Help

BI’s Article search uses Boolean search capabilities. If you are not familiar with these principles, here are some quick tips.

To search specifically for more than one word, put the search term in quotation marks. For example, “workers compensation”. This will limit your search to that combination of words.

To search for a combination of terms, use quotations and the & symbol. For example, “hurricane” & “loss”.

Login Register Subscribe

SECURITIZATION OF RISKS REMAINS FAR OFF

Reprints

Special to Business Insurance

THE SECURITIZATION OF insurance risks involves the transfer of a finite segment of future underwriting risk to the capital markets.

The capital markets have grown accustomed to providing debt capital secured by a designated pool of assets. Examples are mortgage-backed securities and asset-backed securities that are secured by receivables from credit cards and automobile loans.

The inability of some primary insurance companies to secure high layers of catastrophe reinsurance covers at what they deemed to be reasonable prices has spurred interest in the securitization of catastrophe risks.

It would be naive not to believe there ultimately will be some melding of the insurance and capital markets. However, effective utilization of the concept could be years away.

Indeed, recent failed attempts to sell "act of God" bonds and the decision by the California Earthquake Authority to use traditional reinsurance vs. $1.5 billion of earthquake risk bonds (BI, Nov. 25, 1996) underscores the initial difficulties the purveyors of risk securitization face.

At this juncture, there may well be a disconnect. "Wall Street purveyors" may not fully understand the concept of insurance risk diversification. Care must be taken to ensure that a securitized product does not shake investors' confidence after the first loss event. Somewhere along the line, some purveyor's ox is likely to be gored, and we suspect much time and effort is being expended on protecting some oxen.

Structure is critical. Does the instrument result in a sharing of the risk of a loss, or is it more strictly defined to cover a specific event? Assuming the latter, who or what determines the event and the time frame involved? The instrument should be liquid and have hedging facets.

Investor education also is critical in terms of the aforementioned structures. Furthermore, the right type of investors must be sought and their expectations for returns and time frames appropriately addressed. An index or benchmark also will be needed, at least initially, to enable the buyer to ascertain the relative value of the transaction vs. alternatives.

The continuation of a soft pricing environment in the property/casualty industry could delay the implementation of a securitized issue of any substance. The CEA bonds are a case in point.

Furthermore, questions related to rating agency perspectives, tax issues and how the regulators will handle the instruments must be addressed. Also, to what extent will the use of these tools that spread risk to the capital markets make government backstops less important?

Finally, accounting issues have to be addressed. Will the accounting basis mirror that which is applied to insurance derivatives? Will the accounting method be basis accrual, historical cost, pure mark-to-market or a modified mark-to-market method? Whatever the accounting methodology employed, the key at the end of the day will be disclosure.

The obvious question is, what is the potential impact on the reinsurance industry? A reinsurance company could be involved in the process by being an originator, it could help to standardize the insurance contact features, and it also could be part of the distribution process. Underwriting expertise to measure the insurance risk component clearly must be in the loop. A strong balance sheet also is a must for the participating reinsurer.

After all is said and done, however, we believe the intermingling of the capital markets will result in some margin deterioration, which lends itself to further consolidation in the reinsurance industry. We also should note that securitization need not be confined to catastrophe risks or to the reinsurance industry.