ENTERPRISE RISK MANAGEMENT
By Michael J. Moody, MBA, ARM
The hard market makes consideration
of ART almost a necessity
Over the past five to ten years, the alternative risk transfer (ART) market has been characterized as everything from the salvation for the corporate risk manager to the specific cause of the Enron mess. The reality is that the ART market can be a defense against the current hard property and casualty insurance market. However, successful utilization depends in large part on the specific situation involved and doing sufficient homework in advance.
This article will look at the various segments of the ART market as well as the prospects for activity during 2004. Additionally, comments will be offered as to possible roadblocks to utilization.
ART market overview
According to a recently released issue of Sigma, a Swiss Re publication, there are two broad segments to the current ART market. These two segments are risk transfer through alternative carriers and risk transfer through alternative products. For the most part, the alternative carrier concept encompasses self-insurance, pools, captives and risk retention groups (RRGs). Risk transfer through alternative products generally includes transactions such as integrated multiline products, insurance-linked securities (or CAT bonds as they are commonly referred to), credit securitization, committed capital, weather derivatives, and finite risk products.
The origin of the alternative risk transfer market was primarily directed at transactions that allowed entities to insure their own risks. These solutions emphasized the financing of risks rather than transfer of the risks to the commercial insurance market. In truth, most of the alternative carrier concepts incorporate a large portion of risk retention and involve little in the way of transfer; however, the ART name has been given to them and it has stuck.
* Self-Insurance--This segment of the carrier market is one of the oldest and still remains one of the largest. Currently, estimates indicate that self-insurance represents about 75% of the carrier market. Coverages that commonly fall into this segment are workers compensation, general liability, and auto liability and physical damage. Despite the fact that both workers compensation and auto liability are heavily regulated by the various states, growth of self-insurance in these two lines has continued. Since self-insurance is typically associated with cost efficiency and increased loss control, these alternatives are expected to continue to grow regardless of the market conditions.
* Captives and RRGs--By definition, captives and risk retention groups (RRGs) are insurance companies that are owned by their parent(s). The original captive "boom" was in the late 1960s; however, the recent hard market has broadened the appeal of the captive movement. For years, captives have been considered the exclusive domain of Fortune 500 companies but, today, middle market companies are also seeing the advantages of captive formations. As a result, captive domiciles across the country saw a record year for formations in 2003. Despite the continuation of the hard market, it will be difficult to continue this record pace.
* Pools--This ART technique is usually associated with groups of governmental entities that band together to cover specific risks. Most frequently, pools have been established to deal with workers compensation coverage. The year 2003 saw significant growth in the pool concept and since workers compensation is one of the most troubled lines of coverage, interest in pools should continue during this current year and beyond.
* Finite Risks--The past several years have seen finite risk products become an accepted risk mechanism. While these products are designed specifically to the needs of the customers, they are typically multiyear contracts that assist the customer in reducing their cost of capital via earnings smoothing. Finite risk products are long-term solutions that, by their nature, reduce the year-to-year volatility normally associated with a commercial insurance policy. Products can be written either on a pre-funded (prospective) or post-funded (retrospective) basis.
Recently, a variety of applications have been successfully utilized to help purchasers resolve risk problems. Among the current crop of finite products are loss portfolio transfers, adverse development covers, time and distance covers and spread loss covers. To date, the most utilized finite product is the loss portfolio transfer, which is frequently used to eliminate long-term liabilities from a company during merger and acquisition activities. The smoothing effects of the finite risk products coupled with the current restricted capacity in today's marketplace will continue to favor the use of these products.
* Committed Capital--These products, also referred to as contingent capital, are one method to take advantage of the convergence of the insurance and capital markets. The underlying concept of committed capital is that the customer can sell some form of debt via a contractual commitment at a predetermined price should a specific adverse event occur. These products are only about 10 years old; however, they are catching on quickly since many people see them as a bridge between full insurance and full self-insurance. The current hard insurance market should continue to stimulate interest in this approach.
* Integrated Multi-line Products--The late '90s also saw the introduction of another new ART approach--the multiline--and, in many cases, multiyear integrated insurance product. These products were the first attempts to combine insurable risk with financial risks and were yet another sign of the converging capital and insurance markets. These products were heralded by some as the next big thing in risk management. However, due in large part to the events following 9/11, many insurers have moved back to their core businesses and deployed their capital in more traditional methods. As a result, with the exception of Swiss Re and Zurich, few carriers are offering these products today.
* Insurance-Linked Securities (aka Cat Bonds)--These products were developed specifically to offset the decrease in insurance capacity. They are designed to assist insurers and corporations in transferring catastrophic risks (wind, flood and earthquake) to the capital market via a bond issue. Originally, these products were used in response to the lack of wind coverage following Hurricane Andrew. Typically, these products come about as a result of a bond being issued, and the proceeds being invested. Bondholders then receive interest payments and the principal repayment over the life of the bond. However, should the issuer suffer a catastrophic loss, both the interest and principal could be used to pay the loss. While many believed that the hard market would accelerate the use of CAT bonds, utilization has been modest over the past few years. However, as the transactional costs decline and the acceptance of these products increases, usage is expected to grow.
* Weather Derivatives--As opposed to a lack of insurance capacity, the development of these products was directly tied to the deregulation of the U.S. energy industry. Energy companies needed to find ways to mitigate the significant earnings volatility that was usually associated with changes in weather. Weather derivatives were introduced in 1997. Use of weather derivatives has quickly expanded beyond the energy industry and many experts see a wide variety of applications for these products in the future. Additionally, although they were originally confined to use in the United States, they are now freely used in many parts of Europe and Asia. Significant growth over the next few years is expected.
* Credit Securitization--Despite the rosy views of the U.S. economy, credit risks continue to be one of the most significant for many organizations. Credit securitization products were designed to hedge these risks. Typically, these products involve a portfolio of loans, bonds, or other credit assets. By bundling these assets together, they can be structured as a single portfolio with many layers, each with its own credit rating. The major advantage of these products is that bundling these risks diversifies the credit risk across single companies, industries and geographic locations, thereby becoming more attractive to the capital markets. The increase in default rates and credit rating reductions have damaged the reputation of this particular market, but interest in these products remains strong.
At this point in the property and casualty pricing cycle, ART solutions have consistently gained market share in each of the past few years. Despite this, there are some troubling signs that are beginning to be associated with some of these mechanisms.
Recent events in California could spell major problems for the future of ART products. One of the key aspects of ART transactions is that they are long-term vehicles, many being three to five years in length or longer, such as the case with loss portfolio transfers in which many go on for 10 to 20 years. This was the case with a group of school districts in California that had established a self-insured workers compensation pool. In 1998, the pool purchased a loss portfolio product that transferred $900,000 in reserve liabilities for a $1.4 million premium. Unfortunately, the pool purchased the coverage from the now defunct Fremont Indemnity Co. and about $600,000 of liabilities remains unpaid. To make matters worse, the California Insurance Guarantee Association has refused to allow the state's guaranty fund to be used to cover the losses.
Another trouble spot for ART programs is the nonstandard approach to the transactions. While David Bowie and the infamous "Bowie Bonds" made headlines several years ago, not all deals within the entertainment world went smoothly. As a matter of fact, one aspect, film financing, has taken a significant hit. The complexity of these transactions, coupled with some films' failure to generate expected revenues, has caused these transactions to become one of the most litigated areas of the ART market.
As always, the continuing hard market has accelerated the growth of alternative solutions. Today, many experts estimate that the alternative risk transfer market may now account for over 50% of the commercial insurance market. If that is the case, should we continue to call it the "alternative" market? And semantics aside, who cares if ART transactions have overtaken the traditional market? Everyone in the insurance industry should.
Insurance companies should be concerned because those customers that move to alternative products rarely come back to the traditional market. For the most part, they are gone forever. And those accounts that remain in the traditional market should be concerned. On average, it is the better risks that are the first to move to the alternative markets. This means that the pricing of the traditional insurance products is going to be based on the past loss experience of a group of accounts with the highest loss ratios. Should the ART movement continue, the traditional commercial insurance market would ultimately become nothing more than a glorified assigned risk pool with pricing to match. Agents and brokers will need to make certain that they have their good accounts consider the feasibility of the ART market. *
Michael J. Moody, MBA, ARM, is the managing director of Strategic Risk Financing, Inc. (SuRF). SuRF is an independent consulting firm that has been established to advance the practice of enterprise risk management. The primary goal of SuRF is to actively promote the concept of enterprise risk management by providing current, objective information about the concept, the structures being used, and the players involved.