Dr Alan Punter has done his homework on the London market - and offers some answers on competitiveness, convergence and the future.

Question 1: The London insurance market's history has been built on a reputation for innovation. Will this be equally true for the future? Discuss.

The two key words here are “market” and “innovation”. London is still unique in the world for the nature of the insurance business transacted - the key characteristic is that it is an international market. It is the pre-eminent centre for international business, as demonstrated by the non-UK insurance and reinsurance companies who have underwriting operations in London and have taken a financial stake and/or physical presence in the City.

London is also unlike any other international centre for insurance in that it is truly a market - with many providers of a wide range of products. Unlike many other centres around the world where insurance is transacted, it is not dominated by one or two domestic carriers. And it is well served by a diverse group of brokers; local, national, international and global - bringing both new clients and new products to market.

In addition to innovation, the London market has also displayed resilience. For instance, just take the 1990s. Looking back at the challenges and obstacles that had to be overcome, the success of the whole Lloyd's reconstruction and renewal (R&R) is almost beyond belief. Bermuda took advantage of the market conditions following Hurricane Andrew in 1992 to build a very significant presence in the property catastrophe market, but London is now increasing its market share, mostly at the expense of Bermuda.

However, the record on innovation has looked less impressive in recent times - perhaps precisely because of the other issues that the London market has had to address. London's record for innovation has been largely in developing and extending traditional insurance products. It has not been in the forefront of developments in so-called alternative risk financing or alternative risk transfer (ART) where ground has been lost to other centres, such as offshore centres like Bermuda. Bermuda has two primary benefits. First, it is a tax-friendly environment in which to domicile capital, and secondly, the definition of what can be included in a contract of insurance is less restrictive than in most onshore centres.

Lloyd's has begun to address this issue, with the establishment of an ART unit, and the development of “the capability to offer alternative risk transfer products and techniques” as one of the strategies adopted in Lloyd's recently published Priorities for Growth as part of broadening the franchise. This also supports the objective of the Lloyd's market board's for: “the London's market position to become even more firmly established as the world's leading centre for underwriting specialised risks” as part of a world market for risk solutions.

Part of the key here is to provide customised solutions and not just sell standard products. This raises the requirements and presents challenges, not just to underwriters, but also to capital providers and capital regulators. The London market shows signs that these lessons have been noted and are being addressed.

Question 2: There is much talk of convergence within the financial services sectors, in particular between the insurance and capital markets. What real evidence is there that this is actually happening?

Convergence has been most tangible in the personal lines sector, in particular with banks and building societies distributing household and motor covers. In the world of corporate property/casualty insurances, the capital markets and insurance industry have long worked together. However, these activities have covered traditional corporate finance and asset management functions. What has been a new development over the last five years or so has been capital market players and investors exposing their capital directly to underwriting risk, rather than indirectly through taking a shareholding in an insurance or reinsurance company.Over recent years the number and types of insurance-linked securitisation transactions have grown steadily. Completed deals include structures such as catastrophe bonds, where principle and/or interest payments are contingent upon the occurrence of a specified catastrophe insurance loss; contingent capital, such as catastrophe equity puts or CatEPuts; swaps and options. All these deals demonstrate innovation and creativity.

To date the underlying perils covered have been largely restricted to natural catastrophes and their impact on property exposures, and most deals have provided protection to insurance companies in place of, or in addition to, traditional reinsurance. However, the time periods vary from a few months to upwards of seven years. The basis of cover has also varied from deal to deal, ranging from a traditional ultimate net loss indemnity through to purely index-based covers.One of the most recent deals has been the structure placed for Allianz, which can be best described as an option on a catastrophe bond. In the event Allianz suffers a catastrophic loss, it has the option to issue a catastrophe bond, for which the terms and buyers have already been secured. The value to Allianz of having the option is that if conventional reinsurance is also available at the time on competitive terms, then Allianz can decide to purchase a traditional reinsurance programme instead. Therefore, Allianz has succeeded in setting a cap on its reinsurance programme costs, and given notice to the conventional market that it cannot react too strongly to any future catastrophe losses and still maintain its client base - the capital markets will be waiting on the sidelines ready to come on to the field of play.

This deal also illustrates one important consequence for the insurance industry of convergence with the capital markets. The insurance industry does not currently appear to have any shortage of capital, as evidenced by the continuing soft market conditions, acquisitions by insurers and reinsurers seeking premium to feed their capital base and the recent special dividend proposed by Royal & SunAlliance to give some capital back to its shareholders. Therefore, the need for risk capital from the capital markets is currently lower than it was back in 1992 and shortly thereafter.

However, the “technology” for bringing capital from non-traditional sources directly to bear on underwriting risk has now been proven and cannot be reversed. The capital markets, therefore, provide a sort of glass ceiling which will inhibit any significant hardening of rates in the traditional insurance market. Investors in catastrophe bonds include institutional investors such as pension funds, money managers and hedge funds, as well as life insurers adding to their bond portfolios.

The major area of development in alternative insurance products or corporates is the increasing availability of multi-line, multi-year policies, which are sometimes also referred to as blended or integrated risk coverages. Starting from the premise that it is more efficient to protect a combined portfolio of risks rather than to protect each risk separately, major insurers have developed programmes providing multi-line, multi-year coverage, usually on some form of aggregate basis. The truly non-traditional aspect of some of these programmes comes where one or more traditionally non-insurable risks have also been introduced into the portfolio. These new exposures can include financial risks, such as fluctuations in foreign exchange rates, interest rates and commodity prices.

A variant on integrated risk in a reinsurance context is a double-trigger approach. Two such deals are those on behalf of the CLM Insurance Fund and the California State Automobile Association (CSAA). The CLM policy responds if it suffers from both adverse underwriting results and a significant fall in the stockmarket index. Similarly the CSAA reinsurance protects against the occurrence of a major catastrophe and any fall in a specified equity index below the level pertaining at the start of the contract.

Advances in financial and statistical risk modelling that underpin the modelling of an insurance company's full operations, including underwriting and investment (often referred to as dynamic financial analysis models), greatly assist the development of such covers, which provide full balance sheet protection for assets and liabilities, These approaches demonstrate a very close and intimate convergence between insurance and capital markets.

Question 3: Will the insurance industry, during this process of convergence, lose out to the banks and other financial institutions?

Rather than being side-lined, the challenge for the insurance industry is to restructure and re-segment its activities. Outsourcing of non-core services is a growing trend across all industries. Insurance companies may have to decide what their core competencies really are - underwriting, claims handling or investment management - and specialise accordingly. We have already seen the growth of companies providing services to the insurance industry, and some of the larger insurance and reinsurance companies are giving priority to developing their asset management operations (an area where there seems to be potential for economies of scale).

The implication is that the two key words are focus and efficiency. Size assists, but a clear focus on areas of competency and specialisation and an efficiency in management of capital and quality delivery of service are all essential to survive and prosper in today's market.

Dr Alan Punter is the executive director of Aon Capital Markets.