likely to continue to be successful in special situations.
However, not all insurance companies seek the best risks, many of which have only come to the insurance market as a result of extraordinary circumstances. Indeed, some insurers are looking to broaden the scope of their efforts into what appears to be direct competition with the financial institutions. While this seems to present an exciting future for the use of insurance capacity, the actual response of the various market participants is unknown at this point and poses many questions. Particularly interesting will be the response of insurers in the face of losses. As much as it has been discussed in connection with the uncertainty regarding investors' responses to losses in securitisation deals such as cat bonds, the same holds true for insurance-backed finance business: what will be the response of many of the new entrants in this market should they suffer losses?
Does the senior management at these companies fully understand the risks being assumed under these structures?
Will they continue to commit the high level of resources if they suffer a setback?
Additionally, one may ask the question regarding the continuing commitment to this line of business in the event of the traditional market hardening. If the core business demands high levels of capital in order to expand capacity for lines of business which are at the root insurance operations, will the “special risks” groups lose focus?
Finally, what is the likely response of the insurance regulators and banking regulators to insurance participation in this market? As underwriters, we would hope that as long as the products that are being provided continue to resemble and operate much as an insurance policy, the regulatory advantages will remain. However, more and more products and policies are being used which closely resemble pure financial guarantee, i.e. investment products. Regardless of the answers to these questions, the times ahead will certainly be interesting and the ultimate convergence of capital market and insurance industry has still to be defined.
Chris Allen and Christophe Létondot, Chubb Insurance Company of Europe S.A. Mr Allen is avp and manager for the UK and Ireland, and Christophe Létondot is avp and manager for Continental Europe in Chubb's Alternative Risk Consulting Unit (ARC). ARC is a team of expert consultants dedicated to structuring and servicing a range of strategic risk solutions called architect.