March 04, 2005

Reading: Banks, "Alternative Risk Markets" (2004)

Erik Banks, "Alternative Risk Markets: Integrated Risk Management through Insurance, Reinsurance and the Capital Markets," (Wiley Finance 2004)

Banks' work turned up while searching for a text for an insurance law course I'm co-teaching in Hartford. Apart from a CPCU text we've found little to cement our case readings for our course focused on Surplus Insurance Lines and Alternative Risk Transfer ("ART"). Large deductibles, self-insurance, risk retention groups, captives, catastrophe bonds and other insurance linked securities, derivatives and other alternatives to traditional insurance are a controversial and cutting-edge topic, especially in light of recent disasters and investigations. Banks brings his experience as a senior risk manager at global institutions including XL Capital (the Bermuda reinsurer), Merrill Lynch, and a record of a dozen books already published in the field.

An online look at the Table of Contents of Banks' text looked promising, but after a full read, the text left much to be desired as a law school source. It was organized into four parts, which I’ll follow below with a few observations of my own.

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Risk and the ART Market

The first two chapters open with an examination of management approaches to risk management. They include a discussion of the insurance price cycle and the influence of capital availability and investment return on the dynamic cycling between "hard" and "soft" markets. The author writes about the credit risk of "intermediaries," including in that category a broader spectrum of players than does much of the insurance sector, to include global insurers, reinsurers, and commercial and investment banks. He points out that traditional insurance, while simple to get (when available) is not ideal for addressing more "intricate or comprehensive solutions," such as multi-year structures and non-traditional covers such as terrorism and financial risk. He speaks of "regulatory arbitrage," in which differential regulatory treatment of banks and insurers may motivate them to lay off different types of risk, and the effects of continuing deregulation and "convergence" on those influences.

Closing the first part, his third chapter becomes more specific, defining the ART market as the "combined risk management marketplace for innovative insurance and capital market solutions," and ART itself as "a product, channel or solution that transfers risk exposures between the insurance and capital markets to achieve stated risk management goals." Banks, p. 49.

Insurance and Reinsurance

Banks opens the second part of his text with a primer on primary insurance and reinsurance contracts commonly used in ART situations. In 25 pages, he reviews basic insurance concepts and the tools used to manage risk in the spectrum from risk retention (e.g. self-insurance, captives and finite risk programs) to risk transfer (e.g. full insurance with low deductibles and coinsurance). He concisely explains the features of various types of loss-sensitive contracts, including those that are experience-rated, and programs employing large deductible, retrospectively rated (both paid loss and incurred loss), and investment credit methods.

He continues exploring the risk retention end of the spectrum with a useful introduction to finite risk programs, organizing them by retrospective (e.g. loss portfolio transfer, adverse development cover and retrospective aggregate loss cover) and prospective polices. He finishes with a capsule lesson about layering of insurance programs.

His introduction to reinsurance and retrocession provides concise explanations of the financial and balance sheet effects of reinsurance, and the difference between facultative and treaty reinsurance. He also provides an overview of the varying effects of excess of loss, quota share, and surplus share agreements, and illustrates the possibilities of both vertical and horizontal layering of coverage. He closes with additional information on spread loss and finite quota share versions of finite reinsurance arrangements that provide substantial financing benefits with minimal risk transfer.

Banks provides a chapter dedicated to captive insurers, opening with a cash flow table illustrating the cost-benefit analysis that goes into evaluating the business justification for forming a captive. He provides some easily understood diagrams supporting his brief explanation of the role of a “fronting company” and the different forms of captives, including pure captives, sister captives, group captives, rent-a-captives and protected cell companies. He includes a short introduction to Risk Retention Groups, which are vehicles that are similar to captives, but that are organized and regulated in a different fashion. He closes with a very brief sketch of the tax consequences of employing a captive for risk management.

Banks’ chapter on multi-risk products extends the concept of a multi-line or package policy to the more complex products that are used in the energy industry. For example, a “dual trigger” policy might pay if and only if both of two triggers exists, say interruption of the insured power supplier and a market price for replacement power price over a certain level. Banks describes such multiple trigger products as a way to more precisely manage the outside risk of both events coinciding. He notes that multiple trigger products tend to be individually negotiated and structured, so that they need to include a charge for the cost of such custom development. In addition, such structure may not fall within all definitions of insurance for accounting, legal and tax treatment.

Capital Markets

Banks’ third part concentrates on capital market instruments and securitization, opening with an overview of insurance-linked securities, including catastrophe bonds. He goes on to explain contingent capital structures that (unlike the insurance-linked securities) have no characteristics of insurance and are subject to different regulatory, tax and accounting issues. Both contingent debt and contingent equity financing are arranged prior to a particular class of loss or adverse event, but provide for financing to be provided only after the occurrence of the adverse event. The capital can be less expensive than post-loss arrangements because it is arranged in advance and is not available at will.

Banks closes his third part with an examination of derivatives used to manage insurance-related risks. Those instruments include futures, options, futures options, forwards and swaps. Because derivatives are not based on insurable interest and demonstrated loss, they do not qualify as insurance, and may be subject to basis risk (a term describing the disconnect between the trigger of the derivative and the exposure from which protection is sought).

Exchange-traded derivatives have been developed for catastrophe risks, which were introduced in 1992, but failed to generate interest or a critical mass of participants and were abandoned in 2000, according to Banks. Temperature derivatives have been better received by energy suppliers and have led to active trading environments in some financial exchanges. Banks makes an observation that has applicability beyond this field when he notes that temperature derivatives “are heavily reliant on very robust historical data for accurate modeling, valuation and risk management. In the absence of 30-50 years of high-quality daily temperature data, the pricing exercise becomes difficult and subjective, which can lead to erroneous risk management choices. Given this minimum requirement, most activity remains concentrated in locations that have good data records under the quality control of a national weather or meteorological agency (e.g., US, Canada, Europe, Japan, Australia). Expansion into other countries without this minimum requirement will be slow.” Banks p. 162.

Over-the-Counter (OTC) traded insurance derivatives have been more successful, according to Banks. He describes OTC-traded catastrophe reinsurance swaps, pure catastrophe swaps, temperature and other weather derivatives (e.g. precipitation, stream flow and wind) and credit derivatives. Through swaps, reinsurers exchange exposures to un-correlated risks (e.g. Japanese earthquake and North Atlantic hurricane) to achieve greater portfolio diversification.

“Transformer” companies are those created to address the regulatory obstacles barring banks from writing primary insurance or reinsurance. A transformer bridges the gap between banking and insurance by dealing with its bank clients using derivatives, and transferring the same risk to the insurance market through reinsurance. Banks suggests that the need for transformers may diminish as regulatory changes allow more “bancassurance” platforms to develop.

ART of the Future

Banks fourth and final section addresses his vision of “ART of the future.” He argues for combinations of various financial and insurance risks into a single, multi-year Enterprise Risk Management (ERM) program. Such requires elimination of “silo” approaches to risk management, restructuring of the risk management organization and an extensive analysis of the total risk profile of an enterprise. Banks sketches two case studies and states that “demand for ERM programs by corporate end-users appears to be strong and growing,” citing “industry surveys and actual corporate experience. He does not, however, identify the surveys or experiential data on which he bases this conclusion, and acknowledges that several “pioneers” in the ERM process found their ERM program dismantled following corporate reorganizations in which the pioneers were acquired and displaced.

Prospects for growth in the ART market face both drivers and obstacles, as sketched in Bank’s final chapter. He cites “stronger demand for risk capacity” as the likely driver for future growth, aggravated by future catastrophes that stress available risk capacity. As an additional driver, he points to lower regulatory barriers to entry of new capacity. He briefly acknowledges organizational and cultural obstacles to the elimination of the “silos” and “incremental decision making” that he sees as impeding ART solutions.

Banks closes with subjective forecasts for the future of various ART tools (ranging from “moderate” to “strong”), and an observation that deregulation will encourage convergence of banking, insurance and other financial service industries.

Banks’ work contains little in the way of statistical support for many of his observations and conclusions. While the book includes a bibliography, it does not include legal references, texts or articles. Many of the author’s conclusions are couched in general and broad terms and read much like those one would expect from a visiting consultant providing a backgrounder on his field of expertise, in preparation for a possible retention to assist in an ERM design project.

While the text provided a useful overview of the various risk-retention tools common in the specialty risk market, the absence of meaningful legal references and citations makes it of doubtful value as a supplement to an advanced insurance law course.

Douglas Simpson, J.D.
Wethersfield CT
Connected through LinkedIn

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