This article appeared in Post Magazine

THE ART OF FINANCIAL ENGINEERING

BY

Richard Willsher

Alternative Risk Transfer means different things to different people but many in the industry agree that it could be the shape of things to come in the big-ticket end of the non-life sector.

The word "alternative" may be used to mean taking recourse to other risk-taking or funding structures or markets, other than traditional reinsurance. And "risk transfer" can mean anything from reinsurance itself to parcelling a variety of risks together and selling the package to investors. The definition depends on whom you talk to.

The use of captives, probably based in offshore locations such as Bermuda or the Cayman Islands, is often a feature of ART. Although in themselves captives are nothing new they do feature prominently in discussions of how alternative structures can be employed to spread risk and potential losses across several fiscal periods.

Finite deals

Financial or "finite" risk transfer involves quantifying when future losses might occur and when, if they did occur they could be expected to impact a business. The future value of those losses can then be present valued and a premium paid to a corporation's captive. The principle value of the premium plus the investment return earned on it can then be used to meet the cost of the future loss or returned to the insured with its accrued investment income.

"The essential theme that underlies this and what the alternative market all about," explains Clive Thursby, a risk management consultant Tillinghast Towers Perrin, "is taking a view on the scope of exposures you are trying to make provision for and the time scale over which you are trying to do so and stretching both in different directions."

Dan Malloy, President and CEO of Bermuda-based Stockton Re says,"Reinsurers are just capital providers. In most cases they provide contingent capital. When there are losses they provide actual capital." On that basis, with the added value of added tax efficiency, finite reinsurance is providing a shield against regulatory and other constraints.

Stockton is what might best be described as example of a reinsurance financial engineer, with the emphasis on financial. Dan Malloy: "What I'm saying to people is, if you were allowed to run your business for five years without needing to report the way you currently report would you do things differently? And the answer is typically, "yes". That's where I can help because a finite relationship with me transfers the day-to-day, month-to-month, quarter-to-quarter volatility from your balance sheet to mine."

Packaging risk

In addition to the financial engineering aspect of finite insurance a client may choose wrap traditional insured risks together with his financial risks.

"Whereas previously," says Clive Thursby, "you may have bought a fire insurance policy and then separately you may have hedged some foreign exchange exposure through a particular instrument, you might now put together a programme which embraces both which effective becomes a hybrid of trading and financial risks."

Such hybrid vehicles are useful for corporate risk managers to demonstrate that they have taken adequate cover against a variety of threats of future significant losses. Such alternative finite products are tailored to meet specific insured's needs. Each deal is different from the next. Similarly captives are increasingly being used to structure more sophisticated insurance and capital market linked solutions. To date this has often been achieved on the back of catastrophe insurance.

Cat bonds

A number of major reinsurance firms such as Aon Re, European Re, Swiss Re and St. Pauls have teamed up with investment banks, often US-based, such Goldman Sachs, Merrill Lynch and Chase. Together they have manufactured products such as bonds, to place with investors, which carried sufficient balance of catastrophe probability risk and level of return to make the investment appealing. But it sounds easier than it is.

Part of the problem is that capital market investors and insurance industry underwriters and actuaries analyze and price risk in very different ways. Indeed they use different languages. "Capital market investors," as Dr. Alan Punter writing in Reinsurance magazine in October last year explained, "prefer to be able to mark their investment to market. They want to know regularly and easily how much their investments are worth. So it is no accident that almost all the securitisations have been of natural perils, and at attachment levels that mostly represent catastrophes, if not super catastrophes." In other words they are very unlikely to happen.

Furthermore bond investors like, for the most part, to buy rated bonds and in order for that to happen a rigorous analysis is carried out by the rating agencies. This can be time consuming and may, in the end, not produce the required level of rating to make the issue fly.

As one ART sceptic put it, "There are a lot of ideas flying around and tremendous enthusiasm for structuring cross market deals. But in fact relatively few have actually been done to date."

Multi-year, multi-line

While finite deals are certainly becoming more common another alternative approach is what Swiss Re now terms Integrated Risk Management. Indeed when reorganising in spring 1997 it integrated its ART unit into a new Swiss Re New Markets division. The idea, which other firms also apply, is to provide both corporate and insurance clients with a packaged approach utilizing traditional insurance and reinsurance coupled with structured financial and capital market techniques.

Large corporates with experienced risk management teams have been a main target for such so-called holistic risk management to date. Multi-year, multi-line policies have become an accepted part of the ART scene as Richard Reddaway Group Insurance Manager at Glaxo Wellcome and former chairman of AIRMIC, the leading corporate risk management association, explains,

"People like Swiss re and XL/Cigna Risk Solutions came up with a product where you blend property and liability, and that has been further developed as you spread this multi-year, multi-line over a lot of other covers. These might include employment practice, employer's liability, compensation, patent infringement and so forth."

"This should be appealing in part because perhaps because it gives you a stability," says Reddaway. "There are likely to be premium savings and there is a "sleep easy" achieved by putting the blanket over all of your primary covers. In addition you may then above your multi-year multi-line have what are called "towers." So you could have additional pure damage business interruption cover, perhaps an excess liability tower so on."

The key ability of the insurer is to take the circumstances which the client is faced with in his business, package it in a way which is likely to be unique to that client and accept the risk transfer to the extent that meets the client's need. But Reddaway adds that the circumstances, the timing and the cost has to add up to a worthwhile deal. This may involve working with those in the treasury function to see if there are risk transfer and funding options that are more suitable.

He acknowledges that there is a certain amount of "marketing" wrapped into the proposal. "Because they are in the insurance world and they are seeking to promote themselves and their capacity, this is a way in part to generate loyalty. You tie in your clients for three or five years. But then to respond to some of the needs of your clients is good for the client and good for the insurer."

Competition and convergence

Some primary insurers and underwriters may feel that such an approach to corporates by the industry's big guns may be threat to their business. But it is worth noting that such deals tend to be limited to large, Fortune 500-sized corporates. Marie-Louise Rossi CEO of the International Underwriters Association who has had a longstanding interest in the alternative market is positive about the new developments. "ART is certainly part of the competitive environment and insurance companies need to understand it. But it is not just a threat it is a tremendous opportunity for companies. And it is also an opportunity for those in the other financial services sectors such as banks."

Indeed talk of convergence between banking and insurance sectors is a common theme among ART specialists. Stockton's Dan Malloy puts it this way.

"The convergence is a two-way street. We have a lot of banks right now looking to lay-off things like credit risk and political risk in the insurance market. Because we do not write a large portfolio of classic insurance business I don't have within my risk reserves a lot of business that I can package and sell to them... So I don't see myself as someone who would be packaging traditional cat risks and selling them into the capital markets. There are plenty of other people who do that already."

Meanwhile insurers themselves seem to be the major target market for ART structures. Dan Malloy again,

"To me, insurance companies with their large aggregation of risk and therefore greater predictability of outcome, are probably more logical targets for me to do business with than the individual corporate entities…." He adds that in the current soft insurance market making the most of excess capital in insurance company balance sheets is something that can be appealing and can be achieved through reinsurance structuring in the finite market.

Another target are captive insurers where capital efficiencies can be applied using an independent reinsurer which frees up the parent's capital to invest in its own business rather than having to use scarce resources to support its risk-taking captive.

Which brings us back to the idea of reinsurance as a financial engineering tool rather than a traditional risk transfer recipient. And therein lie some question marks over the role of Lloyds and ART.

Lloyds Chairman Max Taylor made clear at last year's annual general meeting that ART was among its priorities. In five year's time he said, "Lloyds will have expanded its "toolbox" to include alternative risk transfer techniques, blended products, multi-year contracts and, quite possibly, many captive syndicates."

The good news is that Lloyds' members have among them a formidable range of skills, available capital and experience to allow them and their market to become a leader in the field. For the time being the not so good news is the current restriction on Lloyds underwriters writing financial guarantee business without special dispensation from Lloyds' Council. In addition the UK is not as appealing a tax regime as a variety of others, particularly Bermuda.

Lloyd's position then is one of "watch this space". ART is clearly a major field for future development though concern will be whether, in the meantime other centres and markets steal a march on London and on Lloyds as centres of excellence in the field.

For sure whatever role it is to perform ART looks like it is here to stay as consolidation spreads not only throughout the insurance industry but across financial services generally. The key focuses are how the markets treat risk, how risk capital is raised, protected, rewarded and optimized. And here, it seems major corporations, mainstream traditional insurers and reinsurers, investment bankers and investors have a lot to be talking about in regard to ART.

Break out quote:

"…insurance policies are swap transactions, they are derivatives. The insurer receives a steady predictable stream of income, the premium. The counterpart, the client, receives a variable stream back which are loss recoveries… So in terms of that swap transaction we are providers capital…" Dan Malloy President and CEO Stockton Re.

Close break out.