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Known as the "Father of Financial Futures," Richard L. Sandor is chairman of Hedge Financial Products Inc., a CNA Financial Corp. subsidiary specializing in the securitization of insurance risks.
CNA acquired Hedge Financial, formerly Centre Financial Products Ltd., earlier this year. Hedge Financial's charge is to find ways to transfer traditionally insured risks to the capital markets, using such techniques as derivative instruments and structured financial products.
In addition to his Hedge Financial role, Mr. Sandor is vice chairman of the Chicago Board of Trade. It was during a 1970s stint as vp and chief economist at the CBOT that he earned his reputation as the principal architect of interest rate future markets.
Mr. Sandor, who received his bachelor's degree from the City University of New York, Brooklyn College, and his doctorate in economics from the University of Minnesota, began his professional career as an academic and continues to work in that arena.
He has held faculty positions at the School of Business Administration of the University of California at Berkeley and at Stanford University and has taught as a visiting professor at Northwestern University's J.L. Kellogg Graduate School of Management. He recently was appointed distinguished adjunct professor at the Columbia University Graduate School of Business.
In 1973, Mr. Sandor authored an article published in a British academic journal suggesting insurance risk could be traded as futures and options. Two decades later, he was instrumental in making that concept a reality as the Chicago Board of Trade introduced its catastrophe insurance futures and options contracts.
Mr. Sandor, 56, spoke about the cat contracts' progress, the securitization of risk and the future of risk transfer with Associate Editor Rodd Zolkos.
After hundreds of years of the insurance and reinsurance industries doing business in the "traditional" way, why the interest in recent years in securitizing risk and taking advantage of the capital markets?
Here is the fundamental premise: We have a $7 trillion economy. There's $250 billion of capital in the insurance business. The numbers don't compute.
The second thing is that the buildup of coastal property values has been enormous. Cities like Miami exploded. Needless to say, Los Angeles, San Francisco, Tampa, the Texas area, all of these high-risk areas had enormous growth in property values. And as that was occurring we began to get a number of disasters: Hurricane Hugo in '89, Loma Prieta, Andrew, Iniki.
We're just witnessing a confluence of weather events striking high-risk, high-property value areas. So it seems that with $250 billion in capital, a $7 trillion economy, all of the liabilities associated with that: E&O, medical liability, tobacco, etc., that the property and casualty risks are now larger than they ever have been in the history of the planet. And in spite of the fact that rates on line are low, there is still unsatisfied capacity in high-risk zones at reasonable prices.
And I think the growth of the economy coupled with the recent catastrophic events has really focused the insurance industry and the capital markets on opportunities to provide risk transfer mechanisms.
It would seem that CNA's establishment of Hedge Financial is a good example of a traditional insurance company recognizing those opportunities and moving to get involved in them.
I think what you're seeing in CNA's formation of Hedge Financial is a perfect example, recognizing that we need to bridge the gap between the insurance markets and the capital markets. The recent venture between AXA and Paribas is yet another example. The recent efforts by Aon to deal in the derivative area, the efforts of AIG, Phoenix Re, the buildup of Goldman Sachs' specialty unit, everywhere you look you see that this industry is well on its way to becoming a critical element.
The interesting thing is you couldn't have imagined a better scenario in which to do it, but it's one that's typically available.
The first thing that happens is you get a lot of risk that becomes apparent or new -- volatility. You search for standardization, ways to standardize the product. Once you standardize the product, you're capable of developing organized futures and options markets as well as morphing risk into the capital markets.
This timing was perfect, because prior to the real beginning in December '92 -- following Andrew, when the Board of Trade launched its futures -- rates had gone up because of all of the recent catastrophes. So the rates of return to people who became synthetic insurers were very, very attractive. Fortunately over the next five, six years, anybody who had taken insurance risk made money as the markets again became quiet.
If you take financial futures, you had your first kind of introduction of risk and high rates in '73 at the oil embargo; you started interest rate futures in '75; in '79 you had the second embargo and the Jimmy Carter inflation and, boom, the market took off.
So typically what happens is markets demonstrably show that there are attractive risks to be undertaken in the capital markets, that they have the depth and capacity with $20 trillion to $30 trillion in capital.
The economic environment responds after one introduction of volatility, and perceptions about risk become realized, markets start to form, and the next scenario is another big catastrophe and some young man or woman in an insurance department gets written up on the front page of the Wall Street Journal having hedged the company's catastrophes and then, all of a sudden, you get the market maturing.
In some quarters you hear the talk that the catastrophe futures contract hasn't taken off, that it's been slow to take off or whatnot, but I gather from what you're suggesting that this is sort of a normal maturation process.
Yes, very much of a normal maturation.
The problem is that gestation periods of organized markets and over-the-counter markets are a lot longer than people would suggest. The communication that we now have focuses a lot of attention and looks for immediate gratification, but most industrial inventions and most financial innovations.*.*.it took 15 years to get the mortgage-backed market into futures. It took 10, 15 years to get financial futures off the ground.
As a matter of fact, it took close to 20 years to get junk bonds to be an accepted medium -- right? -- and finally do it. Power steering was invented in the 1930s and didn't get into use until the '50s; Xerox took 20 years to get to photocopying.
Then what's happening here isn't just consistent with what's happened with financial innovation, but technological innovation?
As well, as well.
While I taught around at a bunch of different universities, I actually didn't get trained in finance. My Ph.D. dissertation and my early writings were indeed more on the economics of science and invention.
So I kind of look at this all as a process and take a great deal of comfort that any student of inventive activity is going to really take comfort from the fact that in any industry in which there is change, it takes a significant amount of time.
So, we have to recognize that we're taking change, looking for it to occur instantaneously, but even the most successful inventions, like the personal computer, the Web, you know you could be asking the same questions five or six years ago about the Web, even today, and it won't be in full force for 20 years. We know it'll take that much longer.
Thus far most of the securitization of risk has occurred has been in the catastrophe area. You mentioned the possibility of transferring other sorts of what are now insured risks to the capital markets. Any reason why it's focused on catastrophe so far?
Capacity and the biggest fear -- I mean everybody recognized you could have a $100 billion event, you know, $100 billion in Florida, California, Kobe. The cat represented the largest concentration, and it was not diversified away, and so I think the numbers are so humongous that it became the obvious.
It's the same way the securitization of assets such as mortgages preceded credit cards, because it's the same technology. Now you wouldn't think about not securitizing a receivable. I think the natural sequence was, "What's the biggest market that lends itself to it?" and then once you crack that, you'll figure out a way or the inventors will figure out a way to securitize longer-tail liabilities.
At least, with a cat within 12, 18 months, you know the damage. You do a liability, it may take five years. But, there's no reason why you shouldn't securitize the claims on liabilities. I mean, how's that for a novel idea? Why not securitize potential lawsuits and the claims arising therefrom and put them into the capital market?
I happen to think that not only would you liquefy the insurance companies, but you'd probably get the lawsuits settled quickly because, if you have a personal claim where people are not emotionally tied to something, you can get to a business. Once you commoditize it, the ability to settle it, I think, increases.
So I think there's enormous opportunity from the securitization of liabilities, which will have direct benefits to the insurance companies and social benefits in that it will reduce litigation. I know that sounds a little way-out, but you start putting values on these -- markets clear a lot more quickly than the U.S. judicial system.
Once the investor gets hold of it, he's got a real clarity with regard to "This is a financial instrument," that it has nothing to do with personal pain, suffering, things that are going to get in the way, lawyers, you know. With putting a value on it, markets are color-blind and emotionless in their best sense, and they're the best way for conflict resolution. So I see an enormous opportunity in that and one that would have very big implications in the whole legal structure and claim settlement for the insurance business.
I consider that the major challenge.
So beyond bringing prices down and making insurance more available, securitization of risk might have greater social value by reducing litigation, for example?
Sure. You would have all the standard benefits of lower premiums, wider availability for liability insurance.
And, by the way, we've looked at it, and it could extend to things like medical care. I mean, capitation is a security.
Any form of disability, disease management, which everybody is concerned about, this can all be securitized. As a matter of fact, the Board of Trade looked at medical insurance futures, and we may bring that back at some time.
Do you think it's possible that as these markets develop, some of the larger corporations -- and maybe even some smaller ones -- might be able to begin transferring some of what are now their insured risks directly into the capital markets, without the involvement of the insurance companies?
It's possible but unlikely. It's not at all clear that we won't see enormous changes with corporates.
We have to ask what the role of captives will be in the future. And we also have to ask finally about the melding of financial risks and insurance risks. Because the end game as a chess player is really earnings per share.
And the day an insurance company can take enough of these separable financial, property and casualty risks and combine them into a policy, which in effect guarantees earnings per share, you will have reached the maturity of the market, because you really want to protect earnings and the balance sheet.
You mentioned the coming together of the insurance industry and the banking industry, the convergence of the financial services industry. Any other sorts of speculation on possible changes of the structure of the insurance industry and even within some policyholders themselves?
I think we're going to see financial risk management and traditional insurance melded in the corporate environment. You know, separately the person would buy insurance and whatnot, but you could easily see airlines buying combined hull coverage and jet fuel caps in one policy.
And that becomes maybe cost-effective, provides degrees of comfort where you deliver a financial guarantee within an insurance policy, get rid of rogue trader type of problems; it all becomes one coherent risk management department and it doesn't matter what those risks are.
The second thing I see as a possibility is that self-insurance now can be changed.
There's an enormous amount of risk out there now; you know a quake that strikes Intel's plants or shuts down Microsoft's office, that's self-insured, right? And that's just because of the cost of it.
Suppose you were to shut down Microsoft's Washington operations for three months because of a major quake in Seattle; you can't even imagine the billions of dollars. Well, there's no real effective way to transfer that risk, and I'm sure they'd like to. It doesn't compute. So I do think a lot of the self-insured risks today, if there was an efficient mechanism, would be absorbed.
And ultimately you might see big connects like Chilean earthquake risk and copper. There are natural relationships between listed markets and insurance markets, all of which might lead to outside products where a professional risk manager could say to a large Chilean copper producer, "You know you perhaps are self-insuring now, but you might go directly into the market."
Is there any way to predict any kind of dollar amount or percentage of what is now insured risk that might be transferred into the capital markets in 10 years?
Tens of billions to hundreds of billions, I think. The numbers will, as I say, accelerate as we solve these problems bit by bit. And, again as in all research, it's always a refinement of the technology.
The numbers are so enormous, and we know as students of economics that there's one thing that human beings consistently do: They're willing to pay money to avoid risk. This is a characteristic of any economic system. And the amount of these risks is in the trillions.
Is there anything that could prevent the development of a market for transferring these kinds of risks into the capital markets?
I think it's an inevitable trend. It's Victor Hugo, "Nothing is as powerful as an idea whose time has come," and this has come. In a prior time I would have said regulation or non-market forces could have stopped it. But with the whole globalization of markets, Bermuda, you know, we no longer live in a closed economy, and if anything, the trend is toward deregulation, which I think will accelerate the amount of financial innovation as we go to deregulated or re-regulated markets.
I'd like you to assess the way you see your role. You've been an educator, an economist, you're involved with the Board of Trade, here at Hedge Financial. Do you see yourself as a financial trader? An insurance executive? A visionary? All of the above?
A professional inventor.
More than anything I enjoy problem-solving. Sometimes the solutions are not so good. (Laughs.) And, you know, I've been privileged to be involved in three areas: one is financial futures and the invention side, another is insurance derivatives, and I'm currently working on environmental derivatives. We're advising the U.N. on global warming and market-based solutions to environmental problems and trading sulfur dioxide entitlements.
I think there's a segue and a bridge between the insurance industry and environmental, and I'm most intrigued with some of those areas as well as the insurance. I just like a problem. So I'm a businessman and a professional inventor and an academic.