Lloyd's enjoys many advantages which would enable it to exploit the burgeoning alternative risk transfer (ART) market, according to Richard Spiller. However, it must first overcome significant regulatory hurdles.
A report to Lloyd's Market Board (LMB) earlier this year, which was circulated to the market, analysed the opportunities and threats posed to the market by alternative risk transfer (ART) mechanisms. The focus of future development work is likely to be on those ART products which present particular opportunites for Lloyd's: finite risk and insurance securitisation. Market participants have been invited to register interest in those aspects of ART which they believe may offer realistic commercial prospects.
In relation to finite products, the report points out that the market's general perception - that the annual venture prevents it from writing multi-year products - is misconceived. Lloyd's has for many years underwritten such contracts and has, for example, a significant presence in the construction risks market.
The writer's own experience is that, while the principle of equity between Names in different years of account imposes some problems in relation to both inwards and outwards contracts, they are rarely insurmountable. Moreover, despite the market's view to the contrary, the ability to bind future syndicate years, is supported by legal precedent: see The Zephyr (1984).
However, the fragmented, subscription-market nature of Lloyd's places a number of commercial barriers to writing such contracts:
* The often lengthy development period for ART products, coupled with a significant failure rate, often after considerable investment.
* The need for underwriting skills to be teamed with the skills of actuaries, accountants and lawyers.
* The need to tie up substantial capital for a long period to support a single contract.
An additional issue is that many of Lloyd's new corporate capital providers, such as Ace and XL, already have ART capability and enjoy a more beneficial tax regime, important where investment income on premium is a major factor in determining limits.
The report suggests that a number of possibilities could be investigated to overcome these problems. They include:
* Consortium arrangements.
* Formation of a shared offshore vehicles.
* Permitting reinsurance between related parties.
As regards insurance securitisation, the report makes the point that the nature of these products bears a strong resemblance to what Lloyd's has always done: assembling and pricing risks for third party capital providers, in this case capital market institutions. To date the capital markets have not been tapped as a source of underwriting capital, although gearing reinsurance contracts have a number of similar features. Several insurance companies, much more highly capitalised than Lloyd's, have undertaken insurance securitisation issues, for example the St Paul Companies, Hannover Re and Tokio Marine and Fire, although most issues to date have involved the lay-off of catastrophe risk.
There are significant regulatory hurdles at Lloyd's to laying-off insurance risk through securitisation. The special purpose vehicles established in the above and other securitisation issues have carried investment-grade ratings for some classes of their securities.
A high claims-paying rating to satisfy Lloyd's risk based capital requirements would be necessary but could, presumably, be obtained through establishing a reusable offshore vehicle (perhaps a market vehicle) or through interposing a highly rated reinsurer, as happened with the Tokio earthquake bond issue.
A reusable vehicle, which could be created through the use of a protected cell company or through limiting the trust funds available to meet particular classes of claim, would have the additional benefit of progressively reducing transactional costs, which can otherwise be prohibitively high in the case of smaller issues.
Regulatory issues which the report specifically flags as requiring consideration include:
* Permitting capital to be provided as business is transacted.
* Reducing risk based capital requirements where there is limited risk transfer.
* Reducing the central fund levy for "bankruptcy remote" vehicles.
The size and importance of the ART market is such that Lloyd's cannot afford to ignore it. The market's tradition of innovation and the strength of its distribution channels suit it well to the development of some types of ART product and insurance securitisation in particular. The regulatory and commercial barriers to doing so should be high on Lloyd's list of considerations.
Richard Spiller is a partner in the insurance department of City solicitors D J Freeman. His article originally appeared in D J Freeman's quarterly Insurance Review. Tel: +44 (0) 171 583 4055. Fax: +44 (0) 353 7377.