RiskMarket RiskWhat is ART?

What is ART?

Alternative Risk Transfer (ART) has sometimes suffered from the same type of jibe as the British historian, Edward Gibbon, claimed against the Holy Roman Empire in its mature years – that it was neither holy, Roman nor an empire. Is ART neither alternative, rarely about risk nor about transferring it? There is some truth in this view. All of the main ART products have been in the market for a number of years. You could argue therefore that they are fairly mainstream rather than alternative – but there have been new issues affecting these products. The most significant developments that have arisen in the last three years have been:

  • The impact of a more stringent interpretation of accounting regulations that makes it more difficult to ‘spread’ losses through financial reinsurance programmes.
  • An increase in the threshold of acceptability of credit related ART deals caused by insurers increasing returns on conventional business since “9/11” in the US and the withdrawal of some insurers from collateralized debt obligation (CDO) related business in the face of losses.
  • The growth in the number of insurers willing to underwrite derivatives.

Main Products

The main ART products are Finite Insurance, Contingent Capital, Loss Portfolio Transfer, Catastrophe Bonds and Derivatives. These are described in the following sections.

Finite Insurance

A finite insurance contract is usually considered to be a multi-year contract where the aggregate premiums that may be due constitute a substantial proportion of the insurance capacity that the contract offers. It is essentially a funded contract and the risk transfer embedded within the contract is limited. The funds are held in an ‘experience account’ and in many such contracts there is a mechanism whereby unused premiums, held in the experience account, can be handed back to the insured on expiry of the contract.

Finite contracts have been used when there is:

  • No conventional market for the risk.
  • A substantial difference of opinion between the insurance market and the client on the correct risk pricing. As a result, the insured is prepared to accept the major part of the risk but wishes to smooth the earnings effect of a loss.
  • A regulatory obligation to purchase an insurance policy but at the same time the conditions above hold true.

It is the second reason for employing a finite contract that has been causing problems, particularly in the reinsurance world. Real losses had been disguised by recognising the payment of the claim not now, but the impact of future premiums each year as they fall, instead of their cumulative effect (which if recognised would wipe out the additional earnings represented by the claim). This mismatch had caused concern that earnings were being flattered, resulting in a misleading message to investors and regulators alike.

The cure has been to tighten the way (mostly existing) accounting standards are applied. There is now an insistence that the liability for those future premium payments have to be recognised in terms of their present value (and recognised in the year that they become a firm liability as opposed to a contingent liability pre-loss). In addition, the accumulated premiums in the ‘experience account’ have to be treated as an asset of the insured – an asset which has to be unwound in the event of a claim.

This more rigorous application of accounting rules has damaged the attractiveness of finite policies and, although still underwritten, their use by insurance and reinsurance companies has declined. The effect has been less on the way non-insurance corporates must account for finite policies and there are still situations in this context when finite policies will be the appropriate insurance mechanism.

Contingent Capital

A contingent capital facility, as offered by insurers, is a variation on the finite mechanism described above. In this case, insurers offer to inject a sum of capital, either as equity or more usually as debt, following a defined insurance event (some catastrophe). The insured pays a small contingent fee for the currency of the facility and has the option, but not the obligation, to ‘call’ the capital if he needs it following the catastrophe. Once called, the insured puts a capital instrument (usually subordinated or preferred debt) to the insurer. The repayment terms on this instrument represent the mechanism by which the insurer recovers the claims money he has disbursed.

Few of these facilities have been put in place but it is perhaps surprising that more have not been established as they have many advantages. The repayment terms are agreed prior to the triggering catastrophe when the corporation is in good health. The insured will not suffer from the decrease in credit rating that is likely to occur once the catastrophe has hit – that becomes the insurer’s risk. Moreover the borrowing facility (for that is what this amounts to), while untriggered, does not affect bank-borrowing lines (although the impact on existing covenants will need to be watched when negotiating the facility).

The reason for the comparative paucity of completed, insurance based, contingent capital facilities seems to lie in the limited number of sufficiently highly rated companies with whom insurers will deal with. Companies that are perhaps confident that they could arrange equivalent financing easily even if a catastrophe did strike and the cost of these facilities, which is normally higher than equivalent forms of finance, at least before the event. Nevertheless, this form of contingent capital has its application and can be much cheaper that carrying permanent capital on the balance sheet.

Loss Portfolio Transfer (LPT)

LPT describes the practice where a portfolio of risks, some of which may already have unsettled claims attached, are transferred to an insurer, together with a premium which is the discounted value of expected claims, those that are known and those that are merely likely – what is known in the industry as ‘insured-but-not-reported’ (IBNR) losses. The new insurer (or re-insurer) has to take the risk of the ultimate level of claims as the loss experience on the portfolio develops. The premium paid, to the insurer who acquires the portfolio, may or may not be sufficient to cover the fully developed losses.

It is arguable whether this is ART at all but it is usually included in texts on the subject. LPT is often used in the commutation of corporate captives. In this situation, the parent wishes to transfer the risks in the captive to another insurer, hopefully for a premium less than he has collected. The transfer then allows him to wind up the captive and release capital and reserves back to the parent. There will be a limit on the policy provided by the LPT underwriter and should losses exceed this then further losses may flow back to the parent.

Catastrophe Bonds (cat bonds)

Cat bonds transfer risk to the capital markets via a debt instrument. Investor’s monies are held in escrow against a defined trigger event. If the trigger is ‘pulled’ then the escrowed monies are used to pay the claim and the investors will suffer a corresponding reduction in capital returned to them on maturity of the bond. The triggering mechanism is usually a ‘parametric’ index event – that is, the cause of a claims payment is not indemnification as with conventional insurance – but whether or not the calculation of a formula, which attempts to represent the basic numerical characteristics of the risk, results in a value above an agreed threshold number. This may result in a ‘windfall’ gain or loss for the insured. The cat bonds are issued on a multi-year basis, usually between five and ten years.

Cat bonds came into existence because of a supposed lack of capacity in the reinsurance market. Ever since then, they have been almost entirely the reserve of the reinsurance market, although there are a few examples of corporates issuing them when capacity has not been available (e.g. Disneyland Tokyo protecting itself against earthquakes). They have some clear advantages over the conventional markets which are:

  • agreed terms over many years;
  • no credit risk (fully collateralised); and
  • no claims argument (automatic claims trigger mechanism).

On the other hand, the disadvantages are:

  • basis risk;
  • cost (issuance and ongoing); and
  • no portfolio effect (thus each risk/bond is fully collateralised, which is inefficient when compared to a conventional/insurance company structure).

The issuance of cat bonds continues but the market is still small and has not really reached ‘take-off’ yet. It remains a specialist market that is limited to isolated opportunities.

Derivatives

Insurers have become increasingly involved in developing and structuring derivative products in the past few years. Some of this activity has been in modestly liquid, traded derivatives, such as Credit Default Swaps (CDSs) and instruments based on weather indices, others in essentially non-traded indices such as UK house prices or grain volumes. These contracts differ from traditional insurance in that they are not indemnity based and the purchaser may well have to accept basis risk.

Much of the CDS activity has now been cut back in the face of losses (the possible result of information asymmetry between insurers and banks) but some insurers continue to underwrite tranches of CDOs. There are also now derivative based products based on indices of natural events (other than weather), which are effectively synthetic cat bonds. The underwriting of weather-based derivatives has also been affected by past losses and the demise of some of the big traders in this area who generated much of the demand, such as Enron and Aquila. Nevertheless, we believe that the insurance based underwriting of non-exchange based derivatives will grow. The isolation of the risk to a specific event, the use of International Swaps and Derivatives Association (ISDA) documentation and the hassle free nature of claims assessment is attractive to insurer and customer alike.

Future of ART

The future of ART is less likely to be in the creation of brilliant new products which no-one has ever thought of before, and more in the development of specific applications to individual client problems which employ a number of the different techniques in combination. For example, in a recent transaction, Willis built a structure for an agricultural trader to hedge crop volumes that employed a combination of finite and derivative technology. We expect the use of non-market traded derivatives to grow as insurers use analytical tools which are familiar to them to determine volatility, combined with their ability to take and hold catastrophe risk – something that banks, for example, are generally reluctant to do.

This will all take place against a background of accounting developments and regulatory oversight that will make it harder to use ART as a way of masking or flattering financial results. This used to be a big driver of ART purchases but it is surely right that this particular product attraction should be discontinued. ART has its place in the corporate armoury as a way of managing risk and its techniques will now grow in a more transparent environment.

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