Dublin: attractions to ART providers
Favourable infrastructure, regulatory, accounting and tax environment.
• Stable political and economic climate
• Located in capital city of EU country with AAA sovereign debt rating
• Strong network of professional support services
• Close to London market
• Close to international banks located in Dublin
• No minimum solvency requirements
• Freedom in choice of investment strategy
• Flexibility in product design
• UK GAAP - Substance over form
• No regulatory valuation or admissibility rates
• Attractive taxation on corporate profits
• No specific taxation of investment income
• No capital or trade taxes
• Wide range of double tax agreement, minimising withholding taxes
• No Irish withholding taxes on interest or dividend payments out of Ireland
An examination of the implications of alternative risk transfer for reinsurers by Martin Davies and John Byrne.
Any discussion of alternative risk transfer presupposes a need or an inclination on the part of someone to transfer risk in the first place. Yet for many years the world's major reinsurers have been as much financiers as recipients of risk. Although technically a secondary market in insurance risk, reinsurers have often been called “the bankers to the insurance industry” as a result of the way that their products can operate more as a means of finance than as a simple laying off of a speculative risk position.
Why does an insurance company need capital? Unlike an industrial company where capital is largely employed in building infrastructure and in creating stock, an insurance company, like a bank, mainly needs capital to protect its solvency against a run of financial losses. The company's capital supports the promises to pay which it sells. The greater the company's capital in relation to its exposure to risk, the larger its margin for error and, therefore, the stronger and more attractive the company to customers.
Yet there is a tension between an insurer's solvency and its profitability; any conventional measure of return on capital will suffer from any excessive capital employed within the organisation. Insurers have struggled with this conundrum for centuries and a variety of capital structures have been employed.Underwriters (or Names) at Lloyd's, whether private or corporate, have only ever supplied annual capital to syndicates - each Lloyd's syndicate being legally recreated anew at the start of every year. Although satisfactorily lean and flexible from a capital efficiency point of view, this structure has left the institution vulnerable to rapid disappearance of capital. The conventional insurance company, however, has suffered from the opposite problem: capital, once paid in, is “permanent” and in a soft market cycle will either be under or badly employed.
Early insurance companies were often based on partly paid capital structures - which meant that excessive capital was not paid into the business in the early years but was available on call if needed. These structures foreshadowed many of today's “contingent capital” ART products but, again, suffered from the permanence of the capital once it was paid in.
Recent years have seen the capital markets groping for capital structures for insurance companies which strike a balance between short term and permanence. Multi-year securitisations have been reasonably successful in effectively allowing an insurer to accept risk against someone else's capital for a fixed period of time. Against a background of falling reinsurance prices, however, most insurance securitisations have tended to supply capital (usually to a special purpose company) on a single year basis. We are, however, beginning to see transactions which provide insurers with options on future capital, or capacity, in order to insulate them from the vagaries of risk.
Why not multi-year reinsurance as a means of ART? We have seen that the purpose of capital in an insurance company is to protect the company by absorbing the volatility of profits and losses which threaten its stability. If, however, the problem of volatility can be addressed within the profit and loss account, it will cease to endanger the stability of the balance sheet and there will be less need for capital. Similarly, if risk volatility can be effectively contained, outside commentators and analysts (such as stock market analysts and credit and rating agencies) will all reward the resulting stability of results and key ratios with lower borrowing costs, higher ratings and a lower expectation of conventional capital.
The significant characteristic of a multi-year reinsurance arrangement - often known as finite or alternative reinsurance - is that it is intended as a means of financing profit and loss volatility over time rather than ultimately transferring it to the reinsurer. Such a programme simply exists to smooth results over time and has sometimes been likened to the “fixed-for-floating” swap of cashflows of the capital markets in that one party accepts the unknown, floating future cashflow over an agreed period of time in return for paying a fixed cashflow.
Of course, almost all reinsurance acts to reduce volatility. For example, an insurance company over 10 years may experience a loss ratio (claims divided by premium income) on its property account ranging from 40% to 100% but with an average of 70% (as in the United Kingdom recently). The business is fundamentally profitable over time, but exposed to significant swings in isolated years. The proper role of the reinsurer is to accept this volatility and to stabilise the loss ratio of its client at around the average.
Where alternative reinsurance diverges from the conventional product is, of course, in its long term nature. An insurer buying conventional cover is exposed to the pricing vagaries of the market and, as happened in 1993-94, may find that there simply is no capacity available when he needs it. In contrast, the multi-year transaction provides the exchange of fixed for floating results over a guaranteed period of time and at a pre-agreed price. For this reason, multi-year reinsurance comes close to being a capital surrogate.
Moreover, multi-year reinsurance enjoys a number of unusual advantages over capital. The premium is usually tax deductible, the financial impact is seen on the profit and loss account, terms are usually flexible and, not least, the reinsurance counter-party is an expert and fellow participant in the insurance market.
Cash flow exchange
Not all alternative solutions are designed to smooth annual results. The same problems of result volatility can affect long term claims reserves and other aspects of an insurance company's operations. Consequently, the exchange of cashflows, which underlies all these transactions, may take the form of a single “upfront” payment by an insurer to a reinsurer in exchange for a fixed cashflow, in return, over many years (a loss portfolio transfer) or, indeed, the exact opposite (post loss funding). Regardless of the structure, the intention is clear: to re-shape the cashflows of the insurance company in the most capital-efficient manner.Clearly, almost any issue facing an insurance company could be alleviated by the injection of a large amount of capital! It is the role of the alternative reinsurance market to find more efficient ways of achieving the same - or better - results. To do this, reinsurers, themselves, require a strong balance sheet, an understanding of their clients' issues and a clear commitment to long term transactions which will genuinely benefit both parties.
What impact does the growing importance of this field have on the reinsurance market? One conclusion is that reinsurance companies need to focus more on the value which their products bring to their clients. One reason why conventional reinsurance prices appear to be in a prolonged slump may be that clients value the product less than they did.
As the insurance sector consolidates in most developed countries, the demand for annual, account specific, reinsurance has fallen. Meanwhile, the volume of alternative programmes continues to grow and increasing numbers of insurers and reinsurers have announced that they are establishing ART capabilities. The successes among these companies will focus on corporate value and the achievement of corporate objectives rather than on the short term mitigation of risk. With the arrival of cheap, commoditised capacity in the catastrophe reinsurance market by means of securitisation, providing capacity alone is no longer an option for any but the capital markets investor.
Technical expertise and a detailed command of reinsurance disciplines will continue to be critical for a successful reinsurance operation; believing that reinsurance underwriting is simple or easy has too often been a recipe for a swift disappearance from the market. In a changing world, the successful reinsurer will remain the expert in its field so that it can provide tailor made solutions. Equally, the successful reinsurer will be the one which adapts to meet the changing needs of its clients. Reinsurance can be capital but, when it is, it is a “smart” variety; a carefully structured form of capital uniquely crafted for the user.
Martin Davies is a principal in the General & Cologne Re's alternative solutions unit. Tel: (+44) 171 426 1825; John Byrne is underwriting manager, Cologne Reinsurance Company (Dublin) Ltd. Tel: (+353) 1 6702060.