ART products: Back in vogue?

An improving financial services sector bodes well for alternative risk transfer mechanisms

By Michael J. Moody, MBA, ARM

One of the most innovative concepts to emerge from the financial services sector over the past eight to 10 years has been the alternative risk transfer (ART) market products that marry insurance with capital market products. While captives, large deductible programs, and self-insurance have garnered the majority of attention in the alternative market, it has been the insurance-linked securities (ILS) that have gotten the lion's share of attention recently.

These programs had experienced modest growth until 2005 when the financial effects of Hurricanes Katrina, Rita and Wilma were felt throughout the financial sector. While the insurance industry was able to meet its financial obligations, the storms left the industry short of capital.

As a result of the costly storms, several groundbreaking ART solutions were introduced to help ease the financial shortfalls within the industry. While a number of the products had been available previously, the ART industry began to see meaningful growth at that time.

Not only was there a concern about the lack of capital in the industry, but several other reasons also were cited by investors for the newfound interest in ART products. Among the more popular reasons noted were the higher interest rates associated with these new products.

Additionally, investors were looking to diversify their portfolios with financial vehicles that were considered as "zero beta" investments, meaning that they were unaffected by stock market results.

ART market innovators were only too happy to locate sources of new capital that appealed to institutional investors and hedge fund managers. At the time, it appeared to be a "marriage made in heaven."

Unfortunately, it was a marriage that ended all too soon when the financial services sector began its well-publicized meltdown. At that point, many industry observers believed, this meltdown was going to provide a fatal blow to this group of investments.

The press "fanned the flames" with regular reports that at the peak of the financial crisis (around October/November 2008) most of the financial markets were, for all intents and purposes, closed.

Reinsurance, however, was still providing a ready source of contingent capital. In fact, the lack of major storm damage in the past couple of years had left the insurance industry flush with cash. But, this situation has resulted in steady price competition that has left the industry with falling or, at best, flat commercial property and casualty insurance rates.

Regulatory relief for securitization sector

While there were numerous reasons for the financial services meltdown, many of the shortcomings have been addressed in one form or another. For example, perhaps the largest group of investments that experienced problems was securitized home loans, or as they have become known, "subprime" home loans. This group of investments has caused significant, nationwide problems for the investment community. The full effects are still not known today.

Much of this issue resulted from a housing bubble that many investors believed could go on indefinitely. As a result, many loans were made that should never have seen the light of day.

One of the primary reasons that this approach caused problems was that loan originators/securitizers had no vested interest in the loans that were ultimately packaged together. Legislation in the form of the Dodd-Frank Act should help avoid this situation in the future.

The Dodd-Frank Act, which was signed into law in July 2010, is a massive piece of legislation, which will change many aspects of the financial services industry. More specifically, with respect to the securitization issue, the Act will require any issuer of such investments to retain at least 5% of the credit risk associated with the transaction. And while there are a few exceptions, the expressed intent of this feature is to require issuers of such investments to "have skin in the game," thus requiring better underwriting of these products.

Specific requirements in several other ILS products are also included in the provisions of the Dodd-Frank Act. While many experts are still poring over the individual sections of the Act, it is clear at this point that the Act's aim is to address many of the most obvious financial regulatory shortcomings and assure an orderly securitization sector.

In general, among other things, the Act gives regulators much broader powers and mandates higher operating standards that should reduce the chances of a similar financial crisis in the future and provide investors with the assurances they were requesting.

A new day for ART

One of the ART products that had really made significant inroads into the financial services sector prior to the financial meltdown was catastrophe bonds (CAT bonds). These are financial instruments that are designed to pay a stated limit of liability in the event of a serious natural disaster, regardless of the actual loss. Interest in CAT bonds had started slowly. However, after the "three sisters" hurricanes of 2005, interest grew rapidly.

Prior to the financial meltdown of the past couple of years, CAT bonds were being modified to meet specific situations quite quickly by increasing the risk basis from wind and earthquakes to hail, rain, etc., as well as potential loss locations. What started out as a transfer mechanism focused exclusively on Gulf and Atlantic coast locations has grown to include potential worldwide coverage.

Once the financial crisis began, interest in these bonds evaporated quickly. However, all that has changed. According to an August 2010 report from Aon Benfield, investors are again eager to get back in the markets, and Aon Benfield predicts that actual sales could eclipse pre-meltdown levels quickly. Aon pointed out that this did, in fact, happen very rapidly by noting that for the 12 months ending June 30, 2010, 20 new bonds, which represented about $4.6 billion, were written. This compares quite favorably with the prior 12-month period that reported just 11 new bonds at a value of just $1.7 billion.

As noted above, the investment community has been extremely keen to participate in CAT bonds. While there are a variety of reasons for this newfound interest on the part of investors, Aon Benfield's new ILS Indices benchmarking study sheds some light on this matter. Last year, for example, Aon projected investment returns of about 2.94%—at the time, not too bad an investment. However, Aon now indicates that the projected returns stand at 12.85% for the year or about 10 points higher than last year; certainly causing a situation that is bound to gain the attention of any institutional investor or hedge fund manager.

A further development that should also gain favor within the industry involves a Swiss Re "deal" in July 2010. The "deal," known as "parametric insurance,"  was between the State of Alabama and Swiss Re. Swiss Re describes the coverage involved as protection that does not pay for damages to a particular property but, rather, pays when a specific event occurs—a Category 4 hurricane, for example. While this is similar to a CAT bond, Alabama officials point out that the state would have had to change state law to allow for a CAT bond. They also add that the pricing of the parametric insurance was ultimately less expensive than the CAT bond approach.

The big point here is that the state purchased the coverage in the first place. Typically, governmental entities self-insure these types of risks and depend on their taxing authority to fund the loss, should it occur. Alabama was the first state to move in this direction; however, the Mexican government, as well as the Caribbean Catastrophe Risk Insurance Facility, has structured similar deals with Swiss Re.

A number of related advantages occur with these types of programs, especially in the claims area. First, since the only criterion for payment is a specific event, there is no proof of loss to prepare and payment can be made more quickly. Further, the entity can use the claims proceeds for any purpose it chooses.

Conclusion

Incurance linked securities have been around for a while. However, problems in the financial markets following the meltdown caused concern, with a concomitant drop in interest. But, some ILS applications such as CAT bonds are returning stronger than before. And with investment income some 10 points higher than conventional investments, it is quite possible that further growth will follow. Institutional investors and hedge fund managers are making strong pitches for new bonds to be written immediately. And all this interest is coming at a time when the insurance industry is flush with cash.

And that is the real problem with the overall ILS market; the insurance market and the capital markets have still not figured out how to play nice with each other. Obviously, in high loss periods (e.g., the three major hurricanes in 2005) capital is at a premium, but the capital markets offer a viable solution. Then when the insurance industry is heavy with cash, such as is the case today, insurers/reinsurers see capital market solutions as competitors.

Longterm, the insurance industry needs to develop a much better capital deployment model that takes maximum advantage of capital market access. Only then will the insurance buyer obtain the best innovations that ILS can provide.