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STRUCTURAL SHIFTS BOOST CAPITAL DEMAND

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SOUTHAMPTON, Bermuda-Capital markets will play an increasing role in risk financing as structural changes in the insurance market create demand for more capital than the insurance industry can provide, forecasts an innovator in financial futures.

"One of the conditions that generally happens to cause a market to be born. . .is some major structural change.

"That structural change occurs and you take a look at the capital of a business and ask if that structural change can be accommodated by the existing capital," said Richard L. Sandor, chairman and chief executive officer of Centre Financial Products Ltd., an affiliate of Centre Reinsurance Co. that has accepted an offer to be acquired by CNA Financial Corp. (BI, Jan. 20).

The structural changes affecting the insurance industry, he said, include a shift in demographics as the population migrates to the nation's coastal areas, especially California, Florida and Texas.

This shift has led to increased property values in these areas.

As a result, tens of trillions of dollars of property values and gross domestic product are protected by "a couple hundred billion dollars" of insurance capacity, Mr. Sandor said.

"Is that enough?" he asked.

Another structural change is an apparent increase in the frequency and severity of natural catastrophes.

"I've been studying this market for 10 years, and in the last 10 years, every year I've seen and am told there's been a one-in-100-year event," he said. "We had the 'storm of the century' a couple years ago in New York, and last year we had a bigger storm of the century."

As a result of these changes, the "value at risk" in the industry is much greater today than in the past, according to Mr. Sandor, who spoke during a session at the Bermuda Insurance Symposium III, held Feb. 18-21 in Southampton, Bermuda.

There are several efforts under way to bridge the gap between financial and insurance markets and provide additional capital for that risk.

Mr. Sandor said one example is the Chicago Board of Trade's catastrophe options, launched in 1992 after Hurricane Andrew caused $15.5 billion of insured damage.

"Like most inventions, you don't get it right the first time," said Mr. Sandor, who helped create the CBOT contracts.

The contract was changed a year ago from one linked to an Insurance Services Office Inc. loss ratio to one based on an index of cat losses by the Property Claim Services division of the American Insurance Services Group. In addition, contracts were developed based on cat losses in a variety of geographic regions.

In response to the changes, "what was a dormant contract has just reached record open interest this month," he said. With nearly 11,000 contracts, the market for CBOT catastrophe options is "now 50% bigger than pork bellies," he quipped.

Another financial development is the launch of the California Earthquake Authority, which Mr. Sandor said he sees as "a bridge between a commodity trade and a security trade and a move toward a convergence of insurance markets and capital markets."

Mr. Sandor said he disagrees with many observers who view the CEA's decision to purchase $1.5 billion of reinsurance from Berkshire Hathaway Inc. rather than finance the risk with a bond issue as a failure for securitization of insurance.

In exchange for assuming that portion of the CEA's risk,

Berkshire Hathaway's Warren Buffett is likely to more than cover his exposure by investing the premium, according to Mr. Sandor.

He noted that under the CEA program, Berkshire provided $1.5 billion of capacity for a reported $590 million of premium. The attachment point is above $7 billion in homeowners claims for quake damage, and the coverage term is four years.

Looking at the deal from Berkshire's point of view, "you get paid roughly $600 million, you have the use of the money for four years. And remember: That goes to offset your risk, which is only $900 million," Mr. Sandor said.

"If you take a look at recent advancements in Berkshire Hathaway stock, in fact, you more than double your premium over a four- or five-year period at a 15% to 20% rate of return," he said.

Indeed, the day after Berkshire Hathaway announced the deal, the company's stock rose, Mr. Sandor added.

In response to a later question from the audience, he acknowledged that his analysis did not address the role underwriting plays in assessing whether to assume such a risk, which he said is a critical component.

Mr. Sandor said that if the Berkshire Hathaway deal were structured as a catastrophe futures trade, it would have represented a million and a half contracts, or open interest three times greater than the current market for the U.S. long-term government bond market, "just to put it in perspective why all these Wall Street muggers are hanging around your business."

But futures are not the ideal structure for many investors that are not in the professional market, due to certain regulatory restrictions and problems of understanding, Mr. Sandor said. Many investors would prefer more convenient instruments, such as fixed-income securities, he said.

As a result, investment banks and insurers are working to develop securities such as equities or bonds that will be attractive not only to other insurers but also to professional money managers.

"How can you translate catastrophe risk into a bond or a security? You adjust either the principal or the interest rate, that's all you really can do. Or you can adjust the duration," he said.

By doing so, the financial markets ultimately "can morph an insurance liability into a capital market instrument and tap into that $20 to $30 trillion of capital market instruments," he added.

In searching for where securitization of insurance is likely to lead, Mr. Sandor predicted that some form of risk-indexed securities is where the market is headed. That is because "they are summarized easily, understood easily and can be grasped by the capital markets," he said.

Ultimately, though, it may take years of trial and error before viable insurance securities are widely traded, said Mr. Sandor, who noted it took about 20 years before mortgage-backed securities took off.

"I think these are tremendously exciting times for the insurance business," he said. "I believe that if all of us continue to look at these problems, we will generate more profitability for the industry, and we will be able to efficiently transfer the risk in the same way that foreign exchange risk, interest rate risk, stock index risk has been transferred in other markets."

Mr. Sandor urged the insurance industry not to let securitization and the complex jargon that accompanies it be intimidating.

"The nerds of the world will give you all kinds of fluffy things about this device and that device, but it's real simple: Standardize it, change the interest rate, change the principal, and that's the wonderful world of derivatives," he said.