Terence Wheatley discusses transactions that are taking place at the cutting edge of finance and insurance.
The recent volatility in world financial markets and the constant drive to develop ever more efficient and transparent financial structures has prompted many corporations to actively seek additional sources of capital. Often this search is directed at sources previously considered non-traditional, such as insurance and reinsurance companies. Following the recent round of “mega” mergers between insurance companies and financial institutions, those companies with the appropriate combination of (re)insurance balance sheets and financial expertise are finding creative ways to provide capital to a wide variety of companies, both public and private, in the form of insurance-based solutions.
In an extremely tight or volatile credit market such as we have experienced recently, companies need to find alternative sources of funding for major asset financing. Credit enhancement allows a company or individual project with sub investment grade credit risk to borrow at enhanced lending rates through the use of a credit-worthy guarantor. The guarantor issues a surety bond as a form of insurance, on behalf of the borrower, guaranteeing the amortisation schedule of the lender.
Although there are a number of well known companies that provide credit enhancement, as market volatility increases a company may find it difficult to access sufficient financing. An insurer that is prepared to take on higher risk can then play a meaningful part in providing the support required at a difficult time. The bond provider is often able to accept forms of collateral not acceptable to traditional lending institutions, which is often a critical component of these types of transactions.
Compensation for the insurance company may be in the form of premium payments, participation in the future economic success of the borrower or some combination of these. In many cases the provision of the insurance guarantee is the key ingredient in placing a much larger financing package into the traditional capital market universe.
Residual value insurance is growing quickly in importance to owners of larger operational assets, such as aeroplanes, ships and automobile fleets. This style of coverage insures and, therefore, guarantees the future value of assets at some time in the future and is used as collateral for other institutions to support financing. As a result, the borrower gets improved credit terms and there is reduced risk for the lender. The provider of the insurance may be compensated through traditional premium payments or sharing in the asset's future value. In most cases a combination of mechanisms is used to align the financial interests of the parties.
While surety coverage and residual value insurance are not necessarily considered new products, insurance capital in these forms is increasingly being viewed as an option for financing needs in the same vein as traditional capital market sources. An insurance balance sheet has always been available for these types of transactions; however, a broader and more sophisticated application of insurance solutions to financial problems has emerged over the last couple of years.The skills and experience required to underwrite a broad range of exposures effectively are essential if the insurer is to be successful and to be taken seriously in the market. The ability to absorb the underlying risks in these newer types of transactions into the insurer's portfolio is important. The insurer must also have the flexibility to deliver substantial coverage in the most efficient and timely manner to the customer when working within the capital market environment.A volatile business environment brings a knock-on effect to the banking world. Consequently, banks with leveraged balance sheets are seeking new insurance mechanisms to share that risk and manage earnings volatility. It is becoming increasingly difficult to sell off (at least economically) portfolios of loans that were created with eventual securitisation in mind, as the fast moving capital markets in turn seek to avoid volatility. Insurance of the performance of these portfolios provides a degree of underpinning of the credit quality of the portfolio which can assist in achieving the bank's original objectives. The insurance may also act as a support to capital adequacy ratios by replacing certain capital associated with the provisions for bad or doubtful loans.
Managing shareholders' expectations
The use of (re)insurance support for a broad array of company risks is also generating increased interest from corporate and insurance company senior management seeking to minimise the volatility of business results. This volatility is heightened in times of turbulent markets, when otherwise acceptable business risks may be viewed as unacceptable if combined with other financial exposures or the position of competitors in that sector. Publicly traded companies are very conscious of their earnings in relation to the expected position. The emergence of surprises with negative implications is every chief executive's worst nightmare, and new methods to reduce the risk to earnings in an efficient manner are being considered.
Typically, there will be core drivers to a business's financial risks, such as the price of raw material, the cash flows from one or a series of discrete projects, and the hidden risks associated with mergers and acquisitions. Some companies are beginning to consider medium term insurance support as a viable alternative to protect the capital base from what they consider unreasonable and temporary risks to their businesses. An insurance structure that protects earnings from one or a number of risk factors is usually designed to run for a number of years. The relationship between the parties has to be such that frequent alterations to the original transaction can be negotiated efficiently as the underlying business adapts to its market environment. This style of protection cannot assist with a fundamental long term risk to the business but will certainly help companies overcome what they consider unacceptable short to medium term volatility.
Many businesses are also focusing on their core strengths and values, and some have taken the initiative to divorce older liabilities from their balance sheet. These types of exposures have been termed “legacy liabilities” and typically have been on the company's balance sheet for some years. There is usually little prospect for a short term resolution and the situation is likely to continue for many years. These cases often require constant explanation by management to shareholders. In addition, a drip feed of provisioning is necessary which can lead to a weakened current earnings potential and lowered confidence in the future prospects of the company by analysts and shareholders.
The use of an insurance solution that protects against further deterioration provides the company with certainty that all subsequent development is absorbed on the insurer's balance sheet, not the company's. Although there will be a one-off cost to the company in the form of either a premium or a reserve transfer, the finality that comes with such a solution can have a significant impact on share price.
Frequently the company will receive a profit share if the ultimate outcome of the liabilities is more favourable than expected. This style of protection has been used for some time between insurance and reinsurance companies, but its application for large corporations is still relatively new and has proven to be extremely attractive from a cost/benefit standpoint.
The insurance alternative is not a mutually exclusive approach to that of the traditional financial markets, but a finely tuned combination of the two that delivers the optimum solution to the customer. Although a number of transactions have been completed, there are only a handful of insurance groups today that are really set up to deliver the required solutions in this area of business.
These types of transaction do not follow the typical insurance company approach of portfolio underwriting - taking the same type of risk many times over to create diversification. They require an ability to think and analyse like an investor, to understand quickly the key components of many different businesses and to be able to offer meaningful solutions to medium and large multi-national organisations.
The insurer requires a closer and more long term association with the company as would an investor and must remain flexible to adapt to the changing requirements of any dynamic business. The financial standard of counter-party required by most large corporations mean that many (re)insurers would not be acceptable partners. Only those insurers with the highest credit quality are usually entertained.
This is the ground that forward thinking insurers and companies are currently occupying. It is possible, because in some insurance groups the merging of the disciplines of finance and insurance has already taken place. Also, the senior management of the medium and larger companies, together with their financial advisors, are now more aware of what is possible. The process is complete and the benefits are beginning to show for a limited number of insurers and their customers. By using (re)insurance balance sheets and advanced financial analysis, insurers are able to offer alternative approaches when they are most required: when the traditional form of financing becomes scarce.
Some years ago alternative risk transfer was considered to be an alternative to traditional (re)insurance. Today it is also an alternative to traditional capital and financing support. The banks are watching closely!
Terry Wheatley is head of Centre Solutions' business in Europe and Australia, which is handled through its underwriting office in Dublin and representative offices in London, Zurich and Sydney. He is also a member of the executive management team of the Centre Solutions Group.