George Sandars and Stephen McGlennan review today's market for blended products, concluding that, this time, blended products may be here to stay

The concept of 'blended products' is rather like sex - every generation believes they invented it, but in fact it's been going on for a while.Experience shows that at the end of every hard market, as supply of traditional capital begins to exceed demand, groups of creative individuals throughout the insurance industry begin to seek ways of attracting new and more profitable business.In the 1970s, 1980s and 1990s, providers of these non-traditional lines had, at best, mixed results. Legal complications and a lack of understanding of the core competencies necessary to write such products led to some disastrous results. As evidence of this, one need only think of the experience of providers of residual value cover or reinsurance-backed film finance.And yet, once more, blended products are increasingly in prominence.

What are blended products?Insurance practitioners are guiltier than most of using jargon and buzzwords, often in a vague and loose way. The term 'blended products' is certainly one that is susceptible to this sort of usage. To complicate matters, there is a wide variety of broadly synonymous terms used interchangeably with blended products, including 'integrated risk cover', 'cross-class programs' and, generically, 'ART'. To further complicate the issue, the term blended products has at least two special meanings in distinct but related markets - life and non-life. For present purposes, however, it means a risk coverage package mixing re/insurance with other risk management techniques more associated with investment banking and capital markets.The package is tailored to include risks that are covered by conventional insurance policies and extends to include products designed to achieve such results as earnings smoothing, managing speculative risks, currency and interest rate hedging, deal facilitation and removal of specific balance sheet provisions.Financial support for these packages can be drawn from traditional re/insurance markets, as well as from commercial banks, swap markets, listed and non-listed debt markets, and private equity and institutional investors.

Blended productsThe major integrated financial institutions historically have been seen as the natural providers of blended products. These groups incorporate wholly-owned authorised insurance and reinsurance providers, and have the critical mass necessary to write the re/insurance elements of these contracts. They also have subsidiaries that are authorised to lend money or provide financial instruments. Perhaps most important of all, they have specialist teams dedicated to marketing to major international corporations and to executing the transactions.The relatively recent emergence of the Bermuda-based insurers and the massive capital investment into that market since the late 1990s have created a second group of suppliers of blended products. And Bermuda is a more fluid market where both insurers and regulators appear, in a conducive regulatory environment, to have reacted more responsively to the breakdown of the distinction between traditional re/insurance and other financial products.There is a significant concentration from the Bermudians on 'finite' products - a concept that seems easy enough to grasp until it is examined in more detail. In a sense, most insurance and reinsurance products are finite, with many carrying upper limits on liability. To successfully distinguish a finite product is difficult, since it carries with it a stronger flavour of a limited transfer of risk combined with risk financing on a multi-year, multi-line basis.Where the suitability of a finite solution is being discussed, the risks that remain with the insured are naturally highlighted. The question is, then, how to cover those risks, and this makes a natural point of entry for a sales person with a blended offering.In this connection, it is worth mentioning the interest being shown in participation at Lloyd's of London by both major established Bermudians and newer players. The rating enjoyed by Lloyd's ('A' from Standard & Poor's) is an obvious attraction, but of equal importance is the size and nature of opportunities within Lloyd's.A third market for blended products has been established by the major brokers. Increasingly, brokers have specialist teams established to give full service to clients with significant risk management requirements.These teams offer and place a range of alternative risk transfer (ART) solutions. Crucially, where blended products are offered, these teams are increasingly capable of liaising with both conventional capital and conventional insurance providers to put together multi-principal blended deals. For this purpose the major brokers employ individuals with a wide variety of skills and qualifications including deal arrangers and people who are qualified under the UK Financial Services and Markets Act to advise on capital markets instruments such as derivatives as well as insurance.Regulation and reporting have always proved difficult for parties entering into blended arrangements, due to their unconventional and multidisciplinary nature. Until recently, the UK regulated the insurance industry as a separate and distinct entity, with the Insurance Companies Act providing a regime solely for companies carrying out contracts of insurance. This polarisation of regulation was reflected in the financial institutions themselves which tended to be providers of insurance products or non-insurance banking-related products with no overlap.The same split was evident within the consumer organisations. Risk managers (often reporting into the operational/commercial director) were responsible for anything classified as 'insurance'. On the other hand, financial controllers and treasury officers (reporting into the FD/CFO channel) were responsible for currency, interest rate and other financial hedging operations.Blended products are notoriously difficult to document and this brings with it expense. Pure insurance solutions for complicated insurance risks can be documented much more easily and cheaply because of long-established market practices and (admittedly often inadequate) standard documentation.Difficulties in dealing with the 'legals' can, of course, be overcome.But where deal size is small or even medium sized, the economics can become unworkable.Commercially, the key factor that restricted the success of blended products was a lack of understanding of the product at the core. Who, if anyone (least of all financial institutions), had any idea of the value of a jumbo jet ten years after a residual value policy was written? And what was it about an unspecified slate of films that led insurers to believe they had successfully calculated the risk of financial underperformance?

Plus ca change?In recent years perhaps the key market factor affecting financial institutions is convergence - the breaking down of the traditional distinction between insurance and other financial products. It is different aspects of this factor that indicate that blended products are here to stay.The most concrete example of convergence is the emergence of massive financial groups, including the bancassurers, offering the full range of financial products across retail and business sectors. These groups have the size and international reach to provide 'best in class' products and services that can be brought together to form a competitive blended product. Convergence has also combined with the pressures of globalisation to create bigger clients with bigger risk portfolios that consequently offer better opportunities for the implementation of blended solutions.Convergence is likewise evident in legal and regulatory matters. The Financial Services Authority (FSA) was created by The Financial Services and Markets Act 2000 to regulate not merely insurance, but also investment business, deposit taking and any other financial businesses operating in the UK. This unitary approach is beginning to allow real regulatory harmonisation across the different financial services sectors that was simply not possible under the previous diverse regulatory regimes.This convergence at regulatory level is helping to overcome one of the traditional blockages to building a successful blended products business.Personnel right across the transaction process, from client to supplier to regulator, are developing common skills and a common regulatory language that makes it easier to switch from thinking purely about insurance into the wider possibilities for risk management.

Dark clouds on the horizon?Over the past couple of years, the international markets have had to deal with Enron, WorldCom and Parmalat, and these scandals may have a negative impact on the blended products market. Publicly quoted corporates in particular have become weary of structured products, and this may make them to some degree less receptive to blended products. On closer examination, however, there is nothing inherently open to abuse in blended products and their proponents will simply have to work harder to dispel any misconception to the contrary.Nevertheless, blended products have gained a firm foothold in the market and are here to stay. The less certain fate of other alternative products with less or no connection to traditional insurance should not lead us to believe otherwise.George Sandars is a partner and Stephen McGlennan is a solicitor with London-based law firm Denton Wilde Sapte. Both are non-contentious insurance specialists.