ART market: Stability in a sea of financial woes

Insurance-linked secruitizations gain favor

By Michael J. Moody, MBA, ARM

By now every man, woman, and child is well aware of the financial woes that are going on in the United States. And while the subprime mortgage mess has amassed the majority of attention, it is only one of the factors affecting the overall financial landscape. Other factors such as the high cost of energy, escalating cost of the war and the roller coaster ride that has been occurring in the stock market are also helping to fuel one of the most serious financial situations in recent memory.

But, at its core, the mortgage mess is taking the largest part of the overall financial toll. Months ago, some industry pundits were speculating that there would be a quick resolution to the subprime crisis. However, those predictions have proven to be premature. Today, the financial service sector appears to be knee deep in serious problems, with few good solutions.

While there still are many unknowns regarding the ultimate outcome, what is clear at this point is that those lending institutions that had originally been involved with the subprime mess have again failed to properly assess the scope of their problems. Recently reported, larger than expected losses for some of the country’s largest banks, and savings and loans foreshadows a bleak future for those institutions.

Nor is there much evidence of a quick reversal of declining public confidence in the banking sector. Indeed, one projection recently put forth estimates that there will be 300-plus bank failures in the near term before this mess is resolved. All in all, this has cast serious doubts over the entire financial service sector.

Problems not limited to banks

Early on in the mortgage mess, many insurance industry experts were speculating that the insurance industry would be spared the financial woes that were occurring in the banking sector. Unfortunately, such has not been the case. The past few months have found a significant number of insurers/reinsurers that are suffering a fate similar to that of the banking industry.

Just a small sample of some of the insurance industry’s problems will provide a quick view as to the scope of the problem. Recently the following major insurers/reinsurers have noted serious financial situations:

• Munich Re stated that its 2008 financial results will fall significantly below its previously indicated range.

• Swiss Re indicated that it is about $9.6 billion in debt, due in large part to investments in Freddie Mac and Fannie Mae.

• XL Capital XL said it has to raise new capital to get rid of its exposure to former bond insurance subsidiary Security Capital Assurance Ltd.

Certainly the list will continue to grow as new information comes to light.

ART-related issues

The past 10 to 15 years have seen significant innovation within the financial service sector as the capital markets and insurance markets have learned how to play better with each other. The past few years have actually found meaningful movement on the convergence front, resulting in major changes occurring in the financial service sector. Nowhere is this convergence more apparent than with the insurance-linked securitizations (ILS).

It has taken a while, but the catastrophic bond (CAT bond) market is finally making some real strides. Utilization over the past few years has been increasing exponentially. According to mega reinsurance broker Guy Carpenter, CAT bond transactions exceeded $7 billion in 2007 and included several new sponsors such as Allstate, Chubb, Travelers, and State Farm. Much of the new growth is being attributed to the maturing of the market and better acceptance by the industry.

Today, Carpenter estimates that 8% of the property limits worldwide are provided by CAT bonds and over 12% of the U.S. limits come from them as well. Most experts believe that continued growth will follow as both the time and expense to establish a CAT bond have been steadily reduced.

Another alternative for catastrophic property protection is Industry Loss Warranties (ILW). They get their name from the fact that there are two separate and distinct triggers that must be met for claims payment. The first is the size of the loss to the insurance industry as a whole, while the second trigger relates to the size of the buyer’s specific loss.

Just as with CAT bonds, ILWs have been gaining supporters in a post-Katrina environment. It should be noted that a few ILWs had been written prior to Katrina and were involved in losses that followed her. For the most part, the ILWs functioned exactly as advertised— losses quickly adjusted and paid in a timely fashion. General industry acceptance will help ILWs gain market share in the future as will the fact that they are quicker to establish and do not have the high formation costs associated with CAT bonds.

Yet another weather-related alternative that is receiving significant attention over the past few years is weather-related exchange traded options. These are the newest of the available alternatives and have some big names behind them. Both the Chicago Mercantile Exchange and New York Mercantile Exchange have new weather-related products, as do several lesser known exchanges.

The primary selling point of these options is their open market aspect; they can be freely traded on the various exchanges. Most of these products also provide maximum flexibility and significant transparency with regard to pricing and settlements. At this point, most of the products are still relatively new; however, growth of these creative products appears certain.

One of the most innovative catastrophic property-related products to come along over the past five or six years has been sidecars. In simple terms, sidecars function like quota share reinsurance arrangements. However, structurally, they have a number of significant differences.

For example, sidecars are written for a definitive timeframe, typically multi-year periods. Over the past couple of years, sidecars have become a staple in the Bermuda insurance market, where they have added meaningful capital market capacity for coastal property exposures. The real value of sidecars is that their capacity was allowed to leave the insurance marketplace without all of the typical market disruptions that usually accompany a soft market cycle. While the number of sidecars has declined over the last two years, experts believe that should CAT losses occur, capital market capacity could again be easily and cheaply accessed via the sidecar products.

Conclusion

If the past is any indication, much of the ART market is going to be directly impacted by coastal catastrophic claims. Sure, there are other events such as earth-quakes, tidal waves, etc., that can impact the high-level property loss picture, but it is the hurricanes that have the potential to sink the insurance industry.

Heretofore, the insurance industry was able to respond favorably after past CAT losses. However, as underwriting results and investment returns continue to erode, concern is certain to rise as to reinsurers’ ability to pay their losses. It is inevitable that rating agencies, insurance regulators and even insurance buyers will soon be concerned about reinsurance collectibles. And despite inexpensive reinsurance, a “flight to quality” will become an attractive alternative. And this flight to quality may well be a market changer.

So how does any of this “flight to quality” issue apply to the ART market? It must be remembered that CAT bonds, most ILWs and several other types of ILSs are all fully collateralized. As a result, the potential claims settlements have already been funded and paid reserves set aside. In essence, this means there is no credit risk involved with these products. Nor are there any reinsurance recoverable issues to be concerned about.

Additionally, for most of these products, claims can be settled in very short timeframes, since most of them are dependent on third-party published loss information, such as data from the Property Claims Service to determine the validity of the claim.

So, at the end of the day, it may well be the insurance industry’s own pricing cycle that hastens further utilization of ART market, particularly insurance-linked security type products.