ART market review

CAT bonds, Triple X, sidecars and a troublesome IRS attach keep things interesting

By Michael J. Moody, MBA, ARM

Not that many years ago, the alternative risk transfer (ART) market had only a minor role in the overall U.S. commercial insurance community. However, several cycles of rapidly increasing premiums have led many of the favorable commercial accounts to seek a viable risk financing option. With increasing frequency, that option has been the ART market. Today it accounts for over half of the U.S. commercial insurance market. The ART market offers insurance buyers a large variety of options with regard to the financing method that can meet the buyer’s risk transfer needs.

One factor that typically affects the ART market movement is property and casualty insurance pricing. Market softening is pretty much universal at this point, including the property market which was hit hard just two years ago. The fact that the insurance industry enjoyed one of its most profitable years in 2006 certainly has had an effect on pricing. Additionally, some of the biggest industry question marks such as the Terrorism Risk Insurance Act (TRIA) appear to be well on the way to long-term resolution. (The U.S. House of Representatives bill, for example, would extend TRIA to 2022.) Generally, the property and casualty insurance market looks as though it will be experiencing further pricing reductions.

Capital market considerations

No review of 2007 or preview of 2008, for that matter, would be complete without noting the effect of the subprime mortgage crisis in the financial markets. And while it is a long way from being resolved—in fact many feel we have just seen the tip of the iceberg at this point—some issues are clear already. In February 2007, New Century Financial, the nation’s second largest subprime lender, indicated it would have to restate its financials due to larger than expected loan portfolio losses. A short two months later, New Century filed for bankruptcy, and the financial market was just beginning to learn the scope of this situation.

Further restatements from other mortgage lenders, resignations of corporate officers and lawsuits from shareholders have all followed. While it is still difficult to determine the total effect of the crisis, current estimates of loss are in the billions and involve most of the major players in the mortgage investment community.

The effect of the subprime mess has resulted in several significant consequences. One of the most obvious results was that the Fed determined that several interest rate cuts were necessary to keep the United States out of recession. While these reductions have for the most part, “kept the wolf from the door,” they have not solved the crisis. However, as a result of the interest rate cuts, institutional investors are again in search of higher yielding investment vehicles. Because of this, insurance-linked securitizations (ILS) will continue to draw the attention of the investment community.

ART market considerations

Exposure to a number of costly disasters over the past 20 years has shown the insurance industry that despite its best efforts, it just does not have sufficient capital to withstand large-scale, catastrophic type events that are frequently associated with weather-related losses. Accordingly, some in the insurance business, along with those in the capital markets, talked of the inevitability of the convergence of insurance market products with capital market products. But for a long time, it remained nothing more than a theoretical discussion, since many in the insurance industry had been busy fighting the whole concept of convergence.

Infighting aside, several ILS products were introduced with limited success. One of the early products was the catastrophic bond (CAT bond) to which several reinsurers were attracted. Over the past five or six years, the CAT bond market has grown and matured. It is now a viable option that is included in most reinsurance portfolios. While both 2006 and 2007 were overall “soft market years” for the property and casualty insurance business, the CAT bond market has continued to grow. Most agree that there were a number of key reasons for this continued growth:

• Standardization of the CAT bond product—This accounted for a reduction in expenses as well as reducing the amount of time it takes to complete the transaction.

• Acceptance by the investment community—CAT bonds have always had several main selling points including returns that are not tied to the investment community, high returns, and since only one bond (KAMP Re) was paid as a result of Hurricane Katrina, investors have become more comfortable with the concept.

• Acceptance by the insurance community—While most reinsurers initially resisted the use of CAT bonds, they are now considered by many to be a core element of reinsurance programs.

• Influence of the rating agencies—The overall impact of the rating agencies following Katrina has been growing and they have been encouraging the use of capital market products to better insulate reinsurers from some of this financial risk.

Two other ILS products have found a market over the past few years as well. The first one was specifically designed to fill a redundant reserve issue within the life insurance industry. Known as “Triple X” securitizations, these products dealt with an accounting issue with regard to term life insurance products. These products were so successful that a similar type of product, “A Triple X” was developed for universal life insurance products. Despite their recent introduction, both of these securitizations have proven to be extremely popular with both the investment community and the insurance community.

The second innovative product is known as “sidecars.” The products were established on the heels of the capacity troubles associated with the property losses from the 2004/2005 hurricane seasons. In essence, the sidecars were fully funded insurance companies that typically entered the market via a pro rata reinsurance product. They usually entailed little more than an underwriting agreement with a specialty underwriter, frequently in Bermuda. At their height there were between 16 and 20 sidecar companies providing additional capacity to a property market that was in need of it. Subsequent to the capacity issues, many of the sidecars have been dissolved, but for the most part, they functioned exactly as designed, coming into existence and dissolving with little market disruption.

Captives

For the most part, 2007 was another growth year for captives. All of the domiciles reported adding new captives to their totals. And there was meaningful growth in several states. Given the current soft market, this is one more sign of the long-term value of the captive alternative. Another important aspect of the current captive movement is that most of the growth is coming from Main Street accounts. And frequently, it’s the mid-sized agents and brokers that are driving this movement.

However, despite the success to date of the captive movement, it is impossible to ignore the 800-pound gorilla that has now entered the room. Over the past five or six years, the IRS and single parent captive owners apparently came to some type of agreement as to how to properly structure a captive that allowed for tax deductibility. It appeared to many that subsequent to failed tax court challenges, the IRS moved away from the “economic family” doctrine and actually removed the Revenue Ruling that supported that position. Many single parent captives used the template that the IRS provided for properly structuring their captives.

But the IRS was never happy about the compromise, and has now found a new avenue of attack. On September 28, 2007, it issued a draft regulation relating to insurance between members of a consolidated group. The IRS requested comments by December 27, 2007, so the issue was still open at the time this article was written, but its effects can still be determined. The regulation leaves little to suggest that there is any hope for single-parent captives to gain tax deductibility for payments made to a wholly owned captive. In essence, if passed, the regulation would result in the captive being little more than a formalized self-insured entity which would have to wait until claims were paid before gaining tax deductibility.

Many interested parties in the captive industry are working to defeat the regulation, but at this point, there is no clear resolution. Should it pass, there will be many issues to address, but most feel that single-parent captives will have a mass exodus to offshore domiciles. There are currently many unanswered questions about this issue, and how it unfolds will have a significant impact on the future of the captive movement. With any luck, the uncertainty that surrounds this matter will not have a stifling effect on captive formations.

Conclusion

Without question, today’s reinsurance market is clear evidence that the long anticipated convergence of the capital and insurance markets is working well. Better than well, actually. CAT bonds have become a mainstay of many insurer/reinsurers and now are also being used by most of the largest players in their own reinsurance programs. Additionally, Triple X and A Triple X securitizations have also found a home in the life insurance industry. And despite some disappointment regarding the ongoing success of sidecars, they performed their role (provider of temporary capacity) perfectly. Should capacity become an issue in the future, it is anticipated that sidecars could become active within a matter of days.

The captive movement continues to grow and mature as an industry. The infrastructure of the marketplace has also matured into an active group of professionals with many well qualified third party service providers and excellent regulators. Insurance buyers of all sizes are beginning to see the value of a captive as a long-term solution to their risk financing needs. Further utilization into critical areas such as enterprise risk management can be expected.

Of course there are still the pending IRS issues. And even here, it’s not the proposed regulation that is the real issue. It’s the manner in which this “attack” took place—unannounced and in the dark of night. Regardless of the outcome of the proposed regulation, the captive industry will undoubtedly find some way to work within the guidelines. Obviously, there is too much at stake to do otherwise.

2008 has all the hallmarks of yet another interesting year in the ART market and Rough Notes will strive to help agents and brokers to better understand and keep abreast of developments. *