Ask any broker or underwriter about the current state of the reinsurance market and they will regale you with stories of shortages of retrocessional capacity, deterioration in loss reserves, companies going into run-off, uncollectible reinsurance, consolidation of risk carriers and low investment returns.

Each of these issues can be a headache for management, especially in quoted companies where market values can react dramatically on release of worse than expected results. Even when management can see the light at the end of the tunnel, with improvements in rates and terms, it can be two or three years before a turn in the cycle shows through to the accounts. Shareholder value pressures are leading to an increasing focus on results at a time when low interest rates are reducing investment returns and underwriting losses are appearing following five years of soft market conditions.

So what, if anything, can companies do to manage these current market issues and protect the balance sheet from these uncertainties? In most cases, solutions can be found in a variety of finite risk policies, which rely on the time value of money to finance losses and smooth results. The following paragraphs give a simple overview of some finite solutions to today's problems.

Retrocessional capacity

Shortages of retrocessional capacity have occurred in the marine, aviation and property catastrophe markets due to high frequency of losses, which have pushed some retrocessionnaires into run off and even insolvency. Many companies are, therefore, having to retain and manage more of their business for 2000 while paying more for the cover they can purchase. These companies now face reporting a more volatile result for 2000 than they previously forecast, unless they have purchased a prospective aggregate stop loss policy. This type of finite risk policy gives protection above a given loss ratio in each of the three to five years of the policy period with additional premium payable should losses exceed a certain amount. This enables management to produce a more stable result for 2000, which is then financed over the life of the policy.

Deteriorating loss reserves

After five years of falling rates, insurers are now realising that their loss reserves may not fully reflect economic reality. Many companies face significant deterioration in their loss reserves, which has an immediate impact on their bottom line. The finite risk reinsurers' solution is to offer an adverse development cover on the company's reserves. Cover attaches at the top of current reserves protecting the company from deteriorating loss development and providing a profit commission if results are favourable.

Run-offs

As companies review the results of their portfolios over the last few years, several will come to the conclusion that there are lines of business which are unprofitable and non core to the business going forward which should be put into run off. If the company decides that it wishes to avoid future surprises on this book of business, it may purchase a loss portfolio transfer. The company pays a premium to transfer its loss reserves to a reinsurer and benefits from being able to draw a line under the results for that book of business and focus on the future. In addition, it may also gain a reduction in letter of credit obligations relating to the portfolio and a possible improvement in the profit and loss account and balance sheet if the liabilities can be removed for less than their stated value due to discounting.

Uncollectible reinsurance

Concern has been growing recently about the problem of potentially uncollectible reinsurance following some high-profile run-offs in the Australian market. However, prospective aggregate stop loss policies can be designed to include non-collectable reinsurance. This allows management to smooth out annual losses and produce more consistent results and, if experience is favourable, profit commission will be paid at the end of the policy period.

Mergers and acquisitions

Consolidation of market players has been a constant theme over the last few years. In many cases, new management may be concerned about the potential performance of some portfolios of business they have acquired. In these circumstances, comfort can be purchased in the form of a retrospective aggregate stop loss policy, which protects the business written from adverse development in the future.

Low investment returns

Insurers and reinsurers have often relied on investment income to exceed underwriting losses to produce a positive bottom line result. However, with the current low interest rate environment reducing investment returns, this is becoming more difficult to achieve. An improved performance could be achieved by purchasing a finite reinsurance policy, such as an aggregate stop loss, from an offshore reinsurer who could be willing to give a higher than risk free investment credit on the experience account balance.

Finite risk characteristics

The above examples illustrate how finite risk policies can help management run their businesses with a view to their medium to long term strategic objectives rather than a 90 or 180 day financial reporting requirement. Each finite risk policy is designed specifically to meet the individual client's needs and is put together by a team of underwriters, actuaries, accountants, tax and investment specialists. The aim is to smooth out short-term cash flows by utilising the time value of money, building up investment income and rewarding good loss experience through profit sharing. Most of these deals are highly confidential, so very few deals get into the public domain.

Companies that have recognised potential market problems and have purchased finite risk policies can achieve significant benefits for their operations at a time when capacity is getting more expensive and some coverage is not available. Finite policies give broad multi-year coverage to meet each insured's needs, giving long term stability of capacity and rates, and the cost of risk financing is decreased with good loss experience. In addition to this, current and potential liabilities can be matched against assets over an appropriate length of time, which is otherwise not always possible, particularly for Lloyd's syndicates.

Finite market

As ART products and finite risk in particular have become fashionable, the number of markets involved has expanded greatly. In the early 1990s a few specialist companies were identified with finite risk, whereas today nearly every insurance and reinsurance company has an ART team. The company, therefore, needs to be clear about its objectives in purchasing a policy and to seek out the reinsurer which best meets its needs, as each reinsurer offers something slightly different. Finite risk policies have become an essential tool in the kit of the CEO, CFO and senior underwriters who are now working more closely together to manage their portfolios, bottom line results and ratings. With increasing focus on shareholder value, this trend is set to continue for the foreseeable future.

Benefits of Bermuda

Bermuda, as an offshore financial centre, is home to a number of specialist finite risk reinsurers who have total capital and surplus of over $3 billion. As well as the attractions of sunshine and sandy beaches, Bermuda has a wealth of expertise in finite risk together with a favourable accounting and regulatory environment. The government and industry leaders designed the Insurance Act 1978 and related regulations and the industry is largely self-regulating within the act. Finite risk reinsurers can, therefore, invest in diverse assets, which can significantly increase investment returns, and discount liabilities. These features enable finite writers to provide the most efficient solutions to the issues facing their clients.

Conclusion

The reinsurance market is currently experiencing poor underwriting results, which are not expected to improve greatly next year, and it is facing hardening rates and terms at next renewal. In this environment, rewards will flow to the management teams who plan for the future, focus on profitable underwriting, bottom line results and maintaining or improving their ratings. Finite risk policies are increasingly being used as a risk management tool in conjunction with traditional reinsurance to help achieve objectives and produce more stable balance sheet results. They provide flexible solutions to the unique and increasingly complex problems that management faces and they help smooth out a bumpy ride through the insurance cycle.

  • Kirsty Gray is a principal, Stockton Representatives Ltd. E-mail: kgray@stockton-house.bm