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INDUSTRY STILL LEARNING NEW TRICKS

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It took years of high-priced liability insurance and property catastrophes to lure the alternative risk financing genie out of the bottle.

He's taken a beating at the hands of cheap insurance and reinsurance rates, but it is unlikely that low premiums will ever force the genie back inside.

The lingering soft commercial insurance market has taken a toll on some alternative risk financing ideas, failed pharmaceutical product liability facilities being a notable discard. Self-insurance as a percentage of the total risk financing market is little changed in the past several years. There has been much talk but less action about new ways to finance risk.

"Soft markets always impede experimentation," observes Richard S. Betterley, president of Betterley Risk Consultants in Sterling, Mass. "This one more than any I've seen."

But innovation does continue in three areas: risk financing; where capacity problems exist; and where risk managers find cost advantages and tax and accounting benefits.

Experts cite several reasons why risk managers pursue a growing field of complex and less esoteric alternative risk-financing choices.

One is that risk managers are becoming more sophisticated in and comfortable with addressing issues like corporatewide, or holistic, risk as well as corporate capital valuation and allocation issues.

At the same time, risk managers' patience with the frictional costs and potential coverage disputes associated with insurance products is dwindling.

Risk managers, along with brokers and insurers, continue to develop new programs, like multiyear, multiline risk financing packages that include elements of finite risk coverage and the involvement of captive insurers and reinsurers.

Some of these programs also cover risks not traditionally insured, such as currency losses and interest rate variations. The threat of property catastrophes also has spurred the creation of some risk financing options, such as the California Earthquake Authority.

Earlier this year, a catastrophe bond was issued to provide an insurer with high-level reinsurance for hurricane risks. The capital markets continue to work on products to securitize risk, to provide capacity the traditional market lacks.

Some suggest that commercial insurance rates are staying low partly because of the existence of alternative risk financial mechanisms.

The notion of financing risk in ways other than the traditional route of buying coverage from an insurer began in the 1970s, often for tax reasons, and gained momentum in the high-priced commercial market of the mid- to late 1980s. During those years, when liability coverages were unavailable or unaffordable for many buyers, captive insurers and self-insured retentions became favorite ways to control costs.

"There was a time when, if you were big enough, you had a captive," said Mr. Betterley. "And if you didn't, people said, 'How come?' If you were big enough, you self-insured," and if not, the same question was likely to be asked.

During the high-priced hard market, self-insured retentions climbed into the millions of dollars, and captive insurers were formed, offshore and in the United States. Public entity pools were formed, and risk retention groups appeared. Risk managers were beginning to control their destinies.

Just when risk managers were getting comfortable with captives and other forms of self-insurance, the market began to soften in the late 1980s.

Insurers began competing again. Rates fell.

As cheap insurance pricing prevailed in the 1990s, some risk managers abandoned their self-insurance efforts for the comfort of paying premiums and letting someone else worry about paying claims.

Companies like PepsiCo Inc. and its subsidiaries, for example, are reducing their use of alternative risk financing to take advantage of low prices in the traditional marketplace.

PepsiCo has found coverage so cheap that the high retentions and other funding mechanisms it used for several years have been abandoned, said Christopher E. Mandel, senior director of risk management for Tricon Global Restaurants Inc., a Louisville, Ky.-based restaurant services company that was spun off from PepsiCo.

He said plenty of others have followed the same route.

Many risk managers don't have the time, budgets and expertise to flesh out the benefits of alternative markets when traditional market insurers are offering low rates, he said.

Even so, Mr. Mandel acknowledged that Tricon is trying not to overlook the benefits of alternative risk financing techniques.

The company has a consultant "looking at how we might be able to use some of these ART mechanisms to capture tax benefits," he said.

Some risk managers say insurers are charging less than they expect the losses to be, driving them to buy conventional insurance.

As a result, self-insurance, in the form of captives, self-insured retentions, risk retention groups and group facilities, is showing little growth in the persistent soft market.

Conning & Co., a Hartford, Conn.-based insurance research firm, reports that in 1996 these risk financing alternatives represented an estimated 33.2% of the total risk protection market (BI, Feb. 17). That's only a small increase from 30.7% in 1991.

Conning has projected that unless pricing changes, the alternative market's share of the total will fall to 32.8%this year and next.

Among the risk financing casualties of the soft market were three pharmaceutical facilities that were to offer product liability catastrophe insurance.

Most pharmaceutical companies have been able to buy all the coverage they want in the current competitive market, leaving little need for specialty companies to provide that capacity.

PharMed, proposed by Marsh & McLennan Inc. before its merger with Johnson & Higgins, was withdrawn earlier this year because of a lack of interest (BI, July 21). It followed two others that were withdrawn for the same reason (BI, June 9).

When the programs were being put together in 1995 and 1996, worldwide capacity of about $600 million to $650 million was available for the risk. Currently, pharmaceutical companies can buy more than $800 million in product liability coverage, plenty for most risk managers.

Although insurance buyers rejected the pharmaceutical facilities because of low rates elsewhere in the market, many companies have stayed put in their alternative programs, happy with the control they seized in retaining their risks.

Cheap insurance rates aren't likely to entice them away.

"The value that they got from having direct control has become so important to their operational practices that it is unlikely they will turn from it," said Mary Ann Godbout, assistant vp at Conning.

One of the most celebrated cases of self-insurance occurred at The British Petroleum Co. P.L.C., which in 1992 decided to self-fund on a pay-as-you-go basis losses in excess of $10 million. The oil giant adopted the strategy after a 1991 audit showed it had paid almost five times more in insurance premiums than it recovered in indemnity payments from its insurers during the 1980s.

The $10 million per occurrence threshold gave the decentralized company's various operations an opportunity to decide for themselves how to best finance risk. Since 1992, those operations largely have concurred with the corporation's outlook and now self-fund most exposures.

Mr. Betterley pointed out that mechanisms already in place still serve their purposes, and innovations in risk financing are continuing.

"Now, there are all kinds of alternatives," he said. "Some work, in some cases, and some don't. But I've not seen any that I would say are real dinosaurs. A lot of time is being spent now trying to think of new ones that haven't been thought of before."

Union Carbide Corp. of Danbury, Conn., for example, is about two years into a program that combines finite risk and integrated risk elements (BI, Feb. 26, 1996).

Generally, under an integrated or blended risk financing approach, a company maintains a single retention for many of its property and casualty exposures combined, rather than individual retentions for each exposure. The company's excess coverage is triggered only after that full retention is exhausted.

Swiss Reinsurance Co. reinsures Union Carbide's Bermuda captive with an aggregate of $200 million of coverage over three years and $100 million in any single year. However, there are sublimits for either property or casualty losses, or combined property and casualty losses stemming from a single incident.

If the program is loss-free after three years, Union Carbide is scheduled to recover the value of three-fourths of its premium. However, unlike typical finite risk programs, Union Carbide's premiums are much lower. The premiums equal what Union Carbide would have paid for the coverage under a conventional excess insurance arrangement in today's market, said Rick Inserra, assistant treasurer-risk management and insurance.

Losses could drive up Union Carbide's premium 25%, he said.

The integrated risk financing program that Norwest Corp. of Minneapolis began forging in 1993 and rolled out nearly a year later also contains a finite risk element (BI, April 24, 1995).

But unlike Union Carbide's program, Norwest's does not contain sublimits for the bank's property/casualty risks. The bank is subject to a single large retention for all the exposures the program covers. American International Group Inc. subsidiary National Union Fire Insurance Co. of Pittsburgh, Pa., reinsures Norwest's Vermont captive.

Among other things, Norwest's program has helped the bank come much closer to satisfying its risk appetite, cut insurance costs 70% and improved the bank's cash flow, said K.C. Kidder, vp and risk manager.

More recently, Minneapolis-based Honeywell Inc. cut its costs by buying property/casualty insurance under an integrated risk financing program that also covers the company's currency losses.

Many of these integrated programs involve reinsurance of a corporation's captive insurer.

Whether used as part of a blended program, or alone, captive insurers are still growing in popularity.

There were a record 3,104 captive insurers at year-end 1996 around the world, according to the Business Insurance survey of 27 captive domiciles (BI, April 14), a 6.8% increase.

On the property side, natural disasters have provided the impetus for innovations in risk financing. The threat of earthquakes, for example, led to the formation of the California Earthquake Authority.

The facility was proposed in 1995 at a time when insurers -- still reeling from $12.5 billion in losses from the 1994 Northridge quake -- were declining to write new and renewal earthquake coverage for California homeowners.

Faced with the market crisis, the California Legislature authorized creation of the facility. It was structured to issue policies through participating insurers, with existing policies converted to CEA policies at renewal.

The CEA is set up to provide a maximum aggregate limit of as much as $10.5 billion in several layers funded by property insurers, reinsurers, the state and policyholders. The maximum aggregate depends on the degree of insurer participation.

The threat of hurricanes also has stimulated new markets.

Hurricane Andrew, which caused an estimated $16.5 billion in property damage in South Florida in 1992, startled insurers and reinsurers into realizing it was time to take a closer look at their exposures. As a result, there was not enough reinsurance to answer demand.

In addition to causing capital to flow to newly created catastrophe reinsurers in Bermuda, Hurricane Andrew lent some urgency to development of the Chicago Board of Trade's catastrophe options, a product launched in 1992. The contracts are linked to an index of cat losses by the Property Claim Services division of the American Insurance Services Group.

In addition, investment bankers are developing other products to securitize risks.

In a closely watched offering, United Services Automobile Assn. generated tremendous interest among investors with a $477 million catastrophe bond issue that gives it a high-level reinsurance layer for East Coast hurricane risks (BI, June 23).

The bonds were issued by Residential Reinsurance Ltd., a Cayman Islands reinsurer USAA created last year. The reinsurer will manage the funds raised through the issue and administer a reinsurance contract it provides to USAA.

The reinsurance contract covers USAA for a loss caused by a single Category 3, 4 or 5 hurricane resulting in insured losses between $1 billion and $1.5 billion to the insurer's policyholders along areas of the Gulf Coast and Atlantic Coast.

The success of the USAA bond offering was hailed as a big step in the cautious move by insurers to transfer risk to the capital markets.

"We've certainly seen a trend toward the convergence of the insurance markets and capital markets," said Gerard Vecchio, vp with Conning. "We're in the nascent stages of that right now, but I believe it will develop over time. The question is, what time frame will it be?"

James V. Davis, chairman of Willis Corroon Corp.'s Advanced Risk Management Services division in Nashville, Tenn., said, "If you look at the deals that have been done so far, almost all have been substitutes for reinsurance for property/casualty companies or what amounts to surplus relief in the event of a catastrophe."

"At current insurance pricing levels, it is unlikely that capital market products will have a big impact" anytime soon, Mr. Davis predicted. "Even the big international bankers acknowledge that. They pretty openly say that there will not be any dramatic growth unless there's a change in the pricing cycle."

Some insurers are moving toward capital markets faster than others.

Chicago-based CNA Insurance Cos. is among the most aggressive, creating Hedge Financial Products Inc. out of its acquisition of Centre Financial Products Ltd., an affiliate of Centre Reinsurance Co.

Plans call for Hedge Financial to explore over the next two years development of securitized products for CNA's approximately 30 business units, to help both the units with their business plans and meet clients' risk financing needs.

Richard L. Sandor, chairman of Hedge Financial, says the securitization of risk is a "20 year process, and we are three to four years into it."

The continuing search for ways to finance risk is in some ways related to risk managers' changing role within their companies.

They are now often described as operating in a more holistic fashion, which means their areas of responsibility have broadened to much more than purchasing coverages for common property/casualty risks.

"Firms are adopting a broader perspective of risk," Mr. Davis explained.

Increasingly, risk managers are coming up with ways to protect not only the common exposures but also to cover "some array of risks not normally thought of as property/casualty risks and not normally thought of as insurable by a property/casualty company," Mr. Davis added.

That could include financial risks such as those related to foreign exchange, interest rates and commodity prices.

Risk management "is more than asset value replacement; it's about shareholder value protection," according to Kevin R. Callahan, president and chief executive officer of Aon Capital Markets Inc. in Chicago.

The boom in risk financing also has helped raise the profile of the risk management profession, Mr. Betterley pointed out. "It's made more choices for risk managers; therefore, the opportunity to think independently is higher."

Some say the emergence of alternative risk financing methods has helped keep a lid on insurance price increases.

"One of the reasons I feel the commercial market is so competitive is the existence of a viable alternative market," commented Jon Harkavy, vp and general counsel of USA Risk Services Inc., an Arlington, Va.-based provider of administrative and management services for group captives and self-insurance pools.

"The biggest effect that it's had is to limit the ability of the traditional insurance industry to dictate price increases or coverage restrictions," pointed out William J. Kelly, senior vp with investment bank J.P. Morgan & Co. Inc. in New York.

The power of traditional underwriters to raise premiums or change terms is not as much of a threat to insurance buyers now that so many alternatives are available, Mr. Kelly noted.

"The traditional market can't unilaterally act because others will move in to provide funding," he said.

The same will be true for insurers seeking reinsurance.

"You won't see a 40%rate on line" for property catastrophe reinsurance, says Mr. Sandor, referring to the high reinsurance rates that were charged after Hurricane Andrew.

The capital markets will offer cat bonds at far less, Mr. Sandor observed.