Alternative market update

ART markets have suffered from financial crisis, but growth will return

By Michael J. Moody, MBA, ARM

The United States—and the rest of the world for that matter—finds itself in the middle of one of the worst financial crises ever. While there have been some recent improvements in some sectors of the financial service industry, it has come with a high cost to every U.S. citizen. We are now part owners in some of the biggest financial dogs in history including, but not limited to: AIG, General Motors, Chrysler, Bank of America, Citibank, Fannie Mae, and Freddie Mac, to name just a few. Ten or 15 years ago, any investor would have been glad to have these companies in their investment portfolios—but today, not so much.

The current financial situation has taken a toll on many sectors of the property and casualty insurance industry, and the alternative risk transfer (ART) market is just one. In the remainder of this article, we will try to provide a snapshot as to the current condition as well as what lies ahead for the overall ART market.

Traditional ART market products

By far the most common use of the traditional ART market has been the establishment of captive insurance companies. Historically, formations have slowed or stopped during soft insurance markets. Obviously, the past five or six years have been considered a soft insurance market, however, while formations have slowed, they have not stopped. In fact, during that time, captives have added to their ranks worldwide.

So, the soft insurance market has slowed the growth of captives, but it has not been the only issue. One key concern for new captive owners is the availability of collateral to fund the capital and surplus. In the past, most captives going through the formation process have chosen to utilize letters of credit to meet capital and surplus requirements. Today, however, there is significant pressure on the LOC market that requires a different approach. More and more, the approach that has been used is a 114 Trust. This has helped to take some of the pressure off the LOC market, but it is still difficult to handle the collateral issues.

For the most part, continued captive growth has come from the fact that insurance buyers want to maintain great control over their insurance program costs, and they are finding that captives can do that. As a result, both new and existing captive owners are trying to find additional uses for their captives.

Discussions about this expanding role over the past few years have centered on including employee health benefits in the captive. While there has been much speculation about this topic, captive owners have been slow to get on board. However, domicile regulators confirm that this topic is still of interest to many owners, but the regulators believe that the owners are taking a “wait and see” attitude with regard to the Obama administration’s approach to health care revisions.

One important segment of captives is Risk Retention Groups (RRGs) and over the past few years, generally, they have been declining. There is one significant exception to this trend, and that is in the health care service sector. The majority of RRGs that have been formed recently have involved hospitals and/or doctor groups as they find better ways to use the RRG in conjunction with their overall loss prevention and control programs. Specialized claims management programs are also being built into the operation of the RRG.

Advanced ART market products

Much of the innovation within the advanced ART market has been directly tied to catastrophic weather related events. Whether it was Hurricane Andrew in 1992, or the three sisters—Hurricanes Katrina, Rita and Wilma in 2005—severe weather related situations have frequently been the catalysts for innovation.

In that regard, it is important to note that Swiss Re indicates that 2008 was one of the worst years on record for catastrophic losses worldwide. In fact, the company notes that more than 240,000 people were killed in catastrophic events in 2008 and the insurance industry paid more than $52 billion in CAT claims. Total damages were in the $269 billion range, with most of the damage occurring in Asia (i.e., over half resulted from the earthquake in China) where much of the loss was uninsured. Of particular interest is that 2009 is already on track to exceed 2008 with regard to catastrophic losses.

Specific CAT products

One of the best-known and successful financial products for dealing with severe weather-related losses have been CAT bonds. These bonds have been used by insurers and reinsurers for 20-plus years and started receiving significant interest and attention following Katrina, Rita, and Wilma. Over the past five or six years, they have experienced exceptional growth and according to Guy Carpenter, they had begun accounting for a significant portion of the catastrophic property market. However, just as with all insurance-linked securities (ILS) over the past 12 months, interest has waned.

While there have been many reasons for the waning interest, one of the key reasons has been the failure of Lehman Brothers in 2008. Lehman had been particularly active in the ILS market and especially in the CAT bond segment, having been involved with several high profile placements over the past couple of years. Once Lehman went bankrupt, those hedge funds were eager to reduce or eliminate their positions in these bonds. This forced a flood of activity in the secondary market to sell their portfolios, thus greatly lowering the demand for new bonds.

However, since the beginning of 2009, most of the bonds in the secondary market have been sold and new issuance of CAT bonds is in full swing. The first four months of 2009 saw about $965 million, compared to $620 million in 2008 for the same time period and $550 million in 2007.

The first quarter of 2009 saw a number of carriers enter the market, including Allianz, SCOR, Chubb, Liberty Mutual and Swiss Re to name just a few. Part of the reason is that hurricane season was fast approaching and the bonds themselves have had several structural changes to the contract.

For example, the new bond design has more stringent requirements to maintain separate accounting for each bond, and in general, the bonds have become more investor-friendly in the event of a default. As a result, most experts agree that 2009 should be a record year for CAT bonds.

Interest in other forms of catastrophic property ILS has not been as fortunate as CAT bonds. Sidecars, for example, which were the darlings of the ILS market just a couple of years ago, have shown little signs of life this year. They reached their peak in 2006 with $4.4 billion in investments, but this number had fallen to $683 million in 2008. Thus far this year, there have been only a couple of public offerings.

While demand for sidecars continues, a lack of meaningful investment returns has hindered this market segment. Some say that this is exactly what was perfect about sidecars—easy to start and easy to discontinue. And they feel that should 2009 prove to be a high CAT loss year, interest in these products would quickly return.

The market for industry loss warranties (ILW) as well as other weather derivatives continues to lag also. In the past, these types of products have helped insurers and reinsurers fill gaps in their high layer property programs. However, as this year’s hurricane season approached, activity on both the Chicago Mercantile Exchange and the Chicago Climate Futures Exchange begun to heat up. Officials at both exchanges expressed optimism that investors will return to this market before the end of the year.

Also slowing the growth in the weather-related products has been the development and standardization of contract wording. While this has resulted in some short-term loss within today’s market, experts believe that these changes were needed to advance the market in the future.

An additional issue that has hindered the return to this market has been the lack of higher returns on these investments. Most participants in the weather risk market segment believe that any remaining issues will be addressed in a timely manner and think that continued growth in this segment should occur.

Summary

Without a doubt, both the traditional ART market as well as the advanced ART market have suffered from the current condition of the overall financial market. However, despite a soft property/casualty insurance market, slow growth continues in the traditional ART segment. Many captive owners are exploring new and innovative ways to utilize their captives.

Further, RRGs, especially those in the health care sector, are proving their mettle daily. Both hospital and doctor groups are finding additional methods to put their captives to use. There appears to be little to stand in the way of future captive growth, and when the hard market finally does come to the P&C industry, captive growth is certain to follow.

Many of the original reasons for the interest in ILS will also continue. Most realize that ILS can provide higher investment returns, while quickly deploying additional capital to the insurance industry. In addition, one of the advantages of ILS from the start has been that they represent zero beta investments or those that do not correlate to the general stock market. This will still be the case, and hedge fund managers will put a premium on these types of investment.

Bottom line, like the overall investment community, the ART market has suffered from the current financial crisis. However, most experts think that once hedge fund managers get more comfortable with the current landscape, growth will return to the ART market.