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Enterprise Risk Management Catalyst for convergence ERM will help drive renewed interest in convergence products By Michael J. Moody, MBA, ARM
Convergence has been one of the buzzwords in the financial service sector for the past 20 to 25 years as financial service companies attempted to bring together the insurance market and the capital market. Over this period, there have been a number of successful attempts at convergence; but for the most part, convergence has remained an elusive concept that has gained little traction. A recent research study completed by Conning Research & Consulting suggests that may be changing soon. The study, “Evolution in Risk & Capital Management: New Value Propositions for P&C Insurers/Reinsurers,” suggests that there will be increased pressure to develop “nontraditional” insurance/reinsurance convergence products. Clint Harris, vice president of research and publication for Conning Research & Consulting (Conning) states that the study began as a “where are we now” project, with regard to the alternative market’s move toward developing convergence solutions. The objective was to look at the evolution of products in the convergence arena. Convergence product basics Conning notes that the primary role of insurance has historically been to provide a ready source of liquid capital (i.e., cash) so insureds could pay for their direct losses and/or their liabilities. This has been an important function since it allowed insureds to greatly reduce the amount of ready cash they would otherwise have to hold to pay for such losses. This benefits the insured in several ways: • Insurance reduces necessary on-balance-sheet capital for all its customers, regardless of their size or ability to access capital from other sources. • The reduction of retained on-balance-sheet capital often increases the insurance customers’ rate of return on capital (ROC). • The benefit of the increased ROC occurs regardless whether there is an insurable loss. But despite the critical nature of these aspects of insurance, their value has decreased in recent years, as is evidenced by the large number of products involving high deductibles, indicating a greater willingness on the part of insureds to assume a larger portion of the risk. Harris says that “insurers’ capability of providing capital for losses that their customers could not otherwise afford is less valuable in today’s economy.” And he goes on to say that, “it is likely to become even less valuable tomorrow.” Convergence product specifics As a result, the insurance industry has been working to develop nontraditional products that are directed at better balance sheet efficiencies for their insureds. Typically, these products increase customer value over traditional insurance by either lowering costs or reducing credit risks. Many times, these products broaden coverages, capital payment plans or possibly capital resources beyond what can be provided in the traditional insurance market. Among the nontraditional insurance/reinsurance products that Conning identifies are multiline and multiyear products, dual-trigger or multi-trigger products, finite insurance/reinsurance, blended covers, securitized products, swap deals, contingent capital agreements, and collateralized reinsurance. Harris points out that Conning did not include credit risk products in their study since they have a high market penetration already. While most of these products have been actively used in the insurance sector for years, their use today is quite limited. While there are any number of reasons for this limited use, the study highlights several concerns from a regulatory standpoint. One is the accounting treatment for such products, since accounting has not kept pace with various product developments. An additional concern centers on how the risk and capital needs of both the product buyer and provider will change with the use of these products. The ultimate impact on the solvency of both the buyer and provider has yet to be determined. And one of the products, finite insurance/reinsurance, unfortunately has been on the receiving end of a lot of unwanted attention over the past few years. This attention has greatly affected the use of the finite products over the past 18 months; however, Conning believes that these products still have value. And Conning also thinks that even with increased regulatory oversight, innovation will continue and greater acceptance should follow. The company does not think that the current issues facing finite products will be fatal, and that timely growth of the entire convergence sector should begin to be seen. Changing role of reinsurance Reinsurers have historically been the salvation for insurers and their policyholders following infrequent catastrophic losses. However, these infrequent cat losses caused periodic market hardening as both insurers and reinsurers began increasing pricing to recoup prior losses. Conning points out that this reinsurance pricing model has all but disappeared. Today’s reinsurers are much more sophisticated with regard to technologies for risk modeling and pricing. And while the modeling continues to be a work in progress, it has assisted reinsurers to better price their products. The key issue today for all reinsurers is the low barriers to market entry. As we have seen in the past, “groups of new reinsurers are created in several waves after large catastrophic events.” And, as a result, “this rapid entry of new competitors has greatly impeded the ability of reinsurers to build substantial profits in prolonged hard markets,” Conning notes. As a result of this market condition, Conning opines that there will be a general softening of reinsurance rates which will put additional pressure on individual reinsurers to develop some type of competitive advantage. This could come from the development of convergence products, according to speculations by Conning. Harris notes that the current barriers to entry are very limited to begin with, but the “fluidity of capital will reduce this even further.” Market drivers It’s the movement to enterprise risk management with its more holistic view of risk management that Conning thinks will be a key driver of change. ERM, coupled with rapid increases in risk management technology, will also help drive a renewed interest in convergence products. Harris indicates that the research suggests that, “risk management decision making is moving up the executive ladder.” Conning has documented this movement through the use of industry observations, intermittent surveys, and other outside insurance industry data. According to Harris, “the preponderance of evidence at this point confirms that ERM is on the move.” Another major driver of the convergence movement will be the recognition by the reinsurance community of its limited ability to sustain hard markets. However, it is the inadequate returns on invested capital of reinsurers that will ultimately motivate the convergence movement. Historically, the insurance industry has not fared well when it comes to return on equity (ROE). For example, over the past 10 years, according to Conning, property/casualty insurers have an average ROE of about 10.4 %. This compares to an average ROE for commercial banks of 16.1% and about 18.7% for diversified financial institutions. Investors are becoming disenchanted with the substandard returns available in the insurance sector. As a result, they will begin to move to investment options that offer more favorable results. Conclusion The latest study from Conning Research & Consulting identifies several key drivers in the insurance/reinsurance marketplace that will force change. For the most part, insurers/reinsurers will be forced to accept the concept of convergence. There are simply too many cards stacked against them to continue to think that the insurance industry operates in a vacuum. There are outside pressures that will change the industry forever, and if insurers/reinsurers expect to participate, they will also need to change and accept convergence. Finally, the movement to ERM will be a major factor in the movement to convergence, Harris believes. Prudent insurance and non-insurance executives would be wise to note the increasing influence that ERM is gaining. * The author |
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