THERE is evidence of a reduction in the gap between capital markets and insurance markets to the point where eventually they will both be offering similar products. There appears to be clear pressure for this change from insurers seeking to avert a catastrophe crisis and from their customers who require a wider range of products to manage risk. The majority of the benefits associated with using insurance to transfer risk are not the unique province of insurers, hence there is a potential role for the capital markets which also find providing insurance type covers attractive. In particular there is a shortage of capacity for catastrophes which the capital markets may be able to help solve. There are problems with using the capital markets. These problems have not prevented the limited development of capital market products, the use of which is expected to increase considerably in the future.
WHAT IS THE ROLE OF INSURANCE?
Insurance is a contract which transfers risks from the policyholders to an insurance company. In return, the insurer requires a premium. The real cost of the insurance is the difference between the premium and the risk which the policyholder faces.
The advantages which the insurance company has in accepting the transfer of risk are in four areas: the reduction of risk arising from the pooling of risks; superior access to capital markets; expertise in evaluating and monitoring certain kinds of risk and specialization and economies of scale in providing services such as claims administration.
An insurer has a finite ability to accept the transfer of risk. Reinsurance is a mechanism by which an insurer, if its ability to accept the transfer of risk is exceeded, will transfer such surplus risk to other insurers. The reinsurer receives a proportion of theoretical premium. Again, this has a real cost which is the difference between the premium required from the insurance company and the risk received. Importantly for our purposes, only the first two of the above advantages will apply to reassurance.
CAPITAL MARKET PRODUCTS
The capital markets have developed a sophisticated suite of products aimed at managing the financial risks that a company will face. These include swaps and derivative products (including futures and options). Derivatives are available on a host of financial measures such as shares, currencies, commodities and interest rates. Trading in these instruments is either direct with the exchanges concerned or 'over the counter' (OTC) which involves products tailored to a company's needs by financial institutions. The capital market products have been hugely successful. The level of trading in derivative products may exceed the underlying markets several times over. This success may be attributable to several factors –
- increased volatility in the underlying markets
- the products are able to be used to hedge risk or to speculate on market movements;
- it is possible to trade in securities which are not owned,
- a high gearing factor Increases the potential rate of return (or loss!);
- the markets are very liquid
WHAT IS THE POTENTIAL ROLE FOR THE CAPITAL MARKETS?
There would appear to be three areas where a role for the capital markets is discernible:
- the need for extra capacity for reassurance,
- direct access by large corporations to the capital markets for the transfer of certain risks which were traditionally the province of insurers,
- hybrid products which combine elements of insurance and traditional capital market products such as interest rate swaps
So far, most of the activity has involved the possibility of the capital markets providing extra capacity for the reinsurance of catastrophe risks. This is because there is not enough capacity to cater for the risks that the insurance industry wishes to transfer. It ls considered by some that the products for transferring catastrophe risk from the reinsurer may do better as an alternative to traditional insurance for, say, firms operating in earthquake belts.
Catastrophe reinsurance
This is the most discussed area of the use of capital market capacity and it is useful to consider this further.
What is the problem?
Economic growth and demographic trends have concentrated people and wealth in high risk areas, such as California, Texas, Florida and New York. It has been estimated that insurers and reinsurers have a total capacity of US$220bn to pay for all US claims in any one year. This compares to the US$125bn of damage caused by the Kobe earthquake alone. It is commonly believed that a hurricane causing US$100bn of insured damage in the USA would devastate the US insurance industry. The trend is not restricted to the USA. The growth in wealth throughout societies world-wide is increasing the need for insurance. Earthquakes in China now regularly cause US$1bn worth of damage insurance that covers against catastrophic events is both expensive and in short supply. Paradoxically there is too much capital for traditional risks and not enough capital for true catastrophe risks or the newly emerging technological risks.
The capital market as a potential solution
Some see the capital markets as the only option to fund insurance. The US$l00bn referred to above, which would devastate the US insurance industry, would barely register when looked at in the context of the US$13 trillion in stocks and bonds which have a daily deviation of US$133bn.
Derivatives have been a highly successful tool in other sectors, attracting speculators because of their high gearing factor - for an initial outlay a lot of cash can be generated. A fully fledged insurance derivative market could attract the investment sector, hence introducing extra capacity into the insurance industry and widening the spread of risk. The benefits are seen as lowering transaction cost and making the market more efficient by having information available to all. It ls also possible that forward contracts would become available which would allow the hedging of risks.
Direct access by large companies
The very largest companies access the capital markets direct rather than going via the traditional route of using a financial institution. This trend, called 'disintermediation', may well extend to insurance products in the future. The benefit would be lower dealing costs through by-passing insurers and reinsurers.
A further trend which is relevant is the unbundling of insurance services by larger companies - for example, the insurer may want the benefit of claims administration, but not the risk transfer for smaller claims. This allows for the uncoupling of risk transfer from other services, allowing capital market products to be considered.
Areas which may be of interest to large corporations have been divided into two areas :
- Financing risk - this is the pre-agreed provision of credit to pay for losses which were traditionally the province of insurance companies. This offers balance sheet protection but does not impact on the profit and loss account;
- Transferring risk - this is the transfer of insurance type risks to investors in the capital markets. As well as individual arrangements, this includes futures and options to be traded on exchanges
However, most purchasers of insurance will continue to approach an insurer who will then access traditional reinsurers and the capital markets, whichever offers the capacity and price required, to lay off the risk.
Hybrid product
A fertile area for new products which link insurance events to traditional options is also developing. This is useful because currency and interest rate exposures may only occur if a particular 'Insured' event happens. For example, if new safety standards are being considered a company may consider that the only option is to import goods until they can be manufactured In the home territory to the required standard. This would lead to a currency exposure only if the standards are implemented. An option which was exercisable only in those circumstances would be far less expensive than a traditional option.
WHY ARE CAPITAL MARKETS INTERESTED IN INSURANCE?
There is clear interest in using capital markets, but what is the attraction from the perspective of the investment management community? The advantages are perceived as a low correlation with other events, profitability and opportunities for reduction in distribution costs
The events of the insurance market which are looking to be transferred are not correlated to the risks associated with the equity, interest rate and currency markets which constitute the mainstay of the capital markets risk. For example, the chance of a hurricane striking is not linked to stock market prices. This type of risk contrasts with many that the capital market is faced with which are linked to economic performances. Involvement with insurance type risks offers the capital market a method of spreading the risk further. Sandor refers to insurance risks as 'zero beta' risks, suggesting no correlation with other capital market risks.
Research supports the belief that adding pure insurance risks to a conventional investment portfolio will reduce portfolio volatility without reducing yield.
A second advantage is that the pricing of insurance risks is attractive to non-insurer investors, as insurance risks offer an opportunity for the capital markets to achieve enhanced returns on equity compared to other investments. In addition there are perceived opportunities to reduce distribution costs considerably.
PROBLEMS WITH UTILIZING THE CAPITAL MARKETS
There are several areas which have slowed down the use of capital market products:
- Lack of a durable and robust index on which to base the derivatives. The danger of not having a robust Index is that the loss experience may not correlate with the index and result in imperfect risk transfer
- Perception of risk - the capital markets feel uncomfortable with the types of risks traded, they feel exposed to a 'lottery' rather than risks for which they have a feel, such as interest rate risks. There is a learning curve for investors in insurance products used to a different jargon
- Inefficient market - there is the perceived danger that insurers may have better information than they release to the index or manipulate the data they release, hence Impairing the efficiency of the markets i.e., there is asymmetric access to information
- Nature of insurance losses - these are seldom clear cut and it can take a considerable length of time to determine the size of a loss. This delay can remove the benefit of buying the derivative product which typically operates with speedy settlements
- Illiquid market - there is not a liquid market so investors have no guarantee they can sell futures and options once they have bought them
- Limited success of the existing insurance derivative market. However the existence of this market has led to some over-the-counter (OTC) derivative products being developed;
- Insurance regulators - these have been suspicious of the development of capital market policies
SECURITISATION OF RISK
Where no index is available then a 'capital market' approach may still be adopted. This approach involves the securitlsatlon of risk in a similar manner to mortgages. Pools of insurance contracts would be created and then sold to a secondary market, allowing the original insurer to accept more risk. Investors are paid returns based on the claims experience of the pool of policies. For the future, several risks are being considered for securitlsatlon, for example US medical costs may be amenable to being measured against an independent economic index, allowing the insurance to be securitised.
SOME CURRENT CAPITAL MARKET PRODUCTS
There are currently some examples in current use which gives a flavour of the similarity to capital market products.
Modest attempts have already been made to use derivatives to boost capacity and lower the price of insurance. The Chicago Board of Trade (CBOD) options were launched in September 1995 and the index tracks nine catastrophe loss indices covering US exposures. The Indices cover approximately 70 per cent of losses. Although these have so far failed to spark the expected interest they are expected to storm the market Act of God bonds.
Act of God bonds are traditional debt but with built-in clauses that release the company from some of its obligations in the event of a natural disaster. These are hybrid products which can be structured In a flexible way and may apply to repayments of principal and/or interest.
One method used is setting up a special purpose vehicle (SPV), which is owned or guaranteed by the company. The SPV issues an insurance policy to the company for a premium. The SPV issues certificates which carry fixed or floating rate with a fixed maturity.
Investors then purchase the certificates. The SPV distributes the interest to the certificate holders plus the premium received from the company.
In the event of a claim, the SPV sells securities to cover the loss. The investors now receive interest on the reanalyzing portfolio, and at maturity, only receive that part of the principal which remains.
Combined risk option
A further hybrid product is a combined risk option. This is a conventional option that is used to hedge a financial exposure. However, the option may only be exercised if another insured event occurs. This is cheaper than a conventional option because it only covers a financial exposure which exists if the event occurs. The event can be virtually anything which is outside the control of the purchaser (for example, a new law or regulation coming into force, a court decision, weather, winning or losing a contract bid). An example is a company which believed it would gain a contract if a satellite launch failed. Hence it would need to source supplies from a Japanese company and as a result incur a currency exposure. lt was able to buy a Dollar/ Yen currency option contingent on the failure of the satellite launch to These products could also be targeted at the layer of risk which the firm can afford to fund in a good year but not in a bad year. The client and the insurer agree on a financial measure which is correlated with poor financial performance, for example, the price of raw materials. A point trigger is then agreed, such as a reduction in the financial measure (X) and the occurrence of an insurable loss of amount. The insurer then buys an option priced on the probability that the financial measure will fall. The price of the policies based on the normal cost of insurance times the probability that will occur plus the cost of the option.
Catastrophe linked bonds
Recently a portfolio of property catastrophe linked bonds has been placed with a leading UK fund manager. These bonds operate if industry catastrophe levels on a particular event exceed a pre-agreed level. Then the principle of a bond portfolio invested off-shore by the fund manager in a reinsurance company will become available to pay claims. The bonds will only respond to the holder's net loss after reassurance and will pay out up to a preagreed limit.
Catastrophe swap
A further example of a capital market type product is a catastrophe swap that allows insureds, insurers or re-insurers to swap participations in each others' results. An exchange, CATEX, has been proposed. CATEX will provide a rating mechanism that will equate the risk factors of a portfolio of catastrophe risks with another. Once the risk factors are balanced parties would in effect swap portions of their portfolios.
The benefits of this are the cost is low and it allows a geographic diversification of risk. However, mere diversification is not a complete hedge. Also as perfect portfolio balancing is probably impossible to achieve, the numbers of those willing to perceive a fair swap and hence participate may be limited.
Weather swap
A weather swap is designed to limit volatility or earnings for a firm whose income is highly correlated with the weather. A client exchanges with the insurer a series of monthly fixed cash flows for a series of variable cash flows whose size depends on an Index based on weather statistics. Hence it operates as a swap with money passing to the 'insurer' if the weather index is favourable and from the insurer if the index is unfavourable. For example, a temperature swap may operate by a client exposed to warm weather paying the insurer £X each month and receiving £100,000 for each degree above, say, 0°C.
WHO WILL ACT AS INTERMEDIARIES
Many of the larger insurance brokers have set up capital market units to research securitisation of a range of insurance risks and other financial ways of managing balance sheet risks. For example, analyzing client balance sheet risks from interest rate changes to catastrophe losses. The intention is then to work with investment banks to devise products to meet the risks.
Conclusion
It has been proposed that the pace of innovation over the next few years will depend on the level of inflation; if inflation remains low there ls limited room for innovation in relation to traditional capital market products. Then innovation would increasingly replace traditional insurance produce with financial derivatives.
Although there has been much talk about capital market products, there has in practice been limited progress so far. Some of the major problems arise because of the lack of suitable indexes on which to base the market, this lack is probably because the insurance industry did not need to produce data in a form which would allow it to be traded. With the increasing realization of the benefits available from an efficient traded market this should be overcome.
There are several exciting products being produced using capital markets techniques such as securitisation and swaps which will allow companies to manage risks such as weather which have not been amenable to such treatment before, to the benefit of the insurance industry and their customers. Overall it appears that the pace of change in this area will continue to increase.
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