ENTERPRISE RISK MANAGEMENT
Recent events created a ripple effect that
served to hasten a hardening P-C market
By Michael J. Moody, MBA, ARM
Even before the tragedy of September 11, the property and casualty insurance market was beginning to harden. The capacity that the industry had been giving away for years is finally in short supply. Obviously, recent events will serve only to hasten the capacity shortage.
September 11, 2001, will be a day that lingers with us for the remainder of our lives. It was a day when most Americans found out just what "worst case scenario" really meant. For most of us, our wildest nightmares would not allow us to consider such a horrific event, certainly not in the heart of New York City.
It seems like the entire world has been affected by the events of September 11--certainly the innocent people who perished needlessly that day, as well as their families and friends. And businesses of all sizes and types are feeling the aftershocks. Big, immediate losers include the airlines and tourist-related businesses. However, another immediate loser is the insurance industry. While we are months away from final loss figures, Tillinghast-Towers Perrin has projected losses to be between $30 billion and $58 billion. Milliman U.K. has recently estimated the total loss at between $75 billion and $100 billion. Regardless of the ultimate loss, it is safe to say that it will be the largest single loss event in history; and it will easily eclipse the previous record holder, Hurricane Andrew at $19.7 billion.
Effect on the insurance industry
Even before the tragedy, the property and casualty insurance market was beginning to harden. For some lines of coverage, catastrophic property, workers compensation, and medical malpractice, escalating premiums were the standard of the day. It appeared that the capacity that the industry had been giving away for years was finally in short supply. Obviously, recent events will serve only to hasten the capacity shortage.
Shrinking capacity as always will lead to accelerated price increases within the insurance/reinsurance marketplace. Not only higher prices, but restricted coverage as well. Most carriers will begin immediately to introduce tighter terms and conditions on renewal quotes. Due to heavy competition over the last few years, many property and liability policies have evolved into "all-risk" type covers. These policies will quickly move back to a "named-peril" basis. Homeowners coverage had already begun this movement as a result of the rash of mold claims throughout the country.
From all indications, the insurance industry will survive this tragedy. Sources within the industry have reported that, as a group, the U.S. property and casualty insurers have over $300 billion in statutory surplus. So even at the outside estimate of $100 billion, survival of the industry should be maintained. The problem, however, is not the industry as a whole; it is the individual insurers/reinsurers that will be required to pay the losses. Company failures can occur from carriers that were poorly capitalized and in financial difficulties prior to the losses.
Hard market concerns
As with previous hard markets, capacity will be king. As a result of this capacity shortage, one would expect to see two trends develop. Since premiums will begin to rise rapidly, the first trend will be to see new capital begin to flow into the insurance industry. Obviously, this new capital will require higher rates of return than were previously available.
Among the early entrants with new capital are well-positioned insurers/reinsurers who have the ability to raise capital to seize the opportunities of a tightening insurance market. Within days of the tragedy, Renaissance Re Holdings, in conjunction with State Farm Mutual, announced the formation of Da Vinci Re, a new Bermuda-based property insurer. Since that time, several other well-financed reinsurers have subsequently announced similar plans. All of this signals a growing disparity between financially strong and weak reinsurers. Many primary insurance companies and their insureds will become concerned with the ability of the weaker reinsurers to pay claims.
Brokers have also reported new insurance ventures to provide additional capacity to the marketplace. Marsh & McLennan Co. via MMC Capital, Inc., announced that it would launch a new property reinsurer company, Axis Specialty, Ltd. As you many recall, Marsh was also involved in creating new capacity during the last hard market, having been instrumental in the formation of both XL and ACE. Aon and Willis also have plans to create additional capacity through affiliated insurance operations.
The second trend will be the accelerated growth of alternative risk transfer (ART) mechanisms. For many corporations, retaining higher levels of primary risks will become more financially attractive. The growth of captive insurance companies has been on the rise, but this movement will accelerate now. Although corporations may find increased retention levels worthwhile, captives can offer the ideal solution for companies that do not want to expose their operating units to those increased levels of retention.
While significant growth across all segments of the ART market can be expected, capital market solutions could experience almost exponential growth. Capital market solutions have been around for several years now; however, the soft insurance market has slowed the movement of these solutions. Current events will obviously speed up the process.
Capital market solutions
While many capital market solutions are available, it is believed that the most obvious alternative will be securitization. Securitization is a process that involves the creation of new financial products that enable the transfer of insurance risks to the capital market. These products have the effect of turning insurance risks into various forms of securities that investors can add to their portfolios. In effect, these types of solutions add capacity without the need for new capital.
One of the concerns that has plagued securitization from the beginning is a misunderstanding of why anyone would invest in these types of ventures. This issue is even truer in light of the events of September 11. There are several key reasons why these opportunities are of interest to investors:
* Diversification - A major objective of any large investor is to develop a diversified portfolio, to the extent possible. Investors are always on the lookout for those investments that will not act in concert with the stock market. These investments are known as "zero-beta" investments, and for the most part they move independent of the stock market. Securitized risk products are considered "zero-beta" investments.
* Rates of return - There is little doubt that the cost of capital within the insurance industry will be quickly going up, both in reaction to the higher cost of capital and investor demand for higher rates of return for insurance-related risks. These higher rates alone should make these products more attractive. However, the fact that neither the stock market nor the bond market currently is offering solid yields should add to this allure.
These reasons should make capital market investors quite receptive to securitized solutions.
For the most part, the capital market solutions that have been successful in the past were for catastrophic risks that were direct transactions between the capital markets and insurers/reinsurers. These solutions allowed insurers/reinsurers to look to the capital markets to replace some of their reinsurance and/or retrocession requirements.
Among the primary capital markets solutions that have been available over the past few years are:
1. Catastrophic Bonds - Pioneered on the Chicago Board of Trade (CBOT) and functioning since the mid-1990s. Additionally, facilities have been developed and all of them should be capable of adding immediate capacity to the insurance marketplace.
2. Catastrophic Swaps - Where two insurers/reinsurers merely exchange risks (e.g., East Coast windstorm for West Coast earthquake exposures). Currently, several facilities are available to assist in these transactions. While technically not adding to the industry's capacity, this solution can greatly assist insurers/reinsurers in balancing their portfolio of risks.
3. Industry Loss Warranties - A relatively new mechanism that is basically structured like an insurance transaction. However, it has a double trigger feature, which requires both an established level of industry losses as well as individual losses.
4. Bank Funded Life Insurance - Involves a reinsurer and a financial institution that enter into a coinsurance arrangement where the bank pays a percentage of all future claims and, in return, receives a percentage of premiums and investment income.
5. Contingent Capital - Allows the buyer to issue and sell securities at a fixed price for a fixed period, if a predetermined event takes place. It requires no indemnification and can be in the form of equity, debt or a combination of both.
6. Innovation - With financial services "modernization," innovative companies are free to develop solutions that encompass the entire spectrum of financial alternatives. Development of new capital market applications for corporate America are occurring now. Rollout of these products will provide the corporate risk manager with a number of long-term alternatives to the current lack of capacity.
The reason that a quick response is expected from the capital markets is that many vendors--investment bankers, insurance brokers, risk management consultants, and even reinsurers have spent significant research and development time over the past few years to fine-tune these solutions. Mechanisms such as the CBOT cat bonds are already functioning and are providing a source of catastrophic protection for a number of insurers/reinsurers. As affordability and availability of quality reinsurance become an issue, these capital market solutions can respond quickly.
Although interest to date has been primarily focused on the catastrophic coverage alternative, the next major movement will be an expansion to non-catastrophic securitization. The events of September 11 have had the most direct effect on catastrophic property exposures, but as the capacity shortage spreads to other lines of coverage, non-catastrophic solutions will need to be addressed.
Initial efforts will be directed at the reinsurance market with a focus on trying to replace retrocessionaires with cost-effective alternatives. Primary insurers will be the next to explore the advantages of capital market solutions. Conceptually, the majority of capital market products can be used to finance any type of insurable risk for any type of organization. As a result, expanding the scope of capital market products to corporate America will soon take center stage.
Effect on enterprise risk management (ERM)
Given the above situation, where does that leave ERM? First and foremost, all corporations will be assuming more of their own risks. Additionally, they will be paying more for the risk transfer methods they do select.
With the additional cost associated with higher retention and escalating premiums, corporations can ill-afford not to maximize any risk management structural advantage. Being able to view a company's risk profile from a holistic standpoint will provide the entity with a clear view of its most important risks. By developing management strategies that specifically address those risks, the company can design a cost-effective program for its risk transfer purchases. By identifying those risks that create natural hedges for each other, the company can free scarce resources to other high-profile loss exposures. Successfully implementing such a strategy will result in less balance sheet volatility, which will ultimately result in better shareholder value.
While many risk managers and their advisers struggle to patch together a viable risk financing program, those firms that have begun to design and implement an ERM program will be in a much better position to weather the upcoming capacity shortage. Corporate risk managers who can find methods to utilize capital market solutions will not only solve this capacity crisis, but will also have a better long-term approach to their on-going risk programs. Those companies that can implement an ERM program can gain a significant competitive advantage during these trying times. *
The author
Michael J. Moody, MBA, ARM, is 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.
Editor's Note:
Well, here we are in the midst of a hard market, faced with enormous opportunities to place commercial accounts at premium rates that actually make sense--and there aren't any markets to take them. Insurance company underwriters have sharpened their pencils down to the nub and are looking only for "squeaky-clean" risks, which are especially hard to find these days. After all, we trained these people to ignore loss control for some 15 years. Good and bad risks alike saw declining premiums. So why bother with loss control? How could a risk manager possibly convince management to spend money on loss control programs when premiums were dropping anyway? The attitude among many was "just shut up and enjoy the ride."
So what can an agent do for those commercial risks that come through the door looking for coverage? Some insurance companies are offering their own versions of alternative markets such as agency-owned captives. But they're also looking for significant dollars from the agent. That isn't to say that might not be a good idea. It may very well prove efficacious for some of your clients. However, there may be other alternatives to consider if you're willing to think outside the box.
Enterprise Risk Management (ERM) could be a method used to identify some of those alternatives. ERM essentially involves taking a holistic view of risk and determining the best way to fund the transfer of some of those risks, while perhaps even turning other risks into positive dollars through collateralization.
Rough Notes expands editorial coverage of ERM, plans seminar
Last July, Rough Notes started a regular column on ERM in recognition of the need for our readers to understand the concept. Beginning in March, we will expand our coverage of Enterprise Risk Management in recognition of the need for agents to use this concept to take advantage of some interesting and rewarding market opportunities. We also will be presenting a two-day seminar on Enterprise Risk Management in August in the Chicago area for those of you who would like to learn more about this rapidly expanding concept. Today, a number of successful agents are providing ERM services to their clients and are reaping substantial rewards both in terms of dollars and client loyalty. In the coming months, we plan to share some of their experiences with you as well as continue to provide Mike Moody's columns on the various forms ERM has taken in recent years.
ERM represents a way for you to help your clients in a proactive manner that will put you well ahead of your competition. Our August seminar will offer substantial networking opportunities as well as educational sessions conducted by ERM leaders from the securities, banking, reinsurance and insurance industries.
For more information about the seminar, contact Dennis Pillsbury at (800) 428-4384.