Table of Contents 

Alternative market report

ART market continues to grow in soft market

By Michael J. Moody, MBA, ARM

Traditional wisdom said that the alternative market grew in the hard market and tried desperately to hold its own during the soft market. However, this no longer seems to hold true. The alternative market appears to have reached critical mass where it no longer is seen as a market of last resort, but rather as a viable method for transferring risk regardless of conditions in the traditional insurance market. Price alone no longer is the most important criterion for many risk managers. Stability and greater control are factors that have led many to head into the alternative risk transfer (ART) market even when a soft market offers pricing concessions.

And the traditional industry’s current profitability also seems to have many looking for ways to keep some of that profit for themselves. As Conning Research & Consulting says, the positive financial results for the insurance industry “fuel the potential for a competitive market.” And those results certainly were outstanding.

The figures are now in, and it’s obvious that 2006 was a banner year for the property/casualty insurance market. The lack of any meaningful catastrophes had an incredible effect on the financial results of the industry. The combined ratio for the industry dropped to 92.5 and, according to Conning, policyholder surplus grew by $64 billion to a total of $506 billion. Conning also said that the return on equity on a GAAP basis was a surprising 13.6%, which resulted in a positive cash flow of more than $58 billion.

And while these results have been accompanied by a soft market in many areas, the forecast for increased storm activity in the Atlantic for the next few years has caused many underwriters to shy away from coastal areas. Most industry observers believe that the results for 2004 and 2005 represent a more normal scenario.

Lingering effects

The financial effects of those two years will not soon be forgotten. Not only were the losses significant, but the structural changes precipitated by those losses and the threat of similar losses in upcoming years are also meaningful. Major changes in the loss modeling and forecasting approaches have had a profound effect on insurance/reinsurance carriers going forward and will require an increased level of reserves to meet the new requirements. The changes requested by the rating agencies will have no less of an effect, since they will also be requiring additional reserves if companies want to maintain current ratings. Not surprisingly, some of last year’s financial results have already gone toward reserve strengthening.

Not only was 2006 a banner year for the financial results of most insurance/reinsurance carriers, but it also was a record-setting year for the use of capital market solutions. From all indications, last year showed that the capital markets were, in fact, coming closer to the long-sought convergence of the two markets. Over the last four or five years, capital market solutions have made some major inroads into the insurance industry and show real promise for supplementing the industry, especially in the catastrophic property area.

Insurance-linked securities

While catastrophic bonds (CAT bonds) are not really new—they were introduced shortly after Hurricane Andrew in 1992—their use has only recently begun to be material. Last year was yet another record-setting year for CAT bonds, according to Guy Carpenter—exceeding records across all measurable dimensions, usually by large amounts. For example, 2006 saw the annual issuance of bonds totaling $4.69 billion in new transactions, which more than doubled the prior record. Additionally, total risk capital outstanding increased to $8.48 billion, compared to $4.90 billion in 2005.

More important for the future of the CAT bond market, last year saw seven new, first-time bond sponsors. The market of covered risks also expanded to include such things as Mexican and Australian earthquake, and United States tornado and hailstorms.

Interest in life insurance-linked securities also increased significantly during 2006. Usually referred to by the names of the regulations requiring that additional reserves be established by life insurers, they are called Regulation XXX securities or Regulation AXXX securities. These new regulatory requirements have caused some financial hardships on life carriers and, as a result, the carriers looked for innovative methods to reduce the financial burden. One answer was insurance-linked securities that allowed the carriers to sell some of their risks to capital market investors, thereby reducing their overall reserve requirements. So while Regulations XXX and AXXX were initially viewed as large impediments to the life industry, they may, in fact, provide a viable method of harnessing the capital markets. Long term, these methods may well hold the key that allows life companies to better manage their financial resources and increase their ability to write new business.

Non-insurance-linked securities

While the use of both CAT bonds and XXX and AXXX securities increased significantly in 2006, it was non-insurance-linked securities that made the real waves in the insurance market last year. A new source of capital market funding known by the unlikely name of “sidecars” was a major story last year. Conceptually, sidecars are quite easy to visualize. In their simplest form, they are typically multi-year quota-share partnerships with existing reinsurers. And since the full effects of 2005 losses have been realized, interest in the sidecar concept has mushroomed.

The actual mechanics of these creative ART solutions are pretty straightforward. Typically, a capital market investor group (e.g., hedge fund) contacts a reinsurer and they decide to enter into a quota share reinsurance arrangement. To date, sidecars have been established only in Bermuda, where a start-up can occur in a matter of days, rather than weeks or months. The investor group funds the sidecar and then makes the new capacity available to an existing reinsurer. The reinsurer provides all of the underwriting and administrative expertise to the sidecar for a fee. Both the sidecar and the reinsurer share in any profits.

This method has proven to quickly provide capital to the insurance marketplace in time of need. It eases any insurance market shortcomings or market displacement by providing a reliable funding source for the reinsurer. The Bermuda Monetary Authority has indicated that more than $6 billion was put to work through 26 sidecar launches during 2006.

But despite the numerous advantages of such a funding source, some industry observers have taken umbrage with the sidecars—charac-terizing them as fair weather friends. Once the market begins to show signs of price competition, say these observers, the capital market participants will be off to the next high-income opportunity. Frequently, these naysayers refer to sidecars as “disposable reinsurers” that provide little real, long-term capital to the insurance industry.

While the actual structure of sidecars continues to mature, one new wrinkle has been drawing significant attention. This is the establishment of Marsh Risk Innovations (MaRI) whereby Marsh reinsures ACE on a quota share basis. What makes this arrangement unique is that, according to Marsh, it can deliver capital market capacity through an A+ rated insurer with admitted paper directly to major corporations in need of additional catastrophic property coverage. The traditional approach to the sidecar has been to work with reinsurers in offering additional capacity to retail insurers. The innovative aspect of MaRI is that the additional capacity is provided by the capital market via a highly rated delivery vehicle, namely ACE. Marsh indicates that when structured this way, MaRI can offer clients more than $1 billion in extra property capacity for catastrophic coverage.

Conclusion

The past few years have shown that the capital markets are finally gaining a comfort level with the insurance industry. And they are willing to put their money where their mouth is. Obviously, the past few years have provided a unique set of circumstances, which has accelerated this acceptance by both the capital and the insurance markets. Historic low rates of return forced the capital markets to find alternatives to their traditional investment vehicles, and historic loss levels required the insurance industry to realize that it had insufficient capital to weather additional catastrophic losses. But together, over the past few years, both market segments have gained an understanding of each other and have found ways to work with each other.

And, along the way, the insurance industry may well have found a “silver bullet” for its long-standing cyclical pricing problems. The traditional approach to this pricing cycle is to add new insurance companies during the hard market portion of the cycle. Obviously, this required a significant commitment by starting and staffing an entire insurance company operation. And once the market cycle began to subside (around every three or four years), the insurance industry faced additional competition battling for the falling premiums. This activity, in and of itself, added to the competition for the remaining business and contributed greatly to the degree of premium reductions. Ultimately, the weaker insurers were put out of business during the soft market phase.

But now, rather than going through the time and trouble of forming an entire insurance company, capital can be brought into the industry via a sidecar-type arrangement. And since it is a short-term vehicle by design, its founders merely move on to other higher return opportunities when the pricing softens. This mechanism offers real hope for reducing the peaks and valleys of pricing that the insurance industry is famous for, as well as a long-term solution to the capital requirements that have become appar-ent over the last 15 or 20 years. *

CONTACT US | HOME