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Property reinsurance Is there a way out? By Michael J. Moody, MBA, ARM At the time of this writing, it would appear that we have managed to make it through the July 2006 renewals. But from a property insurance standpoint, it has been quite a disastrous experience. Many property insurance programs still have holes in them, and programs involved with coastal property may not have any coverage at all. Even those that were lucky enough to get coverage have seen escalating retentions and skyrocketing premium increases. The problems that are now occurring in the property insurance business are a direct result of the substantial catastrophe property losses that have occurred over the past two years. And for the most part, the results have been immediate and profound within the insurance industry and have resulted in several insolvencies, as well as significant recapitalizations. In general, the pressure on reinsurers following these two years has been strong to reduce their aggregates and diversify their book of business. As a result, their writings of late have caused significant constriction in the overall capacity in the property market. Let’s face it, the events brought on by last year’s three sisters, Hurricanes Katrina, Rita and Wilma, were a humbling experience for the insurance industry. And it has left a lingering question as to its overall financial health. While the chapter is still unfinished with regard to the final losses that came out of last year’s catastrophes, it appears that the primary insurance industry weathered the storm quite well, but the capacity of the reinsurance industry was hurt. And what about the next time? Everyone is predicting a challenging year for 2006. At a recent conference on hurricanes, the general feeling was that an East Coast hurricane had a much higher chance of occurring than in prior years. Movement of a Bermuda high, warmer waters along the Atlantic coast and several other key considerations led weather experts to believe that an Atlantic strike far up the coast could happen. And its results would be bad. Recent predictions for a Class 3 hurricane coming ashore in New Jersey, for example, could result in more than $200 billion in losses. Where do we go from here? One of the true failings of the insurance industry is occurring right now. Many in the industry are debating whether the insurance industry could actually survive a $200 billion hurricane. Let’s get real—even if we could survive such an event—how could we go forward? This is more than just an academic exercise. Look at the population and building values that are located within 50 miles of coastal locations. These numbers are growing at an alarming rate and can only add to a major hurricane loss. If the industry is going to remain an essential part of catastrophe planning, it needs to do better than just survive! There are actually several ways to deal with this issue. First and foremost, the industry needs to get serious with regard to the capital markets. We have talked for years about the convergence between the capital markets and insurance market. In fact, recently there has even been some real progress in this direction. The increased uses of CAT bonds, sidecars and weather derivatives have shown some real promise. However, now is the time to fully explore these alternatives and actually look to the capital markets as a solution to this potential crisis rather than as a competitor for premium. Despite the numerous Bermuda startups that have had the active participation of a number of hedge funds, capacity in the catastrophe property market continues to be “as scarce as hen’s teeth.” Another option that needs to be fully explored is the expansion of Risk Retention Group (RRG) legislation. As currently structured, the federal RRG law is confined to liability risks. It is interesting to note that the original Act was written to assist with a crisis in the product liability arena. However, once problems started occurring in other liability areas, Congress quickly expanded the law to cover any liability. Similar speedy action by Congress is needed today. RRGs can certainly provide relief for some property owners. Just as has been pointed out in the recent GAO report on RRGs, they have provided a solution for a number of situations that the insurance market was unwilling to resolve. It is time to give property insureds access to this valuable option. Other options? There is an additional option that should be considered, despite its poor image in today’s insurance market. That option is finite risk reinsurance. Today’s market requires that we leave no stone unturned in our attempt to develop viable solutions to the current capacity shortages. Lest we forget, finite risk reinsurance is not illegal. In fact, this is an insurance product that has been used effectively by the insurance industry for years and has proven its worth over those years. Obviously, the industry will need to review the problems that have been associated with the use of these products. For the most part, the primary issue revolves around the amount of risk that is actually transferred between the parties. While the traditional “10/10 rule of thumb” has served the industry well, it appears that the side agreements that frequently accompany finite deals have led to their undoing. Obviously, this can be remedied. There are actually several different products that make up the general category of finite risk products. Among the more popular products in this group are aggregate stop loss covers, finite quota share, multi-year cat covers, and adverse loss development covers. All of these products have been successfully used to solve specific problems within the reinsurance industry. However, one of the most popular finite products historically has been the loss portfolio transfer (LPT). While experts are not certain how long LPTs have been in use, some say they have been around since the 1800s, when some insurers wished to remove themselves from certain lines of coverage. At its core, the LPT provides a method where one party can transfer claim payment obligations to another for a fixed sum of money. While this sounds quite similar to the standard insurance transaction, it differs in several key ways. Most important, it typically deals with claims that have already occurred, as opposed to traditional coverages where the events are in the future. While each transaction is typically tailored for the specific needs of the individual insured, there are, in essence, three values that are basic to any LPT deal: • Technical values such as administrative, accounting, tax-related costs, etc. Of course the real test of an LPT is the risk that is actually transferred. This is the tricky part of the deal. If sufficient risk is transferred, the transaction will be considered as insurance and will receive a favorable tax treatment. However, should the parties fail to meet the risk transfer test, the transaction is then viewed as nothing more than a loan, subject to adverse tax consequences. Over the years, it has been this single issue that has led to the majority of problems with the regulatory bodies and subsequent issue regarding the recent “fall from grace.” And while there still is not a consensus regarding the transfer issue, much has been noted by regulatory bodies, and finalization of guidance should be a top priority so that finite risk reinsurance can again become a part of insurers’ risk management programs. In more recent times, LPTs have frequently been used to assist self-insurers in reducing their outstanding liabilities. There are a variety of reasons why self-insurers may want to utilize this product. In single-parent applications, the insured may wish to better reflect a current approach to overall risk retention following a poorer than expected period of financial results, or even following a bankruptcy. In a group self-insurance arrangement, an LPT may be of help should some of the members wish to withdraw from the program, and finalizing of the remaining liabilities is required. These innovative products are also used frequently in merger and acquisition activity, where the seller needs to finalize its outstanding liabilities prior to any major purchase. LPTs can provide assurances since the liabilities have been successfully removed from the seller’s books. |
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