The insurance industry faces over-capitalization, declining underwriting opportunities from commercial clients and the prospect of poor future profits. Securitization promises a new solution - the transfer of risk to the capital markets.

Products and tools combining banking and insurance elements have existed for some time. So far, many of these have gone under the heading of alternative risk transfer (ART), which has comprised two distinct waves. The first involved the establishment of captive vehicles and greater self-insurance on the part of the world's largest corporations.

The more recent, secondary development of hybrid products crosses the regulatory divide between the banking and insurance industries. These are sophisticated products developed for major buyers of risk management products, whether they be insurers, reinsurers or large corporates.

At present, many of these new financial techniques and markets remain marginal to mainstream insurance and reinsurance, investment banking and corporate risk management. Research into the possible drivers of their use has so far been lacking. As a result it has been difficult to make projections of their future success.

Risk securitization offers three main advantages over traditional re/insurance cover. The most popular first choice among those interviewed was that securitization offers better security, or better counterparty or credit risk to the issuer, than conventional cover. As one insurance broker put it: "upfront cash is better than a promise".

The second most popular view was that securitization offers a route to greater capacity in the form of the capital markets.

"The main advantage is a large capital base, of trillions rather than billions of dollars," says a leading broker. "Connectedly, there is much liquidity in the capital markets, which means there isn't as much hand-wringing in the event of a big loss. The capital markets don't punish you for handing them a loss, they forget about it and move on. Because it is such a liquid market, there is none of the moralising and back-stabbing that still goes on in insurance circles after a major loss."

Price stability was placed third: issuing a bond offers a price over the long-term that is fixed and not subject to fluctuations in the reinsurance market. Some respondents drew attention to the upfront price - the initial transaction costs of setting up the special purpose vehicle (SPV), advisory services, etc -which has been high so far. Innovation

The parametric trigger was cited by respondents as the most important innovation in the securitization of catastrophe risk. There are three major ways in which the default of a bond may be triggered:

the specific underwriting loss of the insured;

an independent index of insured events; or

a non-insurance, physical index (such as the Richter scale).

Of late, there has been a growing belief that the third trigger form of reset mechanisms represent the future of the market and the best possible option for investors attempting to quantify the risks (although some investment funds specializing in catastrophe (CAT) bonds have argued to the contrary).

There are two main reasons. First, an index relating directly to natural disaster removes the risk of moral hazard-- in this context the possibility of the manipulation of figures by the insured - and aligns the insured and investor in their knowledge of the risk. Second, from the investor perspective, a security tied, for example, to a meteorological index may represent the closest it can get to portfolio diversification, since a trigger linked to a pure weather risk offers more complete non-correlation with fluctuations in the financial markets.

This thinking was encouraged by the Parametric Re transaction, the first security issue tied to the occurrence of a physical event and not directly indexed to insured losses. In this deal, arranged by Goldman Sachs and Swiss Re (insuring Tokio Marine & Fire, a major Japanese insurance company), a $100 million bond issue was placed in the market in two tranches, both with a 10-year term. The trigger was related to magnitude level, location and depth of an earthquake as announced by the Japan Meteorological Agency.

The second most popular innovation mentioned was the involvement of the ratings agencies. Since the evaluating of pricing and credit risk of CAT bonds is far from straightforward, the success of the agencies in rating the bonds is seen as a major step forward.

The third most popular choice in this section is reset mechanisms. These allow for the alteration of the risk/return ratio if a catastrophe occurs. Effectively, the price is reset ifa catastrophe occurs during the term of a bond, because the probability and modelling for the original price ofthe bond has been altered.

Re/insurance relationships

Respondents played down the likelihood of long-standing relationships between insured and insurer (in both reinsurance and commercial markets) preventing a move away from insurance-based products to capital markets-based products The most common response was that relationships would not be strong enough, but could slow the process down.

Some respondents identified relationships as existing only because of tough times, which could be important in the future. Others mentioned the importance of relationships even in the capital markets-bondholders need to be comfortable with the creditworthiness of companies, for example. One respondent made the point that long-standing relationships exist only because of inefficient markets and "deep structural problems in the industry".

A number of respondents commented that many longstanding relationships had been destroyed by recent low reinsurance prices, enabling greater choice in the market. Others mentioned that relationships are coming under attack because of a changing ethos in the re/insurance industry; managers are under more pressure and do not have the perks of going beyond purely market relationships with clients.

When asked what effect turmoil in the financial markets will have on investor perceptions of buying insurance risk paper, respondents veered more to the view that turmoil only served to point up the diversification benefits. One pointed out, for example, that a recent hedge fund in trouble bought CAT bonds and out of its entire portfolio only these securities held their price. Some respondents stressed the importance of seeing a distinction between a `flight to quality' and `buying CAT bonds for diversification', even though they may be considered `exotic instruments'.

"Now is an opportune time for grooming the investor base, because CAT bond investors have weathered the financial storm better than other investors," said one reinsurer. "Now is the time to hammer home the idea that they should have 5-10% oftheir portfolio in these securities, notjust 1% or 2%."

Many respondents identified a high level of education among those investors who have bought insurance linked-- notes but recognized that this represented a tiny fraction of the global institutional investor population.

Interestingly, we found that respondents were more willing to criticize the lack of issuers' willingness to issue, rather than investors' readiness to buy. Many respondents pointed out that all deals to date have been oversubscribed. Some respondents made the point that investors will invest in anything where lack of market correlation increased portfolio diversification.

The swaps market

An increasing number of catastrophe swap deals have come to the market hot on the heels of securitization deals. Swap deals offer a number of price advantages over CAT bond deals and are easier to conduct.

Respondents mentioned several factors which make OTC derivative instruments more attractive than securitization deals: cheaper cost; simplicity; greater speed to market; less need for rating, risk modelling and documentation; and greater standardization.

The general feeling is that catastrophe swap deals will become more popular than catastrophe securitization, but only in the short-term. Many problems are associated with swaps. First, they lose the security and credit advantages of securitization. Second, there are regulatory constraints - in some jurisdictions only indemnity-based swaps are permissible and there are constraints on the investor type who can enter into transactions. Third, and related, the investor base for buying bonds is much bigger. Fourth, swaps cannot raise the capital amounts seen in securitization deals. Fifth, swaps are less tradeable.

Many respondents said securitization and the swaps market are complementary. A few warned against writing off securitization, especially in the longer-term.

The vast majority of respondents also regard OTC insurance derivatives as more favourable than exchange-traded contracts. Some made the point that the order in which OTC derivatives and exchange-traded instruments had developed in this particular market had bucked the trend of other derivatives markets. That is, counterparties normally enter into OTC arrangements, through which contracts stumble towards a standardized format and can then trade on an exchange. In the catastrophe risk securitization market, however, exchange contracts were established early on and were followed by OTC markets at a later date.

Respondents divided between those sympathetic towards attempts to develop exchange-traded contracts and those dismissive of them. Points in favour were: contracts are cheaper and security is guaranteed through the clearing mechanism. Some respondents commented on the illegality of swaps in many jurisdictions.

On the other side of the argument, some questioned whether insurance contracts could be fungible in this form; others said that basis risk continues to put off many potential re/insurers.

One respondent made the key point that CAT options would be more successful in a mature market comprising "thousands of players". Again, others suggested that the two markets should be complementary. When asked which area is most likely to grow over the next five years - OTC derivatives; exchange traded derivatives; or insurance securitization-44% mentioned the OTC market as their first choice; 26% securitization; and 7% exchange-traded products. 23% declined to give an opinion.

Comment

The high importance ascribed to mitigating counterparty risk as the main reason for issuing a CAT bond, may reflect a combination of current, as well as long-standing, concerns. Historically, the high number of insolvencies after the major US catastrophes in the early to mid-1990s, and the Lloyd's crisis in the UK, may have dented the re/insurance industry's reputation for honouring commitments. More recently, the perception of increasing competition, increasing pressure from shareholders, pressure to improve capital management and cash-flow stability, may have attracted many organizations to the security offered by capital held in an SPV.

The higher credit quality offered by securitization comes at a price. However, securitization is suited to the current climate, where institutions are cash-rich but are more concerned with credit quality. As a result, they are likely to be comfortable paying a higher price for higher credit quality. The demand for securitization should continue to be healthy in the medium term, with steady, rather than explosive, growth. We found that there is a perception that investors are keen to invest in CAT bonds, even given turmoil in their traditional markets. The barrier seems to be greater on the supply side - the reluctance of issuers to experiment.

While catastrophe securitization remains at present a cumbersome process, it is realized that it offers a more comprehensive and ambitious capital raising solution than hedging in the catastrophe derivatives markets, although ideally the two markets should be complementary.

The success of the exchange-traded derivative will be, to a large extent, dependent on the maturity ofthe market. While it remains under-used, the arguments in favour are strong and in time it should develop into a valuable hedging tool for those in the re/insurance industry.

Who is likely to securitize?

Do you expect reinsurers or insurers to make greater use of capital markets risk financing over the next three years?

Two thirds identified reinsurers as being more prepared to go down this route. The top reasons given were that: they are more financially savvy than insurers; they are able to package risk better; offer more diversity to the capital markets; and are faced with fewer regulatory barriers.

However, a number of respondents in both camps qualified their remarks by observing that, in the long run, insurers would be more likely to turn to the capital markets. This is because there is a bigger potential market for issuance and secondary trade: insurers are more numerous and there is more premium volume in the insurance markets. However, some respondents also suggested that securitization techniques would need to extend to non-CAT risks or insurance classes. As some commented, if this occurred reinsurers would face the threat of disintermediation and would have to take on new intermediary roles (such as issuing and trading securities).

Which are the three developments most likely to spur more risk securitization?

Somewhat predictably, the top choice was 'a large catastrophe' which could force further restructuring in the re/insurance industry. More interestingly, non-CAT securitization' was mentioned in joint second place with increased investor interest as the most likely development to spur more securitization. This supports the earlier finding that in the medium to long-term, securitization by primary insurers may represent the future direction ofthis market.

Which two non-cat insurance risks are most likely to be securitised?

Auto insurance was mentioned as the most likely insurance class to be securitized, followed by (in no particular order) life, healthcare, homeowners, workers compensation, satellite and aviation and residual value. Some respondents mentioned risks that could be securitized outside the mainstream insurance arena altogether. These were: technological obsolescence, product liability, industrial disaster and hedges linked to changes in GDP.

A significant number of respondents stressed that liability risks could not be securitized. This is because of the long-tail nature of the risks and the unpredictability of cash-flows, which runs contrary to a fundamental requirement for a successful securitization.

All risks except long-tail liability can be securitized," says a banker. "Investors want to be out of the transaction, so there has to be a cut-offpoint. They buy bonds that have a maturity and so they want to be paid back. Because of this, the easy classes to securitize will be the short-tail risks."

Barriers to non-catastrophe risk securitization What are the factors holding back securitization of non-- catastrophe risks?

A number of respondents mentioned that securitization in this form was more susceptible to potential manipulation by the cedant than catastrophe risk, which is only dependent on Mother Nature. Others questioned the economics: "Why would it make sense for insurers to go down this route if they are underwriting profitable lines?" Finally, a number of respondents pointed more generally to the lack of innovation in the insurance industry.

"There has to be greater market acceptance of a statistical methodology and approach to these risks," says a insurer. "It's a very different argument that you pose to investors compared to CAT bonds. The nature of the risk is very different. You may have a portfolio of 10,000 risks as opposed to waiting for one risk, in one zone. The risk-return relationship is far more intertwined with the underwriting standards of the insurance company: if they are lax with policies, ie they misjudge the mortality risk, the risk-return profile will change. So with these risks investors have to lean more heavily on the cedant company than cat risk."

Comment

A number of findings seem to suggest that insurance securitization in the non-catastrophe area could represent the future of the market. At the level of individual deals, the issues of moral hazard and issuer discomfort with detailed disclosure of risk are the most critical potential barriers.