January 1 2002 may turn out to have been a timely moment to switch the regulation of Bermuda’s fast-growing insurance sector
from the finance ministry to the Bermuda Monetary Authority. In the final weeks of last year, Bermuda was in the spotlight as more than $10 billion of capital poured into new and existing Bermudan insurance companies as part of a rapid recapitalization of the industry worldwide.
Home to a growing number of highly sophisticated insurers and reinsurers (which provide insurance to insurance companies), Bermuda is fast becoming a principal engine of change in the insurance industry. And, after last year’s experiences, it is an industry that could be entering a period of profound change.
Bad years are nothing new in the insurance world. Just ask anyone who has been a member of an insurance syndicate – either in a private capacity or as a corporate member – at Lloyd’s of London in recent times.
But 2001 will go down as perhaps the worst yet. Losses resulting from the September 11 terrorist attacks in the US are still unquantified, but estimates put the bill somewhere between $50 billion and $70 billion.
Add in the capital destruction wrought by weak equity markets, which may have wiped another $20 billion off the industry’s balance sheets, and several billion dollars of losses resulting from exposures to Enron and it is clear why Alice Schroeder, Morgan Stanley’s lead insurance analyst, calls 2001 a “kitchen sink” year.
Others go even further. Axa chief executive Henri de Castries, warning in late December that the French insurance giant’s profits would fall by over 50%, described 2001 as “probably the worst year ever for the industry”.
But as any insurance underwriter knows full well the flipside of risk is reward. Within weeks of the single biggest loss in insurance history, the industry’s leading players were already forecasting that this year could one of the most profitable ever.
New capital chases high rates
Faced with a sudden capacity shortfall, insurance and reinsurance rates – which had been hardening or rising anyway before September, but from their softest or lowest levels in years – have rocketed to the hardest levels seen in a generation.
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By mid-December, according to the Institute of Actuaries, rates for aviation war risk had ballooned on average by 600% to 800%, with marine war rates up by 400% and aviation reinsurance rates at least doubling.
Property and casualty insurance, reinsurance and retrocession (reinsurance of reinsurance) rates also spiked sharply, rising by at least 50% across the board and, in many cases, by 100% or more.
In a bid to ease the capacity crunch and take advantage of the hard-rate market, insurers rushed to raise new capital. In a matter of weeks, some $6.5 billion was raised for six new Bermuda-based operations, with existing Bermudan companies adding a further $4 billion of fresh capital.
At the same time, the public equity and debt capital markets absorbed a wave of insurance capital raisings of every kind – senior debt, subordinated debt, convertible bonds, exchangeable bonds and straight equity.
These financings benefited from a happy coincidence of events: insurers were struggling to bolster battered balance sheets just as investors were waking up to the industry’s dramatically improved outlook.
But the capital that was being raised privately for the Bermuda operations had only one purpose: to create new capacity and start writing business immediately at a time of massive opportunity for the industry.
The new entrants include Axis (set up by Marsh&McLennan and capitalized at $1.6 billion), Allied World Assurance (a $1 billion vehicle controlled by AIG, Chubb and Goldman Sachs), Endurance Specialty (set up by Zurich and Aon, with capital of $1.2 billion), Montpelier Re (a new $1 billion vehicle set up by White Mountain), Da Vinci Re (capitalized at $500 million and formed by Renaissance Re and State Farm) and Arch Re (a new $750 million vehicle of Arch Capital).
These are not the only new participants. Many other less well known and less skilled players are also on the hunt for capital. But the speed with which experienced insurance operators such as these reacted to the capacity crunch was impressive.
Nothing could illustrate more strikingly the opportunity that insurers and reinsurers are eager to seize after a difficult few years for their industry. But the capital-raising was also greeted with dismay in some quarters. Industry executives fear that the new supply could bring the harder rate market to a sudden halt, forcing prices down again just when it looked as though the industry might be able to make some money.
A Morgan Stanley research report in November estimated that some $18 billion in new equity capital would flow back into the market by the end of 2001 alone. With $1 of capital effectively translating into $1 of capacity, the shortfall will soon be refilled.
Industry experts say this flood of capital will inevitably exert downward pressure on prices. But that was not how it looked at the end of last year, as delegates attending the National Association of Independent Insurers (NAII) conference in New Orleans in November reported severe difficulties in putting insurance programmes in place at an acceptable price – or, in some cases, at any price.
What made the situation last December unique was not just the fact that capacity was scarce and prices were sky-high – for virtually every type of cover. It was the fact that this dislocation was happening at the very moment when the insurance world is at its busiest.
December is always a month of frenetic activity as insurance brokers and their clients renew policies for the start of the following year. Some 70% of all insurance and reinsurance policies run annually from January 1 to December 31, with the vast majority of renewals being negotiated and placed in the final weeks of the year.
But last year the process was thrown into near chaos. With reinsurers unwilling to extend cover in many cases before deals are worked out with governments about the future insurance of terrorism risk, the traditional broking and underwriting system found itself under intense pressure.
Underwriters have been unwilling to quote prices, rates have been punitively high in many cases, companies and insurers have found large holes in their protection that they cannot cover, and many insurance users entered the new year without any cover in place.
Dan Sussman, chief underwriting officer at Bermuda-based XL Financial Solutions, believes the effects of this hiatus could last well into the current year.
He says: “There has been some real scrambling around and dislocation as people have tried to get insurance and reinsurance programmes in place and a lot of people have got a lot of holes in their cover.
“The market is going to hit the pavement. People will try the best they can with the traditional insurance and reinsurance providers, but there will be holes that need to be filled somehow.”
Sussman adds: “You will see insurance companies that need to cover themselves not being able to get reinsurance and corporates having to decide whether they are happy retaining more of their risks, or whether they need to find other ways of covering them.”
A speedy resolution to the terrorism bill in the US could ease the strain on the system. And there are plenty of people who believe that the problems in the industry are simply a short-term consequence of a uniquely catastrophic event.
But there are many others who think that the dislocation in the industry at such a critical time could have long-term effects – just as earlier market shocks in the mid 1980s (as a result of soaring general and public liability claims in the US) and the early 1990s (following Hurricane Andrew and the Northridge earthquake in California) triggered profound changes.
Among these are likely to be a flight to quality among insurers and reinsurers, with the largest and best-rated players benefiting from their financial strength; growth in the use of alternative risk transfer (ART) solutions as a complement to traditional insurance and reinsurance programmes; and the continued blurring of boundaries between the insurance and banking worlds.
ART – which has been described as insurance-based investment banking – comes in many forms. Put simply, it covers a variety of ways in which insurance companies, and insurance users, can take on and shed risk.
For insurance companies and reinsurers, this takes the form of risk transfer into the capital markets – either shedding it through the securitization of insurance risks, or taking it on by writing protection on new types of risk such as credit or weather, often via the derivatives markets.
| Swiss Re: where insurance meets banking | ||||||
For insurance users, mainly corporations, this involves new ways of organizing cover. This can be done through multi-year/multi-line policies, through captive insurance companies – which are owned by corporations themselves or by industry groups – and through finite risk solutions, which spread the risks of the policyholder over a period of time via what is effectively a banking facility supported by a letter of credit.
In the short term, it is the corporate side that is seeing the greatest attention as insurers concentrate on their core business of organizing cover for clients at a uniquely difficult time and as insurance companies themselves seek alternatives to expensive reinsurance rates.
In the longer term, however, the insurance company side could see even greater effects as a growing range of instruments and techniques are used to move credit, market and insurance risks among banks, insurers, reinsurers and other capital markets investors such as pension and mutual funds.
The insurance industry is in no doubt that ART can offer a range of innovative, cost-effective solutions. In recent years most of the major insurance companies, brokers and reinsurers have set up specialist risk financing operations – in New York, Bermuda, Zurich and London – to complement their activities.
In the low-rate environment of the late 1990s, companies and insurers had no need for alternative solutions. Cover was plentiful and cheap. But these ART practitioners now believe that their moment has come.
“Companies have found that prices have risen substantially, that capacity is severely constrained and that coverage is not available at all for some risks,” says Jay Ralph, president and CEO of Allianz Risk Transfer in Zurich.
“People are still trying to get their traditional insurance done before committing themselves to alternative solutions, but conversations have been taking place at an increasingly high level within corporations about what their risks are, and what their options are in protecting themselves.”
Self-insurance through captive companies is one option. Since the mid-1980s, captive insurance companies have been a growing part of the insurance scene. Some 1,200 captives are registered in Bermuda alone, and over 4,000 worldwide.
Many analysts believe that the current market shock will trigger another wave of captive companies – not least from the aviation industry, where insurance rates have put traditional cover out of reach.
Retention of risk is another. “Some companies may simply decide to go more naked for a while,” says one insurance company executive. “Or they may decide to retain a certain amount of risk and just place out the very high-level stuff.”
But brokers and underwriters report that companies are queuing up for finite reinsurance solutions. “The ART market knows that it’s got the world by the nuts,” says one broker.
“People are trying to charge commitment fees so that they can concentrate only on the people who really want to do a deal and they can get rid of the time-wasters.”
It is in the area of finite solutions that the increasing convergence of insurance and capital markets techniques is seen to best effect. Using future flows, future royalties and other securitization-style structures to secure risk financing in the insurance world is becoming increasingly common.
One underwriter reports a finite deal put together in the last few weeks for a Canadian company that needed terrorism cover, and was clearly not going to be able to get it in the traditional market. By using future revenues, an ART solution was possible.
Another reinsurer points to a recent case of a pharmaceutical company that was able to get traditional insurance, but only after it was able to bring down the cost by using future royalty receipts.
“There are more and more instances where the capital markets and structured finance technology that is common in the asset-backed securities markets can be used to provide secured risk financing solutions for companies that are not able to insure themselves in the traditional way,” says one insurance professional.
Oliver Prior, director of research and development at insurance brokers Willis, believes that only a fraction of the people looking at ART solutions will have the experience to structure a successful, economic transaction.
“If the impetus to buying alternative risk solutions is a knee-jerk reaction to increased prices, then it’s not going to work,” he says. “You don’t repair a house once it starts falling down. You keep it repaired so it doesn’t start falling down.”
He adds: “Most of the ART and securitization structures that we have seen have been part of a conscious, strategic move by insurance companies and corporations. These people have been using risk finance and alternative techniques through the hard and soft markets, they have been successful and they will keep going.”
Prior continues: “But the people who are exploring this for the first time a week before renewal, because they don’t like the premium and they’re thinking ‘my God, I’d better do something alternative’, they are not going to get very far.”
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In some instance, companies are using ART as a negotiating tool for securing a reduction in insurance or reinsurance rates. One industry executive points to the case of a client that was quoted a 50% rate on line [the premium as a percentage of the notional insured amount] for 2002, started discussions with an ART provider as a bargaining weapon, and ended up paying a 20% rate on line for the traditional insurance.
Don Watson, director at Standard&Poor’s, believes that ART will not develop solely as a function of price. “Primary insurers are going to have a hard time paying the reinsurance rates and they are looking for cheap alternatives, which is where ART comes in,” he says. “It can be very useful for smoothing out earnings and balancing volatility. And it is useful if you are retaining more and running higher risks.”
But he argues that the hard market will not last long. “Let’s not forget that the big guys – Munich Re, Swiss Re, Berkshire Hathaway and GE, who control about 45% of the reinsurance market between them – are still in control,” he says.
“They have not had their ratings dropped and they have so much capital that their capacity has not been affected. As a result, we probably won’t see a sustained increase in rates.”
But professionals inside and outside the ART market are confident that growing sophistication among risk managers, and the desire to have a range of solutions that can be deployed in good times and bad, will lead to a sustained rise in demand.
“The modern risk manager needs to have a golf bag with all sorts of clubs,” says Prior at Willis. “The finite solution is like a sand wedge. You don’t use it very often, and you certainly don’t use it to drive with. But when you find yourself in a bunker, it’s good to know you’ve got it in the bag.”
But the ART practitioners know that, for the next few months at least, they are going to be busy. “Most of what we see and do is not price-driven,” says Ralph at Allianz. “The majority is driven by a problem – a client who can’t get the capacity, or can’t get the coverage at all. That’s where ART solutions come in.”
Sussman at XL Financial Solutions quips: “I told most of my team that they couldn’t take any vacation over the Christmas holidays because we would be so busy. What I should have said was they couldn’t take any holidays in February. ART shops like us are going to be very active throughout the first quarter, and probably well into the rest of the year as well.”
But he believes that the business is set for long-term growth, both in the frequency of usage by companies and in the quality of users. “It’s not necessarily the case that we are going to see 10 times more submissions in the finite business. But the overall hit rate will be higher and the quality will be better,” he says.
“We need motivated clients who know what they want, know why they want it, and are really committed to making it work. If we have that, then over the next couple of years we are going to see a lot of product development that will stand this business in good stead in hard and soft markets, and establish ART as a genuine alternative to traditional risk transfer.”
Keeping lunch in-house
It is also questionable whether companies that have set up risk finance operations do not themselves run the risk of cannibalizing their traditional insurance and reinsurance businesses – although, as one reinsurance company executive comments: “If there is a lunch to be eaten, we’d rather have it ourselves internally than let someone else eat it”.
| Risk transfers among banks, insurance companies and capital markets | ||||
| Direction of risk transfer | Risk type: | Credit risk | Market risk | Insurance risk |
| Banks to insurance companies |
Bank equities and bonds. Trade credit insurance. ABSs, CDOs, portfolio CDSs; financial guaranties; residual value insurance; other forms of credit insurance and surety bonds |
Bank equities and bonds. Insurance companies writing options and buying bonds with embedded options (eg callable bonds) |
Insurance on bank property, legal liability etc. Insurance provided to borrowers to facilitate loans Newly introduced insurance for eg operational, political risk |
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| Insurance companies to banks and other capital market investors |
Letters of credit. Liquid facilities |
Hedging of embedded options in portfolios of life insurance and pension products | Catastrophe bonds | |
| Bank of England, Financial Stability Review: December 2001 | ||||
What is unquestionable, though, is that ART is the area where the insurance and investment banking worlds are coming together – with profound implications for both industries, and for those who supervise and regulate them.
Leading the way in this area is Swiss Re, which recently integrated its pathfinding Swiss Re New Markets operation into its financial services group, which includes its investment banking operations.
Swiss Re has taken on a number of experienced investment bankers, up to board level, and is highly regarded for its work on ART for corporations – through finite risk solutions, multi-year, multi-line products, multi-trigger products and contingent capital (which covers the financing of losses at conditions agreed upon before the event) – as well as capital market innovation in insurance through insurance-linked bonds and derivatives.
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In particular, Swiss Re – armed with its prized triple-A rating – has concentrated in ART on the areas of earnings cover and capital cover, using investment banking-style hybrid capital structures to provide quasi-insurance solutions.
Most notable was a $1 billion contingent capital solution provided to French tyre maker Michelin, whereby the company would have the right to draw down a line of capital from Swiss Re and a syndicate of banks and insurance companies at terms agreed in advance if a trigger point was reached. In this instance, the event was a specified fall in GDP, which is now close to being triggered.
Besides the Michelin deal, Swiss Re has provided several contingent capital solutions to companies that are natural disaster-related, where an event or events work as a trigger.
“Our concepts all have to do with helping people to leverage their capital without taking additional risks,” says Tom Skwarek, head of capital solutions in Swiss Re’s global corporate marketing group in London.
“It’s all about providing stand-by capital – which is what insurance is supposed to be. It is a block of new money that can’t trigger any other defaults, and which allows the company to absorb the event or the risk without eating its other capital.”
But, of all the ART solutions that have been put together – either for insurance companies or for corporate clients – none has been more public or more exhaustively analyzed than insurance-linked securitizations.
Having been kickstarted in the mid 1990s, the securitization of insurers’ catastrophe risk into the capital markets through what are called cat bonds has signally failed to live up to the expectations of its promoters.
Forty-five transactions in six years is not the sort of deal flow that would normally keep fee-hungry capital markets bankers on their toes. But it is a business that could start to pick up speed again in the next year or two.
“As far as I’m concerned, it’s now or never,” says George Maher, principal at actuaries and management consultants Tillinghast. “The problem that securitization is supposed to ease exists right now. Insurance rates are hard and bond markets are cheap, at least in comparison.
“But this market will only work if capital markets investors genuinely want these instruments. Now is the time when the market will either take off or will prove to have been a clever idea dreamt up by some smart investment bankers – and nothing more.”
Cat bonds emerged amid much fanfare in the mid-1990s, spurred by the interest of insurance companies and investment bankers in exploring the ability of capital markets to provide an alternative source of risk capacity.
Business was relatively brisk for a while, with most of the major reinsurers and insurers at least dipping their toes in this potentially intriguing new market. But the deals were generally small, transaction costs high, investor demand uncertain and the economic benefits to either issuers or investors difficult to quantify.
By 1999 and 2000, as the insurance world hit the trough of the softest rate market ever, securitization was off-limits. There was no way that pricing could compete with the absurdly low rates on offer in the traditional insurance and reinsurance worlds. Business dried up.
Now comes the test of whether there is genuine demand for the product outside the insurance industry. Although securitization remains expensive, it is a good deal cheaper than reinsurance.
Already there are signs that activity is picking up again – although, as one US reinsurance company executive remarks: “I doubt they are doing back-flips of delight over at Goldman Sachs just yet”.
Wall Street investment bankers say that four new deals are already in the pipeline for issuance early this year, covering about $400 million of catastrophe reinsurance risk in total.
Three of these transactions are being put together for reinsurers, all of which have tapped the market before. The fourth is for a Lloyd’s vehicle – marking the first time that syndicates operating in London’s insurance market have used catastrophe securitization.
Watson at Standard&Poor’s believes that issuance of cat bonds could double in 2002 from the previous average level of around $1.5 billion a year. “When you have reinsurance rate increases of 30% or more, then cat bonds become a viable alternative,” says Watson. “At the margin that will take some of the pressure off rates.”
Analysts at Swiss Re – one of the market’s driving forces – go further. They reckon issuance will reach $10 billion annually by the end of the decade. Although the volume projections are relatively low, these are high-margin products for the banks and everyone else involved in arranging the deals.
Despite the high yields on offer, it is far from clear that mainstream fixed-income investors, already faced with an array of new credit products, are comfortable with taking on insurance risk.
“One of the problems is that the capital markets have shown a reluctance to build up any decent level of capacity outside known areas such as Japan and Californian earthquake risk,” says Prior at Willis.
“Also, the capital markets are much more interested in volume. If you can’t sell $1 billion of product, nobody wants to do it. I get the feeling that insurance securitization is seen as a bit of a backwater within investment banks – that the business is not moving fast enough to attract and retain the talent.”
Two investment banks have led the way in trying to develop insurance securitization since 1995 – Goldman Sachs and Lehman Brothers.
That’s no coincidence. Both were quick to spot the potential for linking insurance and capital markets in the early 1990s, setting up Bermuda-based subsidiaries – Arrow Re and Lehman Re – that could act as what are known as transformers, connecting the two businesses.
Other investment banks have followed suit, but Goldman has remained by far the dominant force in the new-issue market.
Investment bankers insist that at least two-thirds of all cat bonds have gone to institutional capital markets investors. “This is new capacity in the strictest sense,” says one. But others have their doubts – believing that insurance companies, and particularly reinsurers, have been the main buyers and that the extent of risk transfer outside the insurance sector has so far been limited.
The main brake on the development of cat bonds, say analysts, is the high transaction costs. Analysts estimate the one-off costs of a cat securitization to be around $2.3 million, while the risk adjusted spreads of these deals – according to Lehman Brothers – is around 5.5% to 6.5%.
But these costs have started to look less daunting as insurance rates have soared. “If you are a reinsurance company faced with all this uncertainty as to where rates are going, you would look to the capital markets,” says one Wall Street banker. “In the past, pricing was not competitive. But it will be a lot more competitive now.”
He adds: “Securitization is something that helps reinsurers on the margin. It is not going to replace reinsurance, but it allows reinsurers to free up capacity and take on more attractive business.”
Some industry experts believe that cat risk is not the most natural insurance area for securitization in the capital markets. They argue that more standardized cover – such as life, household, motor pool or workers’ compensation – would be better suited, but that the insurance industry in general has been very cautious about embracing capital management techniques.
“The insurance sector is a provider of capital to business. It probably doesn’t understand that, but that’s what it does,” says Bryan Joseph, partner at PricewaterhouseCoopers. “In the last few years people have got used to saying that the industry is overcapitalized. But it isn’t. It’s just not efficiently capitalized.
You don’t need all the capital in normal times, but for abnormal times like now you do need the capital and you need immediate access to it.”
He adds: “It would only be logical for the insurance industry to package and sell a much wider range of securitizations into the capital markets as part of their own management of risk and capital. Everyone else does.”
There is still a lot of mileage left in the convergence of insurance and capital markets – and, in many ways, the two worlds do not yet understand each other. In the approach to risk, in the legal regime, in the pricing of products, in all these areas there are more differences than similarities.
But in the area of securitization, which is where the blurring of boundaries has so far been most pronounced, insurance companies and investment banks have been able to work in a complementary way.
“The difference is that we are risk-takers and it is useful to have us in the syndicate if you are selling these kinds of deals,” says Skwarek at Swiss Re. “Investors get comfort from the fact that a major insurer, who has been taking this kind of risk for 100 years, is happy to take this risk alongside them rather than just pass it on. We just know the risks better.”
Joseph adds: “We have to work together if we want to build a large capital market for insurance-linked products. Investors don’t really know how to look at cat bonds. Is it debt? Is it equity? Is it credit? It’s easy to say that it is diversifying the portfolio, and that it is non-correlated, but so is betting on the horse races.
“To create a true market, we work with investors to ensure that they have a framework to analyse these risks and make investments based on relative value. This is the difference between betting and investing.”
