Alternative Risk Transfer (ART), also known as structured insurance, provides unique ways to transfer the increasingly complex risks faced by corporations that cannot be handled by traditional insurance and has led to the growth in the use of the form of risk transfer. Alternative risk transfer combine elements of traditional insurance and capital market instruments to create highly sophisticated risk transfer strategies tailored for a corporate client’s specific needs and liability structure that traditional insurance cannot handle. For this reason, art is sometimes referred to as “insurance-based investment banking”. According to a September 2006 report by Conning Research & Consulting, traditional insurance covers roughly 70% of the commercial insurance market in the United states and the balance is provided by the alternative risk transfer [reference: “Alternative Markets: Structural and Functional Evolution”, Conning Research & Consulting, Inc., September 2006].
Alternative Risk Transfer [ART] includes: (1) Insurance-linked Notes; (2) Captives and Mutuals; (3) Finite Insurance; (4) Multiline Insurance; and (5) Contingent Insurance. If you are searching for risk transfer approaches beyond the traditional insurance, this post maybe for you, for I am going to briefly overview each of these alternative risk transfer types in this post accompanied with some real case studies present what company use a specific type of alternative risk transfer, who is in success and who is failed. By comparing each feature offered of each alternative, you should get a clearer picture about which alternative best suites your need. Enjoy!
Insurance-Linked Notes [ILNs]
Insurance-linked Notes (ILNs) have been primarily used by life insurers and property and casualty insurers to bypass the conventional reinsurance market and synthetically reinsure against losses by tapping the capital markets.
Basically, an insurance-linked note [ILN] is a means for securitizing insurance risk. ILNs can be classified as single-peril and multi-peril bonds. The former ILNs are typically referred to as “catastrophe-linked bonds” or simply “CAT bonds“. Typically cat bonds are issued through a special-purpose entity.
CAT bonds are designed to protect insurance companies from events like massive hurricanes and earthquakes, which happen rarely but cause enormous damage. The bonds pay interest and return principal the way other debt securities do-as long as a catastrophe that causes losses above an agreed-upon limit doesn’t whack the issuer. For example, a San Antonio-based insurer floated a CAT bond issue with the loss threshold being $1 billion. As long as a hurricane didn’t hit their client for more, investors would enjoy their junk bond like yields of about 11%, and get their principal back. However, in the event of the losses exceeding $1 billion, the bondholders would lose their principal as well as the interest.
The first use of cat bonds in corporate risk management by a non-insurance company was by the owner/operator of Tokyo Disneyland, Oriental Land Co. Rather than obtain traditional insurance against earthquake damage for the park, it issued a $200 million cat bond in 1999. Three years later, Vivendi Universal obtained protection for earthquake damage for its studios (Universal Studios) in California by issuing a $175 million cat bond with a maturity of 3.5 years. Moreover, the bond had a lower coupon rate than a similarly rated corporate bond.
While cat bonds have primarily been used for perils such as earthquakes and hurricanes, corporations are using them in other ways. For example, the risk to the lessor in a leasing transaction is that the residual value of the leased equipment is below its expected value when the lease was negotiated.
Toyota Motor Credit Corp., for example, was concerned that the motor vehicles (cars and light-duty trucks) it leased to customers would decline in value if the used-car market weakened. To protect itself, Toyota issued a cat bond that insured against a loss in market value of the fleet of leased motor vehicles. As another example, the sponsors of the World Cup, the Fédération Internationale de Football Association (FIFA), issued a $260 million cat bond to protect itself against a (terrorism-related) cancellation of the 2006 event in Germany.
Cat bonds are extremely high risk and high return, with not only insurance companies but also big corporate hedging catastrophe risk by issuing CAT bonds. CAT bonds have come as a reprieve for companies working in high-risk areas like Oriental Land, and the owner of the Tokyo Disneyland. Faced with the prospect of insuring a potential fatality (Tokyo is an earthquake prone area) insurance companies, in trying to manage their risk and returns, prescribe massive premiums on such insurance policies. Reinsurers balk at the idea of reinsuring such high-risk insurance policies. However, with the presence of cat bonds, companies are resting easy.
Key Issues in a Catastrophe Bond Transaction
A Catastrophe Bond deal would be structured in a similar manner to a securitization transaction; the major difference lying in the fact that in the case of the securitization, there are certain receivables which are promised as collateral whereas in the case of cat bonds, there is no collateral, and the investors even stand to lose their principal should the losses exceed a certain threshold.
Catastrophe bond transactions are becoming more and more common with Corporate and Insurance companies alike seeking to hedge risks. However, for all these issuers there are some hurdles which are encountered, and it would be prudent to treat them at this point. The following hurdles could be encountered at various stages in a Cat Bond issue:
- Taxation Issue – The issue of taxation is an old tale in the life of securitization. Most of the special purpose vehicles launched to securitize assets or liabilities usually find themselves being taxed doubly. First, they are taxed on the income generated (the fees etc. flowing in from the issuer) and secondly on the disbursal of interest or dividend (in the hands of investors). This diminishes returns, and to provide a return equivalent to the market on a post tax basis, the SPV has to generate astronomical pre tax returns. As such, it is usually seen that the SPV would be located in a tax haven like Mauritius, Cayman Islands, Bahamas or Bermuda. In such islands, the tax laws usually lead to a single point of taxation, at a much lower rate than say, having the SPV on the mainland in the USA. Similarly, taxation also governs the choice of the issue of securities to investors whether in the form of debt or equity. Equity dividends are usually taxed, whereas interest paid on debt is not taxed in certain jurisdictions. Therefore, it may be prudent to issue debt securities instead of equity, or vice versa, dependant on the taxation laws under which the SPV or the company would be operating.
- Regulatory Issue – The SEC and several other watchdogs and regulators have often issued warnings to Cat bond issuers that their issues to retail investors are illegal as they are not in the business of insurance. However, with the extent of issues which have been conducted till date around the world in various markets, regulators have relented and have allowed the issue of these bonds
- Choice of Investors Issue – At the time of the issue, a choice needs to be made by the SPV whether it wants to target retail or institutional investors. This raises the issues of disclosure and targeted or general issues. Under US laws, the SEC allows a 144A targeted issue to institutional investors which needs much less disclosure compared to that for retail investors. Additionally, given the complexities of structures implemented for catastrophe bonds, it is usually preferred that institutional investors are targeted given their levels of sophistication and understanding of such issues.
- Bond Structure Issue – For the issue of debt securities, several issues and considerations can arise. Primary among these is the issue of the principal repayment. Debt issues can either be made in the form of a Principal Protected issue or a Principal At Risk issue. For a protected issue, the investor does not lose his principal if the issuer faces losses on the insured part of the Catastrophe bonds. However, in the principal at risk issue, the investor can lose part or all of the investment depending on the severity of losses inflicted by the catastrophe. Referring back to the example of Tokyo Disneyland, depending on the severity of the earthquake, the investor may lose part or whole of the principal. Another issue which crops up is whether to make the cat bond a single or a multi period issue. Furthermore, the issuer also carries the option of having a Singe Occurrence or a Multi Occurrence structures. Under a single occurrence structure, the validity of the debt issued ceases as soon as any referred catastrophe occurs, over the limit. The principal is paid back in whole or part, as the case may be. However, a multi occurrence issue continues to exist, with the principal being written down on the occurrence of a catastrophe with a loss threshold higher than that prescribed in the issue.
- Disclosure Issue – Since the bonds can cause a loss of money to the investors, the regulators demand more stringent disclosure norms compared to other forms of securities. The investor’s portfolio is linked to a specific insurer’s portfolio, which creates the necessity of stringent disclosure and reset mechanisms for multi year transactions in order to reflect changes in the mix and quantum of exposure, while preserving the investor’s loss profile.
A parent company, trade association, or a group of companies within an industry can set up a captive insurance company. These entities can be used for financing the retention risk as well as risk transfer.
In order to benefit from a captive, a company needs good information to evaluate the risks that are being incurred by the captive and have sufficient financial resources for funding an annual premium that is large enough to justify the costs of setting up and maintaining a captive. In a mutual insurance company the owners of the company are the policyholders. A group of companies can create a mutual insurance company to insure against specific types of risk common to them. Basically, a mutual insurance company is a form of self-insurance.
According to the report by Conning research & Consulting cited earlier, self-insurance and single-parent captive account for 90% of the ART market.
Finite insurance is an insurance policy that sharply limits the amount of the loss that the insurer can realize. The controversy associated with this type of insurance is whether it truly transfers risk from a corporation seeking protection to the insurer. The reason is that typically for this type of policy the corporation seeking protection makes a large premium to the insurer, the amount being sufficient to cover the insurer’s expected losses. The premium is then held by an insurer in an interest-bearing account. If at the end of the policy’s term the actual losses are less than the premium, the insurer pays the difference to the corporation. However, if the losses exceed the premium, the corporation makes an additional premium payment to the insurer for the difference.
Basically, it has been argued that finite insurance provided a means not for risk management but for earnings management.
Public and regulatory awareness of the problem with finite insurance resulted from the SEC enforcement action against Brightpoint Inc. and American International Group (AIG). The SEC charged AIG with accounting fraud because of the insurer’s role in devising and selling an “insurance” product that Brightpoint Inc. used to report false and misleading financial statements that concealed $11.9 million in losses that Brightpoint sustained in 1998. Without admitting or denying the SEC’s allegations, AIG and Brightpoint agreed to pay a civil penalty of $10 million and $450,000, respectively. There were further SEC investigations of other issuers of finite insurance, as well as then–New York attorney General Eliot Spitzer’s investigation of a $500 million finite insurance deal between AIG and General RE.
These actions have made financial-decision-makers reluctant to use finite insurance, particularly because there is the risk that such insurance might result in an earnings restatement. According to experts, however, the major concern with finite coverage is not that it may allow earnings manipulation but that it fails to transfer risk.
Experts in alternative transfer risk have argued that there are legitimate uses for finite insurance:
- Culp, for example, states that finite insurance “leads to a higher quality of earnings than if the firm doesn’t reserve for a major loss or just tries to set money aside internally”, further noting that companies can use finite insurance to shield them from allegations that they are setting up “cookie jar” reserves to inflate future results.
- A second advantage pointed out by some experts in art is that the coverage provided by finite insurance can assist companies that are reluctant to purchase traditional insurance to fix the cost of risk exposures that are difficult to quantify over a span of years.
- Finally, it is argued that finite insurance is particularly useful in “covering severe risks that are outside the core functions of a company”.
Multiline insurance offers a tool for better integrated risk management by offering one large aggregate limit across several lines of business such as liability, property, and business interruption. The insurer makes a payment if the combined losses on all lines reach a specified amount. The programs usually operate on a multiyear basis. The corporation deals with only one insurer rather than several insurers covering different lines. Moreover, the corporation only has to renew the program every three to five years, thereby reducing the time the chief risk officer must devote to negotiating insurance contracts each year. The flexibility of creating multiline insurance allows an insurer to work with a corporation to obtain tailor-made coverage based on the corporation’s needs.
Contingent insurance, more popularly referred to as “contingent cover”, is an option granted by an insurance company giving a corporation the right to enter into an insurance contract at some future date. All of the terms of the insurance contract that can be entered into, including the premium that must be paid if the option is exercised, are specified at the time the contingent cover policy is purchased by the corporation. Contingent cover includes premium protection options, contingent cover embedded in existing programs, and contingent insurance-linked notes.