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CAPITAL MARKETS LESSON

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SOUTHAMPTON, Bermuda-Losing out on available premium from the California Earthquake Authority does not spell the end for capital markets-based insurance products, investment experts say.

Rather, capital markets experts should learn from the deal and adopt different strategies in attempts to set up insurance and reinsurance deals, said an investment banker involved in arranging a capital markets-supplied layer of risk financing for the CEA.

The layer was later made redundant when Berkshire Hathaway Inc. stepped up with reinsurance capacity for the $1.5 billion layer that originally had been earmarked for the capital markets (BI, Nov. 25, 1996).

Capital markets practitioners have lost out to the reinsurance market in part due to their inexperience in reinsurance, the investment banker says.

But insurance companies also are losing out on the advantages of the capital markets because they have a limited understanding of those markets, according to a broker involved with capital markets.

Only when both sides are comfortable with the products will capital markets-based insurance and reinsurance capacity take off, another investment banker adds.

The trio reviewed capital markets' role in risk financing in the wake of the CEA deal during a panel discussion at the Bermuda Insurance Symposium III, held Feb. 18-21 in Southampton, Bermuda.

Investment bankers should take five lessons away from the events of 1996, said James A. Tilley, managing director of Morgan Stanley & Co. in New York, who was involved with the CEA deal. Those lessons are:

First, "Never underestimate the strength of the relationship between a good broker and his or her client," he said.

The strong relationship between executives at E.W. Blanch Co. in San Francisco and the CEA was one of the reasons why the CEA reverted to conventional reinsurance capacity rather than pursue its original intent of buying a layer of coverage from capital markets, Mr. Tilley said.

The second lesson is to be wary of the ability of major reinsurers to derail a competitive threat, he said.

The CEA deal was profitable for Berkshire Hathaway, but it also was a means of preventing investment bankers from cashing in on the reinsurance market, Mr. Tilley said.

Third, "Work much, much harder at investor education," he said.

Capital markets investors do not understand insurance underwriting and are afraid that insurance and reinsurance professionals may take advantage of them, Mr. Tilley said.

In the future, securitization deals should include significant investments from well-known reinsurers to help legitimize the deals in the eyes of other investors, he said.

Also, the creation of credible indexes for the risks would encourage outside investors to participate in the deals, Mr. Tilley said.

Fourth, "Don't sell short the critical strength of conventional reinsurance," he said.

Conventional reinsurance is straightforward, it can be bought easily and quickly, and the annual renewal process provides flexibility, as coverages can be regularly adjusted to reflect any changes, Mr. Tilley said.

Lastly, capital markets practitioners should be prepared to admit the weaknesses of the few capital markets deals that have been completed, he said.

The deals so far are essentially inflexible special-purpose vehicles that carry high legal costs and offer little price advantage to insurers seeking coverage, Mr. Tilley said.

The dealmakers also focus too narrowly on the individual structure of the deals rather than the bigger picture, added Kevin Callahan, president and chief executive officer of Aon Capital Markets Inc. in Chicago.

"What we are really talking about here is discovering ways to bring outside capital to bear on the problems of reinsurance companies, insurance companies and the ultimately our insureds," he said.

And insurers and reinsurers are in a good position to develop and use capital markets products, Mr. Callahan said.

Insurers and reinsurers have the experience of Lloyd's of London, which has similarities to the capital markets products, and they have the risk assessment experience necessary to devise and invest in the products, he said.

By uniting that knowledge base with capital markets expertise, products can be designed today that would be attractive to insurers even though insurance rates are soft, Mr. Callahan said.

For example, an automobile insurer with $200 million in capital that writes $600 million in premium could raise $100 million on the capital markets to buy back $100 million of its stock. The insurer would pass on part of the risk portion of the premiums to the investors in exchange for the debt and keep all the fees associated with claims handling and servicing, he said.

"The company will show a much higher return on equity and (price-to-earnings ratio), and the stock will go up," Mr. Callahan said.

Although the deals can be done today, there still are growing pains associated with the capital markets products, said Richard H. Bernero, vp in the insurance products group of Bankers Trust Co. in New York.

Legal issues surrounding novel products necessarily make for cumbersome contracts, he said.

Insurers and reinsurers see capital markets contracts that are hundreds of pages long and compare them to single-page slips that normally suffice to place a conventional reinsurance risk, Mr. Bernero said.

And investors go over basic issues that experts in insurance and reinsurance need not normally dwell on, he said.

"However sophisticated the investment bankers are, they are not in the business of underwriting, and they will ask questions," Mr. Bernero said.

But once the risks are broken down to their key components and all the parties involved fully understand the risks, the capital markets products should be more successful, he said.

Richard Sandor, chairman and CEO of Centre Financial Products Ltd. in New York, moderated the session.