Phil Zinkewicz assesses whether the current changes in the reinsurance market are pushing buyers towards alternative forms of risk capital, particularly for terrorism cover.

Worldwide reinsurance companies are playing hardball these days with primary insurers and self-insureds, who depend upon reinsurance to round out their protection programs. It's no surprise. For more than a decade, reinsurers have been at the mercy of buyers of their products. For more than a decade, the global insurance marketplace was so soft that reinsurers could only compete by offering low premiums and very loose contract conditions. In the last two years, that situation changed, but only slightly.

For the 2001 renewals, reinsurers readied themselves for a tough January negotiating season. As it transpired, reinsurance premiums would rise a little, but not by as much as the industry perceived was needed.

Then came September 11. All at once, the losses sustained in that tragedy, mainly by the global reinsurance industry, gave reinsurers their raison d' ĂȘtre for implementing soaring rate hikes and for restricting coverage conditions, especially in the area of terrorist insurance. In terms of reinsurance, it became a seller's market. The question remains, however, whether reinsurance buyers need bend to the demands of the reinsurance industry or whether there are alternatives.

The last hard market in the US property and casualty insurance business was in the years 1984-1985. At that time, rather than remain prisoners of an insurance industry where premiums were out of control and coverages became unavailable, buyers turned to an alternative risk transfer (ART) market. This market included captive insurance companies, finite reinsurance, securitisation and a host of other options that gave them some breathing space.

During the soft market years of recent experience, when coverages were available at bargain prices, there was little need to turn to these alternatives. But in today's hard market, reinsurance buyers may be looking to them again.

Reinsurance perspective
Kurt Karl, head of economic research for Swiss Re in New York, and Thomas Holzheu, also of Swiss Re's economic research and consulting department, put the worldwide reinsurance situation as it is today into perspective. "Even prior to September 11, the reinsurance marketplace was beginning to harden," said Mr Holzheu. "It had to happen. There were so many years of soft market conditions, which had a negative effect on earnings. In addition, low interest rates and faltering equity markets eroded industry surplus. The fall off in surplus, bit by bit, caused excess capital to turn into a capital shortage. Reinsurers realised that prices had to rise.

"After September 11, industry capital lessened even further. So now, we're in a situation in which prices are rising and demand is increasing. But it should be remembered that this hard market is necessary to keep the reinsurance industry healthy so that it will be there when a catastrophe occurs."

And, according to Mr Karl, 2001 saw more than its share of catastrophes. "According to our preliminary estimates, man-made and natural catastrophes claimed more than 33,000 lives worldwide in 2001. The direct financial loss from major events is expected to be more than $115bn, of which over $32bn will be borne by the insurance industry. The insured property and business interruption losses alone caused by the terrorist attacks of September 11 are put at $19bn. These figures do not include the indirect negative impact on the equity markets and the global economy."

Mr Karl said economic losses in 2001 were several multiples of the average annual loss over the previous decade. "The estimated death toll for the earthquake in Gujaret, India, alone was 15,000, and nearly 3,300 for the terrorist attack on the World Trade Center. At over $115bn, the economic losses are more than three times the average for the 1990s. The attack on September 11, with an estimated $90bn damage, chalked up the biggest economic loss by far, but billion-dollar losses were also caused by Code Red computer work and the explosion of a drilling platform off the coast of Brazil. Amongst the natural catastrophes, Storm Allison in the US, and earthquakes in India, El Salvador and the US, caused economic losses that ran into the billions."

So, with an industry beleaguered by such catastrophic occurrences and looking to recoup some of its losses and return to profitability, buyers of reinsurance are either going to have to pay the price or look for alternatives. Traditionally, when the reinsurance market hardens, buyers turn to alternative risk transfer vehicles.

Finite risk concepts
Andrew Barile, president and CEO of Andrew Barile Consulting in Rancho Santa Fe in San Diego, said finite risk transfer concepts are definitely being called into play now that the reinsurance industry has hardened to the extent that it has. "Finite risk transfer has been lying sleeping for a while," said Mr Barile, whose firm specialises in providing consulting services to the insurance industry and self-insureds in establishing captives, fronting companies and negotiating reinsurance arrangements.

"In a soft market, no one likes finite risk transfer because it gives the seller an advantage. Under finite risk, the seller caps the ultimate risk, unlike uncapped quota-share arrangements. But in today's traditional reinsurance marketplace, where prices are soaring, buyers are being forced to re-examine the economic benefits of finite risk transfer."

Mr Barile says that primary insurance companies that are being downgraded by ratings organisations are particularly interested in finite risk transfer. "Let's say that you have been an A-rated company but now, because of runaway losses you have accrued during years of underpricing your products in a soft market, you have been downgraded to a B+ or even a B rating. You've got to look at finite reinsurance to boost your ratings again. Finite reinsurance comes into play when you're trying to correct past underwriting mistakes."

Another alternative for reinsurance buyers, according to Barile, is to start up a reinsurance captive. "Let's say you're having trouble obtaining reinsurance for windstorms in Florida. So you start your own captive and set up a reciprocal arrangement with somebody who has established a captive to write earthquake coverage in California. You each share a portion of the other's exposure. It's also an opportunity to write retrocessions on US reinsurance companies at some of the highest prices the business has ever known. And you're coming in with no long-tail history of claims."

One of the most troubling issues of today is that reinsurers are putting terrorist attack exclusions into their policies. So serious is the problem that primary insurers in the US are lobbying the federal government to come up with some form of federal terrorist reinsurance backup program. But Mr Barile says that a captive set up to provide terrorist reinsurance might do just as well.

"The real estate industry, for example, is in trouble these days because lenders, in many cases, are reluctant to lend money to an operator that does not have terrorist coverage. It's not beyond the realm of possibility for the real estate industry to start its own captive to write terrorism insurance. The captive can charge whatever premiums it feels are justified, and then obtain a tax deduction from the IRS. There's not an IRS person in the US that would turn down a tax deduction for a terrorist reinsurance captive in these times."

Rise of captive formation
Even before September 11 captive formation appeared to be on the rise, perhaps in anticipation of the expected hard reinsurance market. In Vermont, for example, one of the few onshore captive arenas in the US, it was recently reported that 38 new captives were licensed in 2001. "There is strong activity for the first quarter of 2002," said Leonard Crouse, Vermont's director of captive insurance. "We have been extremely busy meeting with some very quality companies and we continue to see an even greater level of interest than in previous years." To date, there are some 527 captives in the state.

Mr Karl and Mr Holzhheu agreed that the ART market is being looked at afresh by reinsurance buyers in the face of soaring rates, although they said they had not seen a mad rush to date. However, they said also that most buyers would prefer to use the traditional reinsurance market with high-rated companies. Nevertheless, they allowed that reinsurance buyers might want to consider taking advantage of capital markets for particular types and levels of protection. They describe the products that exist in capital markets as:

  • Catastrophe bonds: Nearly half of insurance securitisation transactions to date have involved catastrophe bonds, popularly known as cat bonds. In a typical transaction, an SPV (special purpose vehicle) enters into a reinsurance contract with a cedent and simultaneously issues cat bonds to investors. If no loss event occurs, investors receive a return of principal and a stream of coupon payments that compensate for them for the use of their funds and their risk exposure. If, however, a pre-defined catastrophe event does occur, investors suffer a loss of interest, principal or both. These funds are transferred to the cedent, in fulfillment of the reinsurance contract.

  • Catastrophe swaps: A swap transaction is one in which a series of fixed, pre-defined payments is exchanged for a series of floating payments, the value of which depends on the occurrence of an insured event. The transaction can be structured as a swap or option, but the cash flows are the same. The cedent can enter into the swap directly with counterparties or through a financial intermediary. Swaps, by design, offer benefits over catastrophe bonds. They are simpler to implement and entail fewer fixed costs.

  • Contingent capital: Contingent capital instruments provide the buyer with the right to issue and sell securities at a fixed price for a fixed period of time if a pre-defined event occurs. These securities may be equity, debt or some hybrid. For example, an insurance company can purchase the right to issue securities to investors at a pre-negotiated price if catastrophe-related losses exceed a certain threshold. Contingent capital differs from insurance in that it does not provide indemnification. It provides access to capital that either dilutes equity or must be repaid.

  • Life securitisation: In a life securitisation transaction, an insurance company sells its rights to receive mortality and expense fees or policy acquisition expenses to an SPV. The SPV finances the purchase of these rights by issuing securities to the capital markets. There is an important difference between the life securitisation deals that have occurred to date and property casualty securitisations. In the life deals, although some risk has been transferred, the primary motive of issuers appears to be obtaining financing for new business. Cat bond transactions, by contrast, transfer risk to the capital markets.

  • Exchange-traded options: Although efforts to date to develop exchange-traded catastrophe options such as the PCS options listed on the Chicago Board of Trade have not been successful, exchange-traded instruments may eventually become a widely accepted means of transferring insurance risk to capital markets. PCS exchange-traded catastrophe call options are standardised contracts that provide the purchaser with a cash payment if an index measuring catastrophe losses exceeds a certain level, known as the strike price. If the catastrophe index remains below the strike price for the pre-specified time period, the options expire worthless and the seller keeps the premium. If, however, the catastrophe loss index exceeds the strike price, the purchaser of the option receives - and the seller provides - cash payment equal to the difference between the catastrophe index and the strike price. An insurer purchasing a catastrophe call option is hedging against the risk that large aggregate market losses, as measured by the index, will exceed the strike price.

    These then are some of the alternatives for buyers of reinsurance in the current hard market. Experts above warn that they are extremely complex and should, of course, be examined in feasibility studies and with expert consulting advice. Nevertheless, either standing alone or in combination with traditional reinsurance, they do offer buyers a variety of options.

    Phil Zinkewicz is a re/insurance journalist based in New York.