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Paying complements

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The insurance industry has proven attractive to investors recently, and the new capital they're bringing into the market is offering new options for companies looking to transfer risk.

"The long-awaited convergence of the insurance markets and the capital markets seems to have happened," said Christopher McGhee, managing director and investment banking specialty leader at Guy Carpenter & Co. L.L.C. in New York. "There is enough activity that it suggests that clients are using capital market risk transfer products increasingly as a core element of their risk transfer program."

And, as many expected, the growing use of the capital markets as a risk transfer vehicle is developing as a complement to, rather than a replacement for, traditional reinsurance products--becoming just another part of companies' overall risk transfer programs.

According to a report released earlier this year by Guy Carpenter, 2006 was a record year worldwide for one of the most discussed areas of that capital market activity--the catastrophe bond market.

Last year saw $4.69 billion in cat bond issuance, according to Guy Carpenter, a 136% increase over 2005's previous record of $1.99 billion, and a 311% increase over 2004's $1.14 billion.

Significantly, the 2006 cat bond issuance came in 20 different transactions from 15 sponsors, doubling the previous record number of transactions of 10 in 2005 and 1999, Guy Carpenter noted.

All-in-all, the 2006 cat bond activity offers evidence of "the broad-based convergence of the traditional and capital markets," Guy Carpenter concluded in its report, and suggests that the capital markets will continue to develop into an important component of the reinsurance marketplace.

In their own recent report on insurance securitization, Cormac Bradley, a senior consultant, and Charles Pickup, a principal, both with Towers Perrin in London, noted that there are several factors driving expansion of the insurance-linked securities market.

One is the tightening of capacity after the 2004 and 2005 U.S. hurricane seasons, they said, while another is insurers' increased capital needs due to adjustments in catastrophe models reflecting the likelihood of more frequent severe weather events and increased rating agency requirements for capital to address those exposures.

Hard reinsurance and retrocessional markets are other factors, as is more risk-based regulation that's forcing insurers to look for new ways to transfer risks when traditional solutions aren't available. And a more favorable view by regulators and rating agencies of the capital market alternatives is also spurring the activity, according to the Towers Perrin consultants.

There's a factor on the demand side, too, Messrs. Bradley and Pickup and others note. Capital market investors are looking for more insurance-linked securities to diversify their own portfolios and achieve higher returns.

Guy Carpenter's Mr. McGhee noted that as the insurance-linked securities market is growing, the products used to transfer risks are continuing to evolve. While the core set of capital markets risk-transfer products such as cat bonds remains much in use, other methods such as loan-shaped structures are being used.

The growing use of sidecar special-purpose reinsurance vehicles, meanwhile, gives investors an opportunity to participate in the risk transfer on a quota-share basis.

"What that is doing is expanding the universe of investors that are investing in this space," Mr. McGhee said. "There is an expansion going on now that is really quite dramatic."

"As the market evolves, you create structures that are attractive to different types of investors," he said. "That's part of what the investment banking community does."

The sorts of risks being transferred are also expanding. Initially, cat bonds were being used to transfer very low-frequency high-severity events. "Now you're seeing in bond and note form a much broader spectrum of risk being transferred," Mr. McGhee said.

"There's lots of exploration of other kinds of risks, notably in the life area," he said.

"Essentially, we're finding ever more efficient forms to finance risk and, in particular, cat risk," Mr. McGhee said. Ultimately, "You hope that this expands the overall pie," he said. With more capital available for risk transfer, the benefits should trickle down to the insurance buyer, which he likened to developments in the mortgage market with the rise of mortgage-backed securities.

The spectrum of investors for insurance-related risks is expanding, Mr. McGhee said, "and that's important, too, because you're tapping a bigger and bigger pool of available capital."

The growth of the insurance risk transfer market itself has drawn more investors. "That also spurs more issuance. It's sort of a circular process," Mr. McGhee said.

Speaking earlier this year on the subject of new capital entering the insurance market at the annual Harold H. Hines Jr. Memorial Symposium in Chicago, Christopher M. Lewis, vp, alternative market solutions, P&C capital management at Hartford Financial Services Group Inc., noted advantages that new capital sources are providing his company as a reinsurance buyer.

"When we go out and look at different types of reinsurance, we can compare buying traditional reinsurance and buying reinsurance through the risk-linked securities market," Mr. Lewis said.

As part of the "convergence" between the insurance and capital markets, "the pricing of the traditional reinsurance market and the risk-linked securities market is not that far off," Mr. Lewis said.

Mr. McGhee agreed that costs associated with transferring risks to the capital markets are coming down as the market has gotten established. "First of all, they can be done much more quickly than they were in the past and the overall transaction costs have come down, too," he said.

John J. Waller, managing director and co-founder of Chicago-based investment bank Cochran Caronia Waller, was also on the panel at May's Hines Symposium, an annual event sponsored by the Chicago Chapter of the Risk & Insurance Management Society Inc., the Insurance School of Chicago and Business Insurance.

He suggested that the capital markets' interest in insurance risk "is all good for the market," bringing added levels of sophistication and talent to the insurance market, as well as added capital.

Mr. Waller suggested that the presence of the new capital entering the insurance industry--some of it admittedly not long-term, but rather more opportunistic in nature--suggests that insurance has finally gotten to the same point as other industries, supported by different tranches of capital, some permanent and some temporary, entering and leaving as the investment climate shifts.

"The financing of the industry over the past five years has dramatically improved and it's better for everyone in the industry," he said.

It's essential to continue developing "better capital solutions" for addressing insurance risk, Mr. Waller said, particularly for transferring casualty lines risks that have seen less interest from capital markets investors thus far because of the typically longer-tail nature of those exposures.

Another area where the new capital doesn't seem interested in getting involved is terrorism insurance.

"Today we still don't have a fundamental understanding of where a terrorism attack will occur, what kind of attack will occur and when it will take place," Hartford's Mr. Lewis said. "That is just not a risk that is insurable in the classic sense."

"We have met with Wall Street, hedge funds, private equity--they don't want it," he said.

"We've worked pretty hard with investment firms trying to come up with a TRIA-type company," Mr. Waller said. "And what you come up with is nuclear waste--nobody will touch it."

"We couldn't find smart money or dumb money willing to take it," Mr. Waller said.

Going forward, are there factors that could slow the capital markets interest in insurance-related risk? Mr. McGhee acknowledged that it's possible.

For example, if bid prices get too low on insurance-linked securities, that could make the market unattractive for investors, he said. Or a loss that far exceeds what existing models would have predicted--or one that shows the models to be fundamentally flawed--could slow the market.

"Or, for example, if there was found to be fraud in the marketplace, that could have a real dampening effect," Mr. McGhee said. But absent any event of those sorts, the market should continue to grow.

"There's a little bit of a self-fulfilling prophecy about these things," Mr. McGhee said. "As the deal flow gets larger, more investors are going to come in."