The majority of commentators on alternative risk transfer (ART) and its role in risk management are suppliers or intermediaries. Buyers are reluctant to talk, not least because they know that their needs are particular to their company. It was hardly surprising therefore that a relatively small sample - 26 companies - responded to Marsh's survey on views on ART. As a result, the views expressed, while interesting and informative, are indicative rather than authoritative.
The sample includes more companies with revenues in excess of $2.5 billion as a proportion of the whole than in previous years, but fewer in absolute terms. This suggests that ART is of more interest to larger companies, as well as perhaps indicating the considerable consolidation in industry occurring during the past year. Although the energy and finance/insurance sectors have led the way in both their interest in ART and in consolidation, these have been trends across all the sectors.
One of the many arguments for the comparatively low numbers of completed ART transactions is the very low cost of conventional risk transfer. We asked respondents to indicate their total cost of risk (defined as the sum of insurance premiums plus retained losses and the cost of risk management administration) as well as their risk retention capability in the form of the largest financial loss the company could tolerate in a typical year. These are coarse measures, but they indicate the respondents' attitude towards risk.
The retention capability of the sample varies from US$1.4 million to $1.5 billion, with the cost of risk varying from $500,000 to $60 million. Other findings show a similar degree of variation. The ratio of retention capability to revenue varies from 34% to 0.2%. The cost of risk to revenue ranges from 2.05% to 0.1%, and there have been even wider variations in previous years. Although the calculation must take into account a wide range of factors, the make-up of which will differ substantially from company to company, the research seems to confirm traditional yardsticks for risk retention capability at around 5% of revenues and the cost of risk at a range between 0.5% and 1%.
Looking at the use of ART mechanisms, it is clear that the numbers of people actually using ART products, even in a self-selected small group of interested companies, is still quite small. However, the percentage of respondents likely to use ART mechanisms increased over last year and is almost back to the proportion shown in our original 1998 survey. Interestingly, the percentage of “maybe” answers, averaging 37% in 1999, reduced to 25%. This suggests that companies are becoming clearer in their views as to the relevance of ART products to their risk transfer needs.
Over 1999, there was a marked increase in the number of companies that have been offered ART services. Despite this, almost one in four of the respondent companies had not been approached, and some of these were major organisations which would appear to be natural targets. Insurance brokers lead the way in making approaches on ART services. Specialist consultants are also improving their position at the expense of insurance companies.
In programme design and placing, brokers continue to lead. Consultants have gained against insurers in programme design but brokers dominate when it comes to placing ART products. This is hardly surprising as, if there is one area where brokers should feel strong, it is in their traditional role of programme placement.
Having examined the distribution of ART services by categories, the question still remains as to what risks are best served by ART. The questionnaire asked in which key exposures respondents would like to see products developed.
As many as 38% believed that the insurance and hedging contracts currently available are sufficient. However, the other 62% came up with a number of product suggestions, from corporate image and brand risk protection through failure to supply penalties to commodity pricing risks and contingent capital.
Looking at the key exposures for product development in terms of three categories - hazard risks, financial risks and operational risks - there has been a major swing over the past two years from financial risks to operational risks. The largest determinant of this switch has been the change in the make-up of the sample, from a large majority of oil and gas companies with extensive on and off balance sheet exposures (particularly long-term environmental liabilities which we classified in this exercise as financial risks) to a more general industrial base.
This does not detract from the significance of hazard risks. In assessing the most significant issues over the next five years, replacement of assets (hazard risk) remained the number two issue. In fact, there were no changes in the order of important future risk issues between last year and this year, even though individual percentages have changed slightly.
In any assessment of the role of ART, a key question is how far the two conventional markets - insurance and capital markets - are seen to have come together. Respondents are less extensive users of capital market products for interest rate and foreign exchange risks than we had expected, with a highest use of 62% for foreign exchange risks. It is possible that other products are used more extensively at an operational level for, say, commodity risks, but there is little evidence of this in the research.
The pace of integration of capital and insurance markets appears to be slowing - but convergence was seen as inevitable by 85% of respondents and viewed as a beneficial move by 84%. Anecdotal evidence indicates that the reason that convergence is a good thing is because it will make the market even more competitive, probably to the detriment of insurers.
The view appears to be that, as and when the capital markets make their move, the size and scale of their operations will dwarf the insurance markets. As one respondent said: “In the convergence between the insurance and the financial worlds, I doubt very much that the leading role will be taken by the insurance. It seems to me that everything will happen once the financiers discover the business opportunity within insurance.”
With the seeming inevitability of convergence, it is appropriate to look at the two markets and see if there are any concerns over either which would slow down or even preclude that convergence. In respect of both insurance and capital markets, the expressed major concern was the same - the pricing of the products on offer and their liquidity, which also affects the perception of pricing. While security is second with insurers (the same as last year), it is fourth with capital markets, up one place. It may well be that, as the markets continue to converge, the concerns expressed over each will become increasingly similar.
The issue of price as far as the insurance markets are concerned is probably a reflection of the signs of hardening we are seeing in early 2000 and a fear that we are returning to the uncertainty of the insurance cycles of the 1970s and 1980s. In previous years' surveys, it was far less of a concern because buyers were enjoying reducing premiums as the market bottomed out.
Transfer and exposures
As hedging and insurance are both aimed at reducing the volatility of earnings by protecting against the unforeseen, and as it always has some cost involved, it is vital to know why people attempt to transfer risk. The word “attempt” is used deliberately, as there is never any true guarantee that the risk transferred will fit the circumstance of the loss or that the funds will be made available at the same time and in the same way.
Last year, the main reason was protection against catastrophe, with 98% of respondents rating it as high or most important. This year's figure - 89% - is still significant. Last year's second main reason, which was to reduce the cost of financial distress, has fallen to fourth position, while reducing firm-specific risk has risen from fifth in 1998, through third in 1999 to second in 2000. Defensive strategies continue to dominate here, although the ability to pay dividends has gone up from seventh to fifth and increasing the rate of return has risen from eight to sixth. Stabilising or reducing borrowing costs and tax liabilities have not changed their position over the past three years - evidence that the framework for convergence is being built in buyers' minds.
In previous years, we have attempted to classify the unhedged/insured exposures into categories. This year, in addition to there being fewer exposures because of the sample size, there is a wider diversity of types of exposure. How the requirements of insurance - the need for some kind of hazard to be transferred to insurers - will be catered for may well prove to be the differentiating point between the providers.
As in 1999, the most significant uninsured or uninsurable risks are operational issues, with credit/political risks and environmental risks in joint second place.
On the subject of captive ownership, it is perhaps surprising that, after so many years of growth of the use of captive insurance companies, they have not achieved 100% coverage within our sample. Every company surveyed is a company of substance. They have a natural proclivity towards risk retention, and it is almost certain that they could be carrying more risk than they are. It is the competitiveness of the current insurance market that is affecting the insurance need for captives and for risk retention.
Despite this, we can see growth of captives within our sample. We have always argued that the justification for the captive must be grounded within the insurance and risk retention strategy and not solely in tax, accounting or purely financial measures. This result seems to confirm the view that there are still benefits from owning captives, regardless of soft or hard markets.
Research on ART and the convergence of the insurance and capital markets needs to be viewed against a picture of future markets rather than the current situation. The real impact of the drivers for the development of ART are still a few years away. We are likely to see the battle for market share intensify in future years, not only because market share may make the difference between survival and disappearance but also because it will have a very distinct effect on the valuation of insurance companies when or if they are absorbed by the capital markets. There will be strong survivors who will be able to withstand the shocks of competition, but they could prove to be very few.
People will always need insurance. In a free market economy or in a totalitarian economy, there is always a need for risk transfer. The problem is, it might not always be the same people and it might not always be the same insurance. Three years of research have demonstrated that the awareness of change is growing.
Chris Mundy is practice leader in ART for Marsh Limited, and editor of the ART questionnaire analysis millennial edition, published in June 2000.