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The Rough Notes Company Inc.



September 15
10:30 2016

From the Fifties to the future

The phenomenon known as the “alternative market” began nearly six decades ago. Originally, the market included just a handful of Fortune 500 corporations looking for a viable risk-financing approach. They wanted to better align their organizations’ losses with what they were paying for commercial insurance.

At about the same time, insurance innovator Fred Reiss, a former property insurance engineer who became an insurance broker in Youngstown, Ohio,was promoting a new concept. Reiss had noticed that many large, international businesses were paying what seemed to be a disproportionate amount of premium when compared to the rest of the commercial insurance marketplace.

He observed that the industry was not effectively allocating larger firms’ premium, so he established a methodology that allowed businesses to form their own insurance companies that would address their own losses. The concept became known as “captive insurance.” Captive insurance companies were pretty much limited to single organizations—hence the name “single parent” captives. The bulk of these captives were formed and found a willing home in Bermuda.

Initially, a relatively small number of large companies had single parent captives. Before long, more businesses saw the financial wisdom of writing insurance through their own insurance company, and the number of single parent captives started to grow. Mid-sized corporations took notice and became interested in the captive concept; they felt they could, perhaps, benefit from captive ownership.

However, they lacked the wherewithal to own an insurance company. Plus, the insurance industry was not too supportive of the concept and generally resisted captive formation among mid-sized organizations. On top of that, the overall commercial marketplace in the late 1970s had entered into a hard pricing cycle.

To help relieve the pressure on businesses, the federal government enacted the Model Uniform Product Liability Act. The act aimed to help clarify product liability law and stabilize premiums. It fell short, so the feds ended up expanding the scope to include all liability coverage and passing the Liability Risk Retention Act of 1986.

Interest in the alternative market continued to grow. In addition to Fortune 500-sized organizations, many mid-sized firms started to band together, making up an increasingly important part of the movement.

The alternative market has seen a major shift in the types and sizes of businesses insured since the passage of the Risk Retention Act. Involvement of corporations of all sizes has ebbed and flowed, frequently dependent upon the commercial insurance market. Through it all, however, growth continued. The size of the captive market has risen to more than 5,000 entities worldwide, and is estimated to account for between 45% and 55% of the total commercial insurance market.

The captive market, like the traditional market, has been plagued by one major issue: difficulty attracting adequate amounts of reinsurance to support the industry. The issue became more pronounced following a major loss event. Reinsurance rates would increase quickly and limits would be cut, leaving the entire insurance sector in disarray. The general consensus was, if the insurance sector could gain access to the capital market, it could weather any storm.

After many years of talking about convergence of capital and insurance, change began about 10 years ago and convergence started to be a reality. Initially, capital markets provided catastrophic property coverage for a few select coastal locations. Coverage was provided in the form of CAT bonds. While there was ample interest from both parties, the actual transactional cost proved to be too high and the mechanics too complex. As a result, little forward progress was made.

Today, a wide variety of innovative products exist that are designed to increase interest of large institutional investors. One common approach to gaining access to the capital markets is known as insurance-linked securities (ILS). Generally, they entail:

  • Catastrophic (CAT) bonds, which typically are packaged as an ILS,
  • A weather-related derivative or similar financial mechanism that can serve as a hedge for risk, or
  • Reinsurance based on specific portfolios of risks.

Over the last few years, the industry has greatly improved product methodology by continually fine-tuning the
ILS format. This has made the transaction much more transparent to the potential investors. New mechanisms appeared, including CAT bond lites, which we discussed in the August issue of Rough Notes, and sidecars—arms-length mechanisms that have seen significant growth following Hurricane Katrina.

Strides have also been made to streamline the triggering mechanism on CAT bonds and other ILS formats. Overall, the insurance market has worked to develop better, easier-to-understand investment mechanisms.

The capital markets also have developed a much higher level of interest. While many wish it was due to improvements in ILS products, the reality is that much of this interest stems from more attractive yields on the investments. One key concern for investors and insurance companies is the historic low yields that the financial industry has been developing. The converged capital markets/insurance has delivered higher yields than most other investments.

In addition, instruments have been simplified so that they are easier to understand. However, at the end of the day, insurance-linked securities have one overriding advantage that other investments could not duplicate: zero beta risks. These are risks that are uncorrelated with the stock market. In other words, losses that occurred in the stock market did not occur in the insurance market. This zero beta feature was highly prized by the investment community and has been responsible for much of the current growth of this segment of the industry.

As noted previously, the captive portion of the industry accounts for some 45% to 55% of the commercial insurance market. GC Securities projects $5.9 billion in CAT bonds and other capital market instruments for 2016. As the two industries grow and mature, many people expect to see significant growth.

One thing is clear: the future for good accounts is in the alternative market, bringing a fundamental change that will provide a major benefit to those who choose to take advantage of the trend. Those agents and brokers who wish to maintain a relationship with their clients and attract new ones will need to understand the nuances of the market.

As with any business sector, knowledge is power. Keep up with market trends. Take advantage of various learning opportunities through groups like the International Center for Captive Insurance Education. And use this knowledge to better advise and advocate for clients.

By Michael J. Moody, MBA, ARM

For more information:

International Center for Captive Insurance Education


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