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State of the ART market-2007

Predictions indicate that growth will continue

By Michael J. Moody, MBA, ARM

Despite the presence of a soft market in the majority of the property and casualty insurance industry, innovation continues apace in the alternative risk transfer (ART) market.

The vast majority of coverage lines in the U.S. insurance market have recently either held steady or have seen reductions. Most of the major reporting sources have confirmed that market softening is occurring in a large segment of the commercial markets.

For example, RIMS Benchmark Survey indicated that in the fourth quarter of 2006 (the most recent numbers available at press time), premiums for commercial insurance saw some of the most dramatic rate reductions of the year. Significant reductions occurred in both directors and officers liability coverage (5.1% reduction) and workers compensation (7.4% reduction). The D&O coverage line—along with most other liability coverages—has benefited from a very competitive market. Workers compensation became competitive due in large part to reform measures that were passed in several large states.

Property problems

The one problem area in the commercial insurance arena has been property insurance. Not just any property insurance, but coastal property, which has a high risk to catastrophic exposure from wind losses. According to the RIMS Benchmark Survey, fourth-quarter increases averaged 6.6%. However, the increases were not confined to the Southeast. Significant rate increases appeared in the Mid-Atlantic and Northeastern states, as well as with earthquake exposures in California.

It is this hardening property market that has caused a renewed interest in the ART market, which has been helped along by three major factors. First and foremost has been the sheer magnitude of the 2005 storm season’s losses and the overall effect they have had on the reinsurance market. As a result of all that storm activity, cat modelers began to believe that they had underestimated both the frequency and the severity of potential damage.

And finally, subsequent to the 2005 hurricane season, the rating agencies began requiring reinsurers to hold additional capital in order to better “weather” future storm activity. Any one of these factors would normally trigger a significant response from the reinsurance community; however, taken in total, it quickly became apparent that there was not sufficient capital in the insurance industry to meet these challenges.

So over the past two years, the ART market has provided additional amounts of capital via several innovative approaches. Generally these solutions center around several capital market products:

• Cat Bonds—These were one of the first ART products to take advantage of the convergence of the insurance and capital markets. The bonds are written to cover a very narrowly defined risk, typically wind, on an excess of loss basis. While cat bonds have been around for a number of years, the recent increased hurricane activity has caused most experts to agree that their use will continue to increase significantly.

• Sidecars—These types of ART products are a recent innovation. They are primarily a product of the Bermuda marketplace and are structured to attach alongside an existing reinsurance underwriter. These carriers tend to have little interest in becoming a stand-alone insurer but, rather, provide their additional capacity via a quota share basis with the existing underwriter. Subsequent to Hurricane Katrina, sidecars were able to provide additional capacity to the catastrophic property market in a timely fashion.

• Hurricane Derivatives—See accompanying article.

Other ART products

Another weather-related product has begun to gain significant attention over the past couple of years. In fact, many organizations have begun to consider weather risk management as a key component in their overall risk management program. In essence, weather risk management is made up of two primary components, weather insurance and, now, weather derivatives. Each of these areas has a specific role to fill and should be a part of a comprehensive weather risk management program.

Weather derivatives have been attracting interest in many industry segments and, quite unlike the weather insurance products that are primarily designed to cover catastrophic property losses, weather derivatives involve less-than-catastrophic consequences. These would be the smaller weather exposures that can have just as devastating an effect on an organization’s bottom line as the larger cat losses. These are the losses that occur due to small temperature changes that can affect a wide range of industry segments, everything from beverage manufactures to ski slope operators.

The concept behind weather derivatives is based on “degree days,” which is a temperature-based measurement calculated as the deviation of the average daily temperature from a pre-determined base. The two most popular degree days measurements are the heating degree days (HDD) and the cooling degree days (CDD). The Chicago Mercantile Exchange (CME) has been actively trading these types of derivatives since 1999. Today, weather derivatives are routinely used as a hedge against weather volatility around the world. Interest has increased in these types of ART products and significant growth is expected in the future.

Securitizations soar

Insurance-linked securitizations over the past few years have continued to gain favor with the capital market investors. The concept of securitization is quite simple; it is basically a financial technique that pools assets together and converts them into a tradable security. This is a financing method that has successfully been used by the banking industry since the 1970s. They typically are able to either reduce some capital requirements or realize an immediate value from a cash-producing asset. Utilization of securitizations within the insurance industry is a relatively new idea that started in the 1990s; however, it is rapidly attracting interest.

By far the most popular use of securitization within the insurance industry is in the life insurance side of the business. Life carriers have found that by selling risks to investors, insurance companies can dramatically reduce their need to hold capital, thus increasing their ability to write new business. One of the biggest boons to this market segment has been the utilization of securitization to offset regulatory capital requirements such as the XXX regulations and the AXXX regulations. While there have been some property and casualty industry securitizations, they primarily center on cat bonds.

According to SwissRe, the current outstanding volume of insurance-linked securities is about $23 billion. And they note that over the past two years, issuance has increased dramatically. SwissRe believes that the need for these types of financing vehicles is great. Their current projections are for growth to reach the $150 billion to $350 billion range by 2018. As a result, SwissRe is indicating that these types of ART solutions will become an increasingly important source of capacity for the insurance industry.

Captives continue

By all accounts, 2006 was another growth year for the captive insurance industry. While it did not experience record-setting numbers of new formations, most of the major domiciles did maintain orderly growth. Single parent captives, as well as group captives and risk retention groups, were able to see additional formations. Experts have suggested that the increase in the number of reinsurers and fronting companies has helped the captive insurance movement continue to move forward. Captive insurance companies have become the centerpiece of many organizations’ risk-financing programs, and they will continue to gain favor as companies begin to move into enterprise risk management.

Bottom line, the ART market has grown and matured over the past couple of years. Events on the property side of the business have again stimulated innovation within the financial services industry. And with predictions of more volatile weather events in the future, it would appear that the ART market will be able to respond in a positive fashion. As the insurance market and capital market continue to find ways to work together to resolve longstanding capacity concerns, it would appear that the ART market will continue to expand. *

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