Global Reinsurance co-editor Lee Coppack welcomed Warren Cabral, lead insurance partner of Appleby, Spurling & Kempe; Rob Lusardi, executive vice president and cfo of XL Capital; Dan Malloy, president and ceo of Stockton Re; Tom Heise, president of the Bermuda Commodity Exchange and our Bermuda correspondent Roger Crombie to a discussion about risk financing and risk transfer held at Waterloo House in Hamilton Bermuda.

Lee Coppack: There seem to be more conferences about securitisation than there are deals done. How do you see the relationship between insurers, reinsurers and the capital markets today? Do you ultimately see the insurers and reinsurers becoming almost a distribution arm of the capital markets?

Tom Heise: The risks that I am focusing in on the cat side have certain characteristics that require broad distribution of risk. The capital markets have not had access to participants that this can be spread among on a much larger base, which will allow for much more predictable and consistent pricing. That is not only needed - it will be beneficial to the industry - but it is not going to change what these insurers and reinsurers do.

Warren Cabral: Somebody at a primary level is still looking at the actual thing which could be knocked down by a hurricane and making evaluations which get filtered through a distribution system.

Rob Lusardi: Banks worked through the same cycle 10 years ago. You could use the same argument now. What do banks do? They basically originate loans but they package them up, sell them off and do not keep any of the risk. Are they really just a conduit for the funding or financing for their capital flows? Yes and no. They still underwrite the risks, and at some point if you do not do that properly, you cannot package up and sell off the loans.
Roger Crombie: The risks have always been there. There has always been commercial risk, financial risk, credit risk. There have always been country risks if you are an international organisation. I think what we are looking at is different industries finding different ways to underwrite that risk. The way in which you cope with it depends on what is available in the market. I think the market is shifting more than the nature of risk is shifting.

Warren Cabral: Perhaps you question - certainly at the primary level - where within an organisation will you find the person assessing the risk, whether it is going to be a banking type of person or an insurance type person. I think at the moment it is still insurance type people.

Tom Heise: They are both the same people. It is just they call them analysts versus underwriters. It is the same discipline. There may be different ways to train insurance underwriters to give them more information to allow them to do the business better, but whether you are analysing foreign currency exposure or cat exposure in Florida, the fundamental thought processes and fundamental education background are identical.
I think the foreign currency is a tremendous analogy that insurers could really understand. This market in its current form is less than 10 years old. This is a trillion dollar a day market. Yet, 10 years ago when Ford was building cars in Detroit and selling them in France and paying for parts in dollars and selling them for francs, they had a huge exposure. Now, they can hedge that.Who is taking the risk between US dollars and French francs? You have underwriters or analysts, whatever you want to call them, that along with their traders, trade these dollar contracts and franc contracts all day to make sure that Ford can lock in precisely the amount of francs they are going to get for the dollars they put into that car before they deliver the cars.

Roger Crombie: So that risk was uncovered ten years ago?

Tom Heise: Essentially. The Wall Street firms in certain private, individual deals would help, but there was no market for them to hedge in, so they did it very rarely. Now there is a market for them to hedge in.

Dan Malloy: There is a lot of discussion about insurance looking at capital markets type approaches, yet somebody who has hedged religiously all their exposures for the past 10 years, sits down and says: “Wow. I just spent a lot of money. I would have been better off if I had not hedged at all. If it had not been for these damned shareholders wanting me to explain deviations every quarter, I should not have hedged.”
Sometimes, it is like this: Maybe we should sell you a 10 year hedge rather than a one year or 30 day hedge. This gets back to what I do every day on finite risk. It is the classic case where someone looks back and says: “I have protected myself too extensively over the past five years, because the way this product is sold is that I get a chance to make a decision once a year, and the risk that I am protecting against are extremely remote, so I have to over-buy. Every year, I over-buy. I over-buy, over-buy and after five years, I think - Gosh, I should not have done all that.”

Tom Heise: Technically, there is no market for you to go in and out of during the year.

Rob Lusardi: What that basically says is that there has been no true value added in the product. Pure risk taking is a low value-added product. On the other hand, the problem is that it could ignore the true value of insurance which is spreading risks. If someone says I am willing to keep a risk myself, that is fine if there is truly no value in the product, but they are not able to get the law of large numbers to help spread the risk. They are just taking it directly.

Dan Malloy: There is the basic question: What is your tolerance for pain? What I ask people is: Try and look at it prospectively. How would you do things differently if you were left alone for five years? If you could report once every five years to your board, your shareholders and your regulators, what would you do differently, given you understand your business better than anyone else? That is where the idea comes from: I should lay off some of my exposures as a prudent businessman to the portfolio, but there are others that I should manage on my own account. I am happy to take the five year economics where I cannot manage the 90 day economics, given the unpredictability of the results.

Lee Coppack: How much of this hedging and securitisation is a result of diminished appetite for risk and volatility in the equity market? Is that what's driving it?

Tom Heise: Exactly the opposite. Most investors subscribe to the portfolio diversification theory, that the broader the diversified portfolio, the better the returns and the lower the risk. As they are presented with these new products, they look for additional risks that they can take. By doing that, they might, in their aggregate capital base, be a more efficient source of capital for insurers or any other participant to use. They tend to drive it. The insurance industry, because of its massive capital base, has not been as susceptible to the advances of the traditional investors. They have typically said: “You have got two choices: public stock or, on occasion, private stock when we form a company.” But investors have never been offered the risk itself, because it has been very profitable over time and the insurers do not want to share it.
Particular risks, be they cat that the insurers do not want, have created the first opportunity for the insurance industry to willingly provide to others some of the risk that they have wanted to keep for themselves entirely. Now that has happened, through that small opening, the representatives of these large investors tried to get other risks. So the march is on.

Rob Lusardi: I think Lee was asking a slightly different question: Whether as a car manufacturer or an aircraft manufacturer by insuring away the volatility to an insurance company, are you are really taking the volatility away from the equity investor because he wants steadier, smoother earnings? I am not sure that is the case. I think there are some risks that an equity investor really did not buy into. If he buys stock in a car manufacturer or an aircraft manufacturer, he wants the risks and rewards of that business. He does not necessarily want the risks and rewards of foreign exchange, leasing or interest rate movements. He wants to either get the profits from manufacturing a car or the losses or whatever, but there is no value to him in the volatility associated with ancillary businesses.That is the essence of the British Aerospace transaction. They manufacture aircraft, and they got into the leasing business in a backdoor way to help them sell aircraft. They took losses on the leasing business. At the end of the day, they transferred their risk over to a group of insurance companies on that business and the stock price went up tremendously because shareholders were now able to participate in their basic business, the business they wanted to own.

Warren Cabral: What is the long term effect of the transfer of the cost of that?

Rob Lusardi: Well, each company is different. In that case, the cost of the premium for the insurance policy was nominal relative to the loss the shareholders had actually borne in the past. If what you are saying is over time - are there friction costs or is it worth the transfer of these risks either to a group of banks, insurance companies or the capital markets . . .

Warren Cabral: The natural implication of the smoothing is that you actually bring down the overall.

Rob Lusardi: In principle. It is like option theory. You are taking out the peaks and the valleys and you get a steadier stream of earnings.Warren Cabral: You are achieving a mean but not necessarily a higher average.

Tom Heise: Oh, no. You get the higher average by taking a group of means in different categories and putting them together.

Dan Malloy: You are saying the average purchaser of a stock would rather . . .

Rob Lusardi: . . . would rather buy that company's basic business and see a steady flow of earnings. That is why the whole concept of enterprise risk is coming into play, because a cfo or ceo really does not care why his earnings stream is interrupted, whether it was a liability catastrophe, property or some form of financial problem. He would rather just not have the issue to begin with. That is slightly different from getting out of a business that is ancillary and transferring that risk.

Dan Malloy: I have found that most people value stability and predictability only on a relative basis, in terms of how they are being evaluated by the market on a day to day basis as part of a peer group, typically. The cost of absolute stability and predictability probably gets you back to risk-free in some near perfect world, and if they want to make that investment, they buy US bonds.

Rob Lusardi: Although if you look at pure options theory, a company that has more volatile earnings but ends up at the same place is, in theory, worth more than one that got there in a very steady fashion, because there is a chance that you will have a huge peak relative to the company that is steady. But that is theory, and the practice is very different.

Dan Malloy: Few people's constitutions bear that out.

Tom Heise: The idea of valuing a business is labour applied over time, so what you would like to do is allow the business to make its money by applying labour over time and take out all these other elements of risk that are unrelated to the business that it is in. If you can keep the rest of the business essentially risk free, and allow it to create the value by applying the labour over time for whatever it is doing, then you have a very efficient means for investors to get the value that they are looking for, whether it is from British Aerospace or from Ford - or from an insurance company.
That is, I think, the biggest thing for investors to do, particularly with cat risk. An insurance company has a very difficult time providing the capital necessary to support the needs of being able to pay for cat risk relative to taking it. If you can separate that away from the insurance company and give it to investors who really want it, then the insurance companies can focus on businesses where their underwriting and their skills can add a lot more value and take away, essentially the volatility that is totally outside their control and requires a huge amount of capital to sit essentially idle in the potential of this event happening.That is where the value can come from bringing in these investors, which the investors want because of the diversification. They can own the risk without owning the company, and owning the company can have risks other than what it does. The business can be doing just fine, but the value of the shares can drop for reasons that are wholly unrelated. For an investor to be subject to risks like that in addition to what the company is doing, cannot be very useful.

Roger Crombie: Somebody said earlier this week: “It is not about risk; It is about price.” If you say to a businessman: “I will relieve you of all your risks except the pure business risk of whatever it is you do for a living,” of course, he is going to want that - at the right price. At the wrong price, he would rather take his own risks.

Tom Heise: But there are two components to the price. There is the cost of assessment and accumulating the risk, and the cost of the capital that has to be available for the risk.

Rob Lusardi: What I find interesting is that the cat bond market is actually less efficient in terms of pricing than the reinsurance market. The largest part of the market were people who are basically taking the bet that there would not be a loss and that the return versus the probability of loss was much higher than any other type of fixed income instrument they could buy.

Warren Cabral: The Warren Buffet model.

Rob Lusardi: Or the hedge funds. Now that liquidity has dried up, the hedge funds are gone from the market. The cat bond market has not dried up, but it is probably half the size it was a year ago. My big fear is that there is an event - the one in a 100 year event - and the market dries up, even though people were paid 400 basis points above LIBOR and on average in 99 years out of 100, they are going to make a fortune investing in this type of security.
If you look at other asset classes that have been securitised, whether it is credit cards or mortgages, you really do not have the risk of loss of principal that you have in this particular end of the insurance market. Ideally, the other end of the insurance market should be securitised - the workers' comp, the auto physical damage. I find it interesting that it is this end that has been developed, and there are two arguments why it has. One is that, as Tom was saying, it is more efficient to have lots of investors taking the hurricane risk than it is for one or two companies. The other reason is that the returns were there and the marginal investor, the hedge fund, was buying that risk.

Dan Malloy: Maybe the capital market was falling into the same trap as the insurance market. The insurance market runs from losses. You get burned in one area; you move up to another area. You say: “Well, I got burned on the first layer, so the top layer probably looks better for me, and 99 times out of 100, I am actually going to be right. Even if I am wrong, I actually have a chance to escape.”
Getting back to the efficiency of capital, holding workers' comp reserves on your balance sheet in an undiscounted basis is just a horrible thing to do as a US insurance company. They should be selling those off via reinsurance or securitisation to really make themselves more efficient.

Warren Cabral: And free up for additional underwriting.

Dan Malloy: Right. Free up for additional underwriting or free up for catastrophic reserves. One of our brethren on the island is quoted a year ago in one these roundtables as saying that opportunities for price discovery in the property cat market are few and unpleasant.

Tom Heise: There is price discovery because there are not multiple buyers and multiple sellers. The explanation why in this current environment the cat bond market will never be more efficient than reinsurance is that reinsurance has multiple buyers and sellers, which make a market and create opportunity for price discovery. However, the one time profitability for bankers, brokers and lawyers of cat bonds is far in excess than it is for products which are standardised. Without standardisation you are not going to have multiple buyers and sellers and you are not going to have any price competition.

Warren Cabral: It gets back to the risk assessment on a standardised product - the difficulties of risk assessment on a standardised product versus a special cat bond or whatever.

Tom Heise: They are the same to the extent that the products aredealing with models or indices. However, with the bond, every one is different. With the standardised product, you go through the difficult process once, and then you can replicate it without any additional cost. With the other product, it stays at 100%. Without that replication, you are not going to have the repetition of the multiple buyers and sellers and have a competitive price. That drive towards those bonds and one-off type deals is what kept this market from being anything other than new distributors of traditional insurance products. It does not get any of the efficiency of the capital market involved.

Lee Coppack: So why are people not securitising workers' comp?

Rob Lusardi: The only answer I can think of right now is that it is more profitable for insurers to keep the risk. Plain and simple. Ultimately, I do not think that will be the case. Wall Street is spending a lot of money trying to securitise everything that moves. The last great frontier appears to be the insurance industry. I have a quasi cynical view, since I helped lead this effort back when I was at Lehman, which is if Wall Street has enough people spending enough time and enough money to create a market, it is going to be created.

Dan Malloy: You can will it into existence. Rob, you raise a good point. The capital markets are forcing macro changes. The insurance market does not exist in its own bubble. It is part of a larger financial market. The demutalisation of the life insurance companies and the corresponding restructuring of their balance sheets with the wholesale sell off of blocks of business to offshore reinsurers is a securitisation effectively. They are recognising today the value that would emerge over 10 or 20 years and locking it in with a structured reinsurance transaction with someone sitting in Bermuda, for instance, who is able through a different accounting and, dare I say, regulatory regime, to carry on their balance sheet those same reserves more effectively than the onshore taxed, regulated and overseen insurer.

Warren Cabral: A UK life insurer did exactly the structure you just described into a Guernsey reinsurer.

Roger Crombie: Someone made the point that it is the insurance companies that will always end up taking the risk, because that is their business. Capital markets are not interested in risk.

Tom Heise: No, they are insurance companies for the stock market, for the energy market, for the agricultural market, for the banking industry.

Roger Crombie: So they are looking to package the thing and lay it off to you.

Tom Heise: The investors are the insurers. They are the insurance industry for the other two thirds of the GNP of the world. That is the connection that is not being made. In the ones that are easy to securitise, the insurance industry has said: “No, it is profitable. We are keeping it.”

Dan Malloy: Wholesale defaults of reinsurers' obligations to clients was one of the significant parts of the process of the market tightening in the mid 1980s. The idea of setting up companies with very, very significant amounts of capital was a way of reassuring customers that they should be insuring these exposures again with credit worthy and stable markets. When you look at the whole Bermuda phenomenon, ACE, XL and later CentreRe, the idea of an insurance company actually holding what it wrote for its own account and managing risk through the use of judicious and intelligent policy wordings and underwriting was pretty revolutionary when these companies started up. Once they were successful beyond probably the market's initial wildest imagination, everyone decided that was the risk they wanted to take as well. Everybody then moves on and suddenly this huge amount of capital becomes almost a millstone.

Rob Lusardi: It gives us other opportunities.

Dan Malloy: Right. But you cannot stand there and fight in the trenches with that capital base in that same line of business, because it has spawned a lot of imitators and a lot of wannabes.

Tom Heise: But the standardisation gives certain disciplines. Risk quantification will hopefully prevent the type of aggregations that occurred in the 1970s and 1980s in the reinsurance market. It will not allow the massive defaults to occur. There is no element or fundamental theoretical difference between what was done in the 1970s and 1980s and what we are doing in the 1990s and the next decade. It is just applying some of the disciplines and slightly changing the structure and form of the contracts to allow that to occur, but fundamentally there is no difference.

Dan Malloy: For a really catastrophic event - one in a 100 is not even the right number, but maybe one in 250 or one in 500 year events - there are probably very few people you want to take a promise to pay for the second or third one. As recently as 1992 and 1993, the unthinkable occurred: Andrew, Northridge, Iniki. The world was not prepared for that. I know the attention span of the market does not seem to extend back 10 or 15 years back to experiences learned but we are now talking only five or six years.

Rob Lusardi: I think one of the reasons, as an example, that USAA did do a cat bond is because they did remember back. One benefit you get out of a cat bond or risk securitisation is that pool of capital is yours, and you do not have to worry about it having been leveraged or whatever, the insurer route. That is also one reason why it is very inefficient. It is not efficient to use a dollar of capital and segment it for one risk.

Dan Malloy: That's the beauty of an insurer. Leverage and judicious application of the portfolio or, I guess, in the broader markets, margin.

Lee Coppack: It worries me that people are so anxious to say cat events are uncorrelated with other asset classes. In the UK, we had a huge hurricane and Black Monday in 1987 within a few days of each other. That may have been happenstance, but if you had a major disaster in the UK that wiped out a lot of businesses, it would have an impact on the banks because loans would not be repaid. How do you see that?

Rob Lusardi: In theory, it is hard to figure out what the correlation would be between a Miami hurricane and a risk in the UK, as an example, but this is one thing at XL we look at. What are the correlations you did not think of in the past? What is the correlation on the asset side of your balance sheet? What bonds would be wiped out if there was a hurricane or an earthquake somewhere? What would your equity portfolio drop to if the economy of a certain country got wiped out for two or three years as they were rebuilding?

Dan Malloy: Or if inflation picked up for some reason.

Rob Lusardi: But the probability of the event occurring is what people are saying is uncorrelated. The probability of a hurricane is completely independent of the probability of other insured risks. If it was a large enough event, like an earthquake the wiped out the western half of the United States, then you could go down a chain of thought that - the US government would just have to spend money to rebuild and, therefore, it would be borrowing more and it could raise interest rates, and, therefore, the value of bonds would go down. If you bought a cat bond, in theory you could lose on the cat bond and you could lose on your other bonds, so they are correlated, but it would take a very dramatic event, given the size of fixed income markets and currency markets.

Tom Heise: The weather catastrophes we are talking about are random. The events that would lead to financial despair in equity or fixed income markets are not random. The convergence of the most unlikely event that can be calculated combined with the most unlikely event which cannot be calculated is possible. That is why if somebody says there is zero correlation, it is incorrect. It is very close to zero but you cannot identify it. Nobody knows when earthquakes or hurricanes are going to happen. That, in and of itself, is extremely valuable, because you know that if interest rates go down, we know it will have a negative impact on equity markets in a certain way, but it will cause no hurricanes or earthquakes. That direction is what most people focus on.

Warren Cabral: What then is the role of modelling and who has got it right? Everybody you read about has a different model.

Rob Lusardi: Modelling has become more sophisticated - value at risk and general financial models. The problem is that it is so sophisticated that everyone has the same models, so the model says if a 10 standard deviation event occurs, you simply sell, and what happened in October was that everyone's model said the same thing and everyone sold. You got the dollar dropping by 20% in two days, because everyone's model and everything was inter-related.

Warren Cabral: A self-fulfilling prophesy.

Rob Lusardi: Right. It is just like portfolio insurance back in 1987. It worked on the model and everyone hit the window at the same time.

Tom Heise: What is interesting about that precise example, coming back to the margin, is that in the equity option market in Chicago, the way they margined equity options was not sufficient to deal with that circumstance. That was almost a catastrophic situation for that market and for the clearing entity that cleared all those transactions. Luckily, people stopped pushing the sell button.

The clearing firms were looking to clearing houses who were looking to the traders, and the securities that were pledged were not sufficiently liquid or sufficiently there to deal with people keeping their finger on the sell button. That is why I am so sensitive to this clearing issue, having lived through that equity option crisis of 1987. We will not have the benefit of being able to tell God or whoever controls hurricanes to stop blowing the wind, like we get the Fed to tell some of the big firms to stop pushing the sell button.

Roger Crombie: Conversely, the market would do well to have a couple of major events - soon.

Dan Malloy: We are in an interesting time where people are sailing close to the wind by their own admission. The industry is in the pain phase where people do not have much ability to manage their own results through releasing back year reserves. You get a little hurricane like Georges which hits Puerto Rico, which is the classic case where everybody has models but the models did not work that well. The nature of the losses as they emerged from Georges did not follow the patterns that people would expect, so you have people that bought industry loss covers that would be triggered at a $5 billion event suddenly having losses much larger due to the nature of insurance practices and the development of Puerto Rico.People have much larger net losses from Georges than they would have had if a loss two or three times greater had hit the mainland. There is still some variability in this whole process. Again, there will be winners and losers out of that. Some people will have benefited from their thoughtfulness in doing it, and we will also see pockets of unpleasant surprises emerging quarter after quarter, as people say: “Well, it happened to me.”

Warren Cabral: Perhaps it is a leading question, but who are the survivors or who are likely to be the survivors?

Rob Lusardi: Capital markets will be one. If, for whatever reason, reinsurance companies or a large portion of them simply go out of business, whether it is a large event or whatever, we have seen that Wall St can recapitalise these companies very, very quickly. If there is a natural demand, which there always will be for insurance in one form or another, I hate to say this but it almost does not matter. If there are no survivors, new companies will be created very, very quickly.

Warren Cabral: Out of the ashes.

Tom Heise: It is just a matter of how it is created. Is it going to come in through private equity or is it going to come into the commodity markets? It is just a little cheaper and a little quicker to use the commodity markets. It is what the agriculture, energy and banking industries use. Every time a bank goes under, they do not run around and capitalise new banks. Another bank goes into the capital market and gets sufficient capital to make up for the lending which that bank no longer can provide. If 1992 reoccurred, I would suspect that instead of all the private equity coming out and forming companies, the capital would re-emerge either through existing entities or through new entities that did not require private equity.

Rob Lusardi: There was a point probably from 1987-90 when it was very difficult to capitalise a reinsurer. The window was really closed for new reinsurers at that point. Since then, it is more and more rapid. In fact, one of the things that I worry about now is that I see a number of companies that are basically insurance or reinsurance business plans that are going public.

Dan Malloy: Actually, they will trade at more attractive valuations if they do not have any business!

Roger Crombie: This is something I do not understand. We are awash in capital and yet Warren is incorporating big, new companies as fast as he can get the documents into the registrar. What are the new insurers seeing that the old insurers are unable to see and are, therefore, returning capital to their shareholders?

Rob Lusardi: I think there was a difference in the last go-around. In the mid-1980s, capital was being raised to meet a need and the need was capacity in property cat. You could not get liability capacity. You could not get financial guarantee capacity. It was just a whole series of capacity shortages that had to do with past issues that the insurance companies had to solve. In this go-around, it is trying to be more efficient. Maybe someone has a better idea or think they have a better idea, and Bermuda is a good place to implement that idea for regulatory and other reasons.

Tom Heise: There is $200 billion of venture capital out there looking for a home, so guess what? You have a good idea and a decent track record, a couple hundred million can be yours.

Rob Lusardi: That's right.

Lee Coppack: In future will there be much more fluidity among the players in the insurance and reinsurance market? Will people come in and leave?

Tom Heise: It is just the opposite. There may be different people, and they may be in different places, but when the rate justifies the capital, the capital will be there. When the rate does not justify the capital, the capital will go elsewhere, so there will never be a point where there is a need for insurance at a good rate and there is not money for the companies to capitalise themselves to write it. That is what this combination of capital markets and insurance will produce.

Rob Lusardi: If there ever is a case where the capital will not flow for whatever reason and there is still a need for the insurance, then that will be solved through self-insurance, risk retention groups, setting up the next ACE or XL of the world.

Dan Malloy: Fifty like minded companies get together and each chip in $10 million.

Lee Coppack: The idea traditionally is that with professional reinsurers you were dealing with the Munich Re, the Swiss Re year after year. You seem to be suggesting it may look different.

Rob Lusardi: It will look different on the margin. The Munich Re and the Swiss Re will clearly always be there. There have been a couple of large, new reinsurers who have a large enough capital base to give a sense of comfort or belief that they will be around years from now to pay up when the claims come through. The issue that we are discussing is what happens with the smaller, mid sized or new companies.

Dan Malloy: There are a number of companies out there with $500 million or below that are solutions in search of problems, right now. The business plan that they set up to execute does not seem to be able to produce the kind of returns that the market is expecting in the long run.

Roger Crombie: Is there not a back up with you, for example? If there is a pool of capital out there that is not performing as well as it might, that this might interest you for your growth purposes?

Rob Lusardi: If the pool of capital is not yielding an attractive re