A reinsurance lawyer goes to Wall Street.
"A four-year-old child could understand this. . . . Now run out and find me a four-year-old child. I can't make heads or tails out of it."
Four years ago I left a position as a reinsurance attorney in a law firm to join Lehman Brothers, a 150-year old investment bank that was starting a new reinsurance business. The concept of the business made a lot of sense. Capital market investors had been gobbling up innovative products embodying new types of risk for years. Whether it was credit card receivables, airplane leases or commercial mortgages, there seemed no end in sight for the categories of cashflow that could be `securitised'. It was just a matter of time before quintessentially insurance risk - hurricanes, earthquakes, mortality and longevity - would be repackaged as investment products for asset managers and hedge funds.
For insurers and large corporations, the capital markets represented a deep well of capacity, dwarfing the global reinsurance markets in both size and risk appetite. The capital markets held the promise of improved efficiency in price, and if not the end of the underwriting cycle, certainly a smoothing in the price and capacity volatility caused by disasters that periodically would wipe out large amounts of capital in the traditional markets. For investors, insurance risk offered an opportunity to diversify away from risk linked to an increasingly interdependent global economy. The risk inherent in a catastrophe bond does not fluctuate with Russian currency crises or consumer spending in the Midwest. Back in 1998, the concept of our business was sound and success seemed inevitable.
Reality has proven to be significantly more complex. Even the most die-hard proponents of securitisation acknowledge that, as a source of pure risk transfer, the capital markets have not yet held up to their promise. In the property market, the notional amount of yearly catastrophe-linked issuance still hovers at around $1bn - the same amount as five years ago - and the largest single issuance to date remains USAA's 1997 Residential Re deal which provided $476m in coverage against East Coast hurricanes. While the investor base has continued to expand, encompassing more mutual and pension funds, investors have become more finicky about the types of catastrophe risk they can stomach. More deals are being done on a `parametric' basis where coverage is triggered upon the happening of an earthquake or hurricane of specific, objectively verifiable parameters, rather than on an `indemnity' basis where coverage is pegged to the quantum of actual loss suffered by the issuer or underlying cedant. For all their benefits in price and efficiency, parametric deals are an incomplete hedge and always leave basis risk in their wake: somebody has to be left holding the bag for actual losses. And as far as expanding capital market risk appetite beyond natural disasters to where the real action is - mould, terrorism, other man-made events - in the words of Tony Soprano, fuhggetaboutit.
On the life side, the academic argument for securitisation is powerful. The longevity and mortality risks inherent in large life and annuity blocs have many attributes within the capital markets' zone of comfort; lots of historical data, theoretically well-understood risk parameters, the law of large numbers. Demutualisation along with underperforming investments should stimulate demand for techniques to unlock the enormous amount of capital trapped in closed blocs. Prudential's $1.9bn transaction last December was ground breaking and there are clearly more deals to come, but at the end of the day, an insurance company (FSA) and 15 reinsurers had to step up to wrap the deal, and one wonders about the endurance of a product driven primarily by the artifice of regulation.
While securitisation and the transfer of pure insurance risk into the capital markets has been elusive, the broader convergence of capital markets and reinsurance has only eluded the attention of the academic press because it has actually deepened and evolved in unexpected ways over the past several years. Much has been written about property cat, life and credit, but there are two areas of convergence that have not received as much attention but which I believe hold enormous promise: contingent capital and risk financing; and transaction facilitation and liability extinguishment. Securitisation calls upon investors to behave like reinsurers, and credit wraps call upon reinsurers to behave like banks. Contingent capital and transaction facilitation on the other hand, utilise and build upon the traditional strengths of both capital markets and reinsurers.
In a contingent capital transaction (as in a cat bond), a special purpose entity (SPE) is established and is pre-funded by investors. The SPE enters into an insurance or derivative contract with a corporate insured or ceding insurer (the `re/insured') providing that the re/insured will receive the cash in the SPE upon the happening of an event. The re/insured pays a premium to the SPE which, along with the investment return on the cash (typically a LIBOR-based return smoothed through a total return swap), is distributed to the investors as the coupon on their investment in the SPE (see diagram 1).
Unlike a cat bond, however, the investors do not lose their cash upon the happening of the event. Instead, the re/insured is required to deposit into the SPE a debt instrument through which the investors are paid back over time (as long as ten years)(see diagram 2).
If the re/insured believes that it may need a few years to get back on its feet before being required to service the debt, a reinsurer may be added to the structure to temporarily or permanently guarantee interest and/or principal repayment on the debt.
By focusing on the temporary liquidity needs generated by adverse events, rather than the traditional approach of (highly leveraged) event-driven risk transfer, contingent capital is a breakthrough concept. In a recent paper entitled `Framework for Analysing Corporate Liquidity Under Stress', Standard & Poor's emphasised the obvious but often overlooked fact that "even a company with a solid business position and moderate debt use can, when faced with sudden adversity, experience a liquidity crisis" which can drive it into bankruptcy. Whether the event is a natural disaster (earthquakes, hurricanes) or a man-made one (e.g. asbestos, faulty tyres, harmful side-effects from drugs, accounting blunders triggering shareholder litigation), the drain on liquidity can create a spiral effect by triggering call provisions in credit lines, bond indentures, counterparty agreements and MAC clauses. External sources of liquidity like bank lines and commercial paper can dry up very quickly (CP buyers are notoriously risk-averse), and as S&P noted, "even investment grade companies may have difficulty issuing public debt" if a disaster has occurred. What is left? At best, the company is able to raise cash by selling assets (the proverbial fire sale). At worst, it is forced to restructure or seek relief under Chapter 11.
Contingent capital is tailor-made for such situations. For the re/insured, liquidity is guaranteed at the exact moment when it is needed most and traditional sources of cash dry up. Because the cash sits in an SPE, and is committed exclusively to one re/insured, it is not exposed to the leveraged balance sheet of a traditional reinsurer which itself may face liquidity issues connected with the same disaster. For investors, the play is compelling because they are not being asked to be reinsurers - in a worst case scenario they receive the re/insured's debt which is priced in advance to take account of the instrument's likely post-event mark-to-market valuation. For the reinsurer wrapping the deal, the double trigger (probability of event times probability of default on re/insured credit) generates a lower expected loss than a traditional indemnity cover.
A second area of capital markets-reinsurance convergence that has not received as much attention as it deserves is transaction facilitation. In a transaction facilitation, an insurer or reinsurer facilitates a deal - it could be a financing, an IPO, a merger or an acquisition - by mitigating exposure to risk. In recent years, insurers and reinsurers have stepped up to the plate with products insuring reps and warranties, tax liability, environmental, pending shareholder and product liability litigation, successor liability, and intellectual property rights. It is interesting, however, that deal facilitation seems to have attracted as many sceptics as it has supporters. Some M&A professionals cite the fact that transactions have been consummated for decades without the need for rep & warranty, tax insurance or similar products. Why all of a sudden is a product needed for risks that buyers typically self-insure? Moreover, the enormous time pressure of a typical M&A deal does not mesh with the careful investigation and due diligence needs of insurance underwriters. Can it really be done in time?
Proponents of this type of insurance point out, very simply, that the world has changed. In a landscape littered with bankrupt asbestos defendants, Enrons and significantly more stringent disclosure requirements, strategic buyers and private equity funds are increasingly nervous about legacy risks and contingent liabilities. When the market turns and M&A activity heats up again, there will be much more focus on the liability side of the balance sheet than there was during the bull market of the roaring 1990s. It may turn out that deal-related insurance will be instrumental to the consummation of M&A transactions in the future. Environmental insurance already generates more than $1bn in yearly premium, most of it driven by transactions. There have been several large tax-liability insurance deals which, for obvious reasons, the parties have agreed to keep confidential. In a typical tax liability insurance deal, a law firm has rendered a favourable assessment of the client's position on a tax issue, but an opinion letter is never a guarantee. The insurer provides comfort to the client by performing its own, independent analysis of the risk and essentially `wrapping' the legal opinion with a policy that transfers some or all of the risk to the insurer. Several insurers who provide M&A-related products have established specialised underwriting teams who understand and try to work within the time pressure of deals. Moreover, where the need for insurance is not essential to the deal, buyers are always free to lay off risk after the deal is done.
Like contingent capital, transaction facilitation has a bright future because it draws upon the traditional strengths of each player in the deal: strategic buyers and private equity funds are skilled at evaluating and assuming core business risks, but would rather avoid or mitigate the uncertainty around non-core risks such as disasters and contingent liabilities. Investment banks do a wonderful job raising capital but have no interest in holding messy, illiquid, esoteric risks. Insurers are loathe to put up cash at the front of a deal, but they are uniquely skilled at evaluating and pricing those same esoteric risks, and they are in business to leverage their balance sheets through the assumption and distribution of those risks into the global reinsurance markets.
Role of the lawyer
There is another key player in the convergence of reinsurance and capital markets who is also sometimes overlooked: the attorney. Contingent capital, transaction facilitation and other convergence products fuse together the skill sets of extremely different worlds and there are enormous linguistic, cultural, legal and regulatory obstacles that must be overcome. Contingent capital combines a debt deal with a reinsurance contract - lawyers have a pivotal role in structuring this crossbreed and crystallising the terms to the satisfaction of each stakeholder. Transaction facilitation products will only fulfil their promise if there is a true meeting of the minds, and that requires lawyers who are adept at mediating the linguistic and cultural divide between capital markets and reinsurance. As a reinsurance lawyer who had the good fortune to spend four years in the foreign province of a Wall Street investment bank, it has been incredibly rewarding helping clients navigate through the confusing legal and regulatory landscape of this brave new world. Shortly after arriving at Lehman, I realised that basic words like `bond', `underwrite' and oft-used descriptors like `the deal is rich' mean fundamentally different things in the capital markets and reinsurance worlds. The concept of `utmost good faith' is nowhere to be found on the LIBOR swap curve. In one particularly vexing negotiation, I was concerned that purely linguistic differences may cause the deal to fail. I felt like a character in a Lewis Carroll story and I was reminded of a passage from Through the Looking Glass: `"When I use a word," Humpty Dumpty said, in a rather scornful tone, "it means just what I choose it to mean - neither more nor less."`
In that case, we resolved the legal issues through careful structuring and we overcame the linguistic hurdles through the use of specific loss scenarios which shed light on the common ground. Ultimately the deal was struck. The gap was revealed to be an illusion.