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Alternative directions Changes in risk bring a "new wave" of risk transfer mechanisms By Michael J. Moody, MBA, ARM A number of firms have published studies recently about the rise of the alternative market within the insurance sector. And while some of these studies have provided some good information, few can rival the recent study completed by Conning Research & Consulting (Conning). The study, “Alternative Markets: Structural and Functional Evolution,” provides some very helpful insight into the current rise in the alternative insurance market. When reviewing the study, bear several items in mind. The first issue is: Who was the study prepared for? According to Conning, their primary audience for this study is the insurance industry. The conclusions and findings are directed toward insurance company executives. The second issue that should be noted is that the study is part of Conning’s continuing commitment to the insurance industry. As such, the study documents the long-term trends of the insurance industry, and it is the latest in an effort that has continued since the mid-1970s. The current alternative market According to Mark Jablonowski, senior research analyst for Conning Research & Consulting, the study notes that throughout the past 30 years, insurance has been the primary method for organizations to deal with the financial effects of hazard risks. However, Conning noted an important trend since the mid-1970s—“a natural evolution within the insurance business.” Conning observed that corporations began to increase their retentions, assuming more of their own risk. Further, according to Jablonowski, the growing retention levels took the form of single parent captives. Empirical evidence suggests that the current movement to retention-based single parent captives has reached maturity. The study says that over the past 30 years, corporations have found their optimal level of retention, based in large part on the frequency of their losses. As a result, Jablonowski says, most single parent captives have matured to the level where there is little economic value in taking higher retention amounts. Fast forward While the overall retention level of single parent captives has matured, they still face increasing numbers of catastrophic risks for which the captive may be of limited assistance. There are, however, according to Jablonowski, “new products and services that can help corporations face these catastrophic risks.” He also states that the world of risk is rapidly evolving, as are the financial markets. This is an additional trend noted during the past 30 years—the types and sophistication of risks faced by corporate America have made risk transfer more important and more difficult. Due to this evolution, some corporations, particularly the financial services sectors, have begun to increasingly recognize risks in holistic terms. It is now recognized, Jablonowski says, “that both hazard risks and financial risks require more sophisticated understanding and management.” As a result, many corporations are now assessing the best mix of risk treatment options and how best to utilize insurance in treating economic exposure to risks. Movement to the holistic approach, known as enterprise risk management (ERM), has hastened this assessment. The big question is: Will ERM become a reality? Jablonowski says, “Yes, in banking and insurance, it is a no-brainer, because of what are often more complex, wide-reaching risks.” While ERM is progressing, Jablonowski says, it may not be a “big bang,” but rather more of an evolutionary movement. He says this is why some industrial companies are moving to ERM from a legal side (such as compliance or governance) rather than from the financial side. Regardless of how it happens, Jablonowski believes that “ERM will move hazard risks closer to their financial counterparts.” How to get there from here According to Jablonowski, one of the major focuses of the study was to deal with the “new wave” of alternatives that are moving into the insurance market. Given the maturity of the single parent captive market and the need for more capacity in the marketplace, where will new capacity come from? Conning has identified several sources. These include the following elements: Jablonowski points out that these “new wave” options can be used alone or in conjunction with other options—for example, group captives accessing the capital market. “This is only natural,” Jablonowski says. “Captives have frequently gone direct to the reinsurance market, and now that traditional insurers are directly accessing the capital market, single parent captives will follow. Obviously, it is similar for group captives—after all, they are kindred spirits,” he says. Generally, these “new wave” alternatives will be used to support the capacity that is provided by the traditional insurance market. Clearly, in these situations, “they are used as supplements.” However, in a bit of a warning to traditional insurers, Conning pointed out that, “the potential exists that to the extent these new wave alternatives can provide high-layer risk protection more efficiently, they could encroach substantially on market share.” Insurers should consider the capital markets as “drop-in” substitutions for insurance. Jablonowski notes that it may well turn out that insurers are not ultimately interested in these high layer risks but, he says, “they need to make that decision, and not have it forced on them.” They will need to “actively manage this movement within the insurance industry, not just be reactive,” he points out. Conclusions The new Conning study provides a number of conclusions that should be of interest to many in the insurance industry. It should also be of interest to risk managers and other alternative market participants. However, from the insurer perspective, Jablonowski says, “the classic retention market (i.e., single parent captives) is now maturing and retentions are leveling out.” By and large, most single parent captives have now found their optimal retention levels, and they are working to make certain that the captive is being maintained in a cost-effective manner. Additionally, Jablonowski says, when you look at the “next big thing,” it is going to be capacity related. He adds, “It’s not being driven as a product per se, but rather as a need—a need for more capacity.” This is a level of capacity that is needed for businesses to continue to do business. And according to the Conning study, while the capital markets have gotten the lion’s share of attention, both group captives/RRGs and the government will also figure into the equation. Jablonowski sees that the capital markets have been the center of discussions lately, and they may even hold the key to providing a long-term solution for low frequency/high severity risks. But he says, while many may consider capital markets to be the “Holy Grail” for high level capacity, for the most part, they are not currently available on a cost-effective basis. The major issue today is how to bring the capital markets into the mix in an efficient manner, and Jablonowski points out, “Whoever figures this element out, will have a significant marketing advantage.” Hopefully, it will be within the insurance industry, but Jablonowski says, “It could just as easily be within the capital markets or even banks, for that matter.” Regardless of how these “new wave” alternatives come to market, Jablonowski says that traditional insurers as well as captives “will need to be ready for these innovations.” And while there is little doubt that insurance will always remain a critical element in the commercial marketplace, he believes that insurers must “provide proactive involvement and remain ready to adopt new ways of doing business.” * |
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