Alternative Markets Offer a Variety of Risk Management Options

By | August 5, 2002

How do I insure thee? Let me count the ways.” With apologies to Elizabeth Barrett Browning, that question’s become increasingly meaningful for risk managers, insurers, agents, brokers, consultants and investment banks. Alternative markets, alternative risk transfers, parallel markets—all describe different ways of managing risks.

They fall roughly into two categories: Various forms of self-insurance that retain risk, rather than truly transferring it, although many programs rely on reinsurance to do so, and alternative risk transfers (ART’s). The first includes self-insurance, risk retention and risk purchasing groups (RRG’s), captives, rent-a-captives and sponsored captives, insurance pools, associations and groups and to some extent mutual insurers. The second comprises vehicles that mainly transfer risks to the capital markets in the form of cat bonds and other securitizations, derivatives, swaps and in some ways finite reinsurance.

Government sponsored programs covering floods, earthquakes, hurricanes and other special risks, including maybe eventually terrorism, are a third possibility, but they aren’t generally considered an “alternative market.”

Captives and risk retention groups
According to a recent article in A.M. Best’s Review, “nearly half of the risks of the U.S. commercial market will be placed in the alternative market by 2003.” There are plenty of reasons. In some cases no coverage is available, or it’s so expensive it might as well not be. The legal malpractice crisis of the late ’80s in California led at least one major law firm to form a captive, which now writes coverage on more than a dozen other firms. The current crisis in the airline industry brought on by Sept. 11 has led leading carriers to set up a risk retention group called Equitime in Vermont.

Differences in loss experience also attracts many companies to the alternative market. Insurance companies are more or less locked into accepting both good and bad, or at least poor, risks. Companies that take measures to control claims, and therefore reduce losses, frequently end up paying for those who don’t. Setting up a captive or becoming part of a RRG based on similar loss histories can mean substantial savings. In addition, if losses are substantially reduced, the profits on any invested surplus go to the group’s members, rather than the insurance company.

The alternative market isn’t a new phenomenon, but there’s been a lot of recent interest in it. “I’ve been doing a lot more captive feasibility studies lately,” said Andrew Barile, whose firm advises companies, associations and similar groups concerning the formation of captives, RRG’s and other alternative market solutions.

He observed that interest in alternatives frequently corresponds to difficult times. “Every time we go through this [a capacity crisis], one sector gets picked on.” When the loss experience rises out of all proportion to the premiums, carriers either leave the market voluntarily, or are forced out of it because they no longer have sufficient reserves to continue writing business. Seeking an alternative becomes imperative.

“Right now PEO’s [Professional Employers Organizations] can’t find any place to go. After Legion [the Legion companies] collapsed they’ve got no alternative to either creating their own insurance company, or some kind of captive,” Barile indicated. Several PEO groups have approached him for advice. After all the larger brokers failed to place any significant amounts of coverage, and the smaller ones they approached were likewise unable to, they’ve come to the conclusion that their only alternative is to create their own insurance vehicle.

The trend isn’t a new one. If Best’s forecast proves accurate, it’s because over the years many industries and professional groups have gone through what the PEO’s are experiencing, and have opted for an alternative market solution. Barile cited a few examples. “Nobody remembers that Lumbermen’s Mutual was originally founded to insure companies in the timber industry when they couldn’t get coverage anywhere else; or that in 1954 Hertz couldn’t buy insurance from any company, as they all felt that their creative idea [the rent-a-car] was too risky, so they formed their own offshore company.” He also mentioned his own role in forming a Cayman Islands company in 1967 to provide strike insurance for New York’s newspapers, as the coverage couldn’t be written in the state.

A similar crisis is currently facing the nursing home industry, particularly in Florida, where recurrent multi-million dollar jury verdicts have become something of a cottage industry organized by the state’s trial lawyers. “The insurance industry is picky,” said Barile, “you need to figure out what product you’re talking about. The surplus lines carriers could do it [provide coverage], but they won’t, so there’s no capacity available, and that forces them into the alternative market.”

He also mentioned the problems in the California building industry where “insuring their cement trucks is impairing their financing.” In this case, although there’s still capacity available, it’s become too expensive. “The concrete manufacturers just think the prices are too high, and they want [to explore ways] to reduce them.”

So, all these various activities are “leaving the industry,” right? Well, not entirely. Barile pointed out that what’s leaving is the risk. “When an industry owns an insurance company not that much changes,” he observed. “They don’t really leave the industry, as another part of the business picks it up.” In fact captives, RRG’s, etc. need program and claims administration, policy issuance and related services. They also need agents and brokers to place reinsurance, so they buy services instead of insurance.

The lawyers’ captive referred to above contracts with Aon to provide its back office work, and places its reinsurance with Lloyd’s. “The companies have figured it out so that they earn money from fees without taking the risks,” said Barile. “AIG makes a good income from it [providing services].” In fact AIG is becoming even more involved. It just established a “sponsored captive” in Vermont. The vehicle is very similar to a rent-a-captive, except that it’s “sponsored” by an insurer.

Agents can participate in establishing alternative market vehicles. The California-based agency Bolton & Co. formed one of the first captives to provide insurance for several of its contractor clients, who felt they could save money by becoming their own insurer. Insurance companies, brokers and agencies all have a role to play in the alternative market by maintaining facilities to establish and service their clients’ various vehicles. A good portion of the business isn’t really lost, as much as transformed.

Alternative risk transfers (ART’s)
Beyond the captives and RRG’s lies the rather more rarified sector of ART’s or securitizations. Their highly touted potential, however, has so far yet to materialize to the extent that has often been predicted. Activity in the ART market is mainly confined to catastrophe programs—earthquakes, hurricanes, hail storms and the like—weather derivative products, and sophisticated credit guarantees, swaps, hedges and other financial arrangements between banks and insurance or reinsurance companies.

Peter Allen, a senior manager in the property and casualty actuarial group of the accounting firm Ernst & Young examined ART’s in a recent issue of the firm’s Cross Currents magazine. The market really got started in 1993 in the aftermath of Hurricane Andrew, which started the first big wave in the formation of Bermuda-based companies.

Therefore, Allen stated, “many ART observers and market participants were predicting a major increase in the use of some of these products, and a sharp decline in others.” That hasn’t happened. There’s been no significant increase in risk transfers to the capital markets.

Cat bonds, the most well known type of ART, start with the identification of a particular risk, earthquakes in California or Japan, for example. The insured, working through a specialized broker and an investment bank, put together a package that defines the risk. To do this accurately they use catastrophe models, usually provided by a risk management services company, mainly AIR, EQE or RMS. Once all the possible loss parameters have been determined, the investment bank agrees to make payments, or more commonly sets up a special purpose vehicle to do so, if certain events, or “triggers”, occur during a certain time period, two years for example.

The bank then “securitizes” its obligation in the form of bonds, which it sells mainly to institutional investors. The bonds pay interest over the period covered. If a loss occurs the investors may lose part, or all, of their investment. If nothing happens they are repaid the face amount of the bond. So far no cat bond has failed to repay its investors.

There are as many variations on the above as there are banks and insurance companies. In addition to the special purpose vehicles, usually trusts or limited liability partnerships (LLP’s), cat bonds may have more than one layer of coverage, or may use parametric triggers, which define finite layers of loss. Weather derivative products compensate the insureds for the harmful economic impact of unusual weather patterns rather than catastrophes.

The main problem with ART’s has always been that they are complicated and expensive. Goldman Sachs may be interested in placing $200 million worth of coverage on Tokyo Disneyland, but it’s not interested in Ralph’s Garage or Sally’s Dry Cleaning.

After Sept. 11, however, all the necessary ingredients seemed to be present to make securitizations a viable alternative. Coverage for terrorist acts became very expensive or unavailable; multi-million, if not billion, dollar properties were at risk; large, experienced companies owned or managed them and they needed coverage. Reinsurance rates on commercial property doubled, and often tripled. It didn’t happen. The main reason seems to be that the banks put their money somewhere else.

“In the last two quarters, the amount of new and replacement capital finding its way into the conventional reinsurance markets in Bermuda, London and other centres has probably exceeded $15-20 billion,” Allen stated, “whereas the amount of capital risked on cat bond issuance is unlikely to have been more than $1 billion.”

Capital investment since Sept. 11 has gone into forming new insurance companies, or increasing the capital of existing ones, not into securitizations.

While investment banks like Goldman Sachs and Lehman Brothers own reinsurance subsidiaries in Bermuda, their investments have gone into joint ventures with companies such as AIG, Chubb, Zurich Financial, Aon and MarshMac, as have investments from J.P. Morgan Chase and Credit Swiss First Boston.

It’s not hard to figure out why. If the stock market ever recovers, most of those new companies will line up for initial public offerings of their shares, just like ACE, XL, RenRe and others have done before them. It’s a win-win-win situation for the banks. Hopefully the companies they’ve formed will make money, or at least not lose too much; they’ll get a lot of money from the public when they sell their shares, as well as the fees and commissions from handling the IPO. No wonder they aren’t terribly interested in pushing cat bonds.

Allen indicated that the buyers seem to be willing, so far, to pay the high rates, rather than go into cat bonds. He also noted that most of the common triggers wouldn’t have caught the attacks of Sept. 11. That, however, is one component that any risk consulting service can certainly fix.

The increased demand for other forms of alternative markets perhaps also explains the slack demand for ART’s. Allen noted the same upsurge as Barile. As companies see the end of low premiums, low deductibles and high policy limits they “have begun exploring ways in which to curtail their exposure to the volatility of the insurance market.” That’s part of a corporate risk manager’s job.

While the term “alternative markets,” implies that the insurance industry is losing its customers, it seems more likely that what is really happening is a transposition of risk parameters. This has resulted in a trend toward splitting the actual risks of doing business off into a separate category, the captive, the RRG, the cat bond, etc., while retaining the services of agents, brokers and companies to organize and manage them.

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