Aces in the Sleeve

Like all art, the ART market comprises a wide range of categories appealing to different tastes. There are classic works, such as captive insurance facilities, and more modern installations like integrated risk portfolios and hybrid insurance-capital market securitizations. Such alternatives typically fail to arouse much interest when insurance is inexpensive, as it has been for more than a decade. But when insurance costs rise, ART suddenly becomes more attractive.

Already, the 10 percent to 15 percent increase in property/casualty insurance prices in the 2000 autumnal policy renewal period has motivated an increased use of captives in several domiciles. Meanwhile, newfangled integrated risk solutions and even more complex securitizations are continuing apace, with several knowledgeable observers predicting they will soon take off.   

As for when, that is still uncertain. "The ART market will blossom with regard to integrated products and securitizations, but not immediately," says Mitch Cole, a principal at Towers Perrin, a New York-based global consulting firm.

"The hardening commercial insurance market will spur more interest in these strategies, but it does take a while--a couple years in some cases--to get them on their feet," Cole explains. "The decision process tends to be protracted, given the educational, analytical and quantitative processes involved. But blossom they will." 

Hard Day's Year

According to the Insurance Information Institute's (III) most recent Early Bird Forecast of the property/casualty market, insurers' net written premiums surged 7 percent in the previous twelve months, a clear indication that insurers are charging more for products.

The New York-based III estimates 10 percent to 12 percent premium increases on average for most lines of insurance, with workers' compensation even higher, peaking in some states like California by as much as 20 percent and more.  

For many youthful risk managers, the turn in the cycle is not something they have witnessed before, absent a few upticks in property insurance costs during the intervening years. More seasoned risk managers know just what to do when insurance prices tighten--look for alternatives. 

Right now there are plenty. "The last several years in the insurance industry have been a period of incredible innovation, marked by new types of captives and inventive strategies seeking to converge both the insurance and capital markets," says Kathryn Westover, director of captive management operations for Boston-based Strategic Risk Solutions, an insurance captive manager.

"Consequently, ART has become such a broad term," Westover explains. "It now means so many different things to different people, each strategy having its own clearly defined role."

ART market purveyors say their alternative strategies are more than hard market fixes. Indeed, they represent, in some respects, an entirely different approach to risk. "ART isn't just financial solutions or nontraditional solutions to hazard risks," explains John Gantz, a principal at Swiss Re New Markets, the New York-based ART strategist credited with many pioneering deals.

"We're not focused so much on hazard risk as we are on the earnings and financial statements of our clients," Gantz says. "In effect, we don't have an insurance approach, but an insurance-based corporate finance approach." 

Zurich Corporate Solutions offers similar advice. "Whether it's a hard market or soft market, we're looking at a corporate risk financing strategy to help companies smooth out volatility in their noncore business risks," says Randall Clouser, president of the New York-based insurer. "What investors are really looking for are companies that take core strategic risks--not noncore ones. What we offer helps companies to reduce the earnings volatility inherent in their noncore business. That's where they need it, and that's where we can help." 

Going With the Grain 

Swiss Re New Markets has put together several eye-popping earnings-related strategies in the last couple years, among them a transaction for United Grain Growers Ltd. in Winnipeg, Manitoba, that many consider the most innovative ART deal of 2000. 

The insurer, part of the giant Zurich-based Swiss Re Group, crafted a combined lines insurance program that also featured coverage in the event UGG experienced a volume shortfall in the availability of grain. The novel insurance addresses more than just hazard risk, drilling down to what truly affects UGG's financial stability--a fall in grain volume. 

When grain volume drops, typically because of adverse weather, UGG's revenues plummet, as much as 20 percent in past years. Originally, the company searched for a weather derivative to hedge the risk, but the wide geographic regions in which grain is grown in Canada, with wildly divergent weather patterns, made the derivative unavailable. 

Unable to hedge the risk, publicly traded UGG and its shareholders would have to bear it alone. Swiss Re New Markets, abetted by UGG's insurance broker, Willis, proposed an integrated property/casualty program into which the grain volume risk was imbedded. The strategy resolved the uncertainty that plagued UGG's earnings. 

Gantz says similar strategies will take root as the commercial insurance market tightens. "To some extent, deals have been limited because of the inexpensive prices in the traditional marketplace," he explains. "There's no question that as prices move up, these capital market solutions will offer more competitively attractive terms vis-à-vis the cost of insurance than they had previously." 

Abstract ART

Two recent transactions inked by Swiss Re New Markets with its clients stretch the definition of insurance further. The first, for the French tire maker Michelin, represents a new way to tap additional capital when needed--through insurance.

Typically, capital is available through banks via traditional lending strategies. Like many companies, Michelin was fully leveraging its corporate capital, but wanted some flexibility to take advantage of investment opportunities as they arose. In a recession, for example, a dominant market company like Michelin may want to make an acquisition or expand its capacity for an anticipated upturn in the cycle. If it takes that opportunity by issuing debt, however, that increases the risk profile of the company. And if it issues equity, shareholdings are diluted and share price may decline. 

Swiss Re New Markets had a better idea. "We asked them why they wanted capital, and for what use," says Thomas Skwarek, a capital advisory director in the insurer's London office. "Michelin responded,  "Just in case there is a problem." That is when the insurance idea popped up. After all, insurance is designed for "just in case" scenarios. 

So a strategy was developed in which Michelin would be provided capital in the form of hybrid equity (twelve-year subordinated debt) under certain terms and conditions. In effect, Swiss Re has structured an insurance policy that triggers much like the UGG policy--it is linked to a specific movement in a quantifiable index, in this case a reduction in GDP. "We're not transferring risk in the traditional sense, but providing access to capital," Skwarek says. "Typically risk management asks, 'How can I cover future losses?' We're looking instead to help companies manage their earnings." 

The syndicated transaction is also  unique in that Swiss Re New Markets partnered with several banks to offer the $1 billion of twelve-year committed subordinated loans. "The insurance industry couldn't provide a billion dollars on its own," explains Skwarek. "And that's where the whole convergence of banks and insurance companies comes into play. By putting together both, we got the billion dollars needed." 

While the insurance is triggered by GDP, the banks' capital is not. Instead, it is available via traditional means following a typical five-day notice. Since there is a lower probability that the insurance will be triggered, Swiss Re New Markets and other insurers in the deal, including Zurich-based Winterthur, draw a lower commitment fee than the bank. "This is the first time that banks and insurance companies have combined in a global committed capital facility," Skwarek says.

The insurer also just closed a major securitization for the fast-food restaurant chain Arby's, best known for its roast beef sandwiches. "Arby's wanted to find the most efficient form of financing for the company," says Nick Giuntini, a Swiss Re New Markets director in New York.

"But its holding company was not investment grade, meaning that if it wanted to borrow in the high-yield market, it would incur higher borrowing costs than through other means, such as the asset-backed market," Giuntini explains. "We figured if we could take this one big chunk of future cash flow the company received from its franchise fees, that would give it the investment grade it needed to borrow better." 

The franchise fees represented income that was stable and more certain than the company's other capital streams. Given this stability, the holding company could then achieve investment grade status. "The role of insurance was to bring Arby's from the more expensive high-yield market to the less-costly asset-backed market," says David Moran, a Swiss Re New Markets associate director.

"We did that by creating an asset-backed security (a $290 million issue), in which the underlying risk is linked to the stability of the franchise cash flow stream," says Moran. Swiss Re New Markets is taking the first loss position in the security, with Ambac Assurance Corp. taking an excess risk position. "This demonstrated that the convergence of capital and insurance markets is two sides of the same coin," says Moran. "In this instance, we are transferring capital markets risk to the insurance market."    

Call of the Captive

The traditional alternative to commercial insurance is a corporate-owned captive. With insurance prices spiking, domiciles in which captives are licensed predict bullish times ahead. "The activity level is quickening," says Lisa Ventris, president and chief operating officer of the Vermont Captive Insurance Association, which represents more than 170 captives in the state.   

"Captive managers say they are hearing a lot of anecdotal information indicating the captives they currently have in their stables are becoming more active, in terms of the premiums running through them," Ventris adds. "Many risk managers are looking out at their current insurance lines, and instead of renewing them are thinking about including them in their existing captives." 

Len Crouse, the director of captive insurance at the Vermont Department of Insurance, says property insurance rate increases are spurring significant interest in captive alternatives for that line of risk. "We had a number of large corporations in New England that went through their property policy renewals and saw the rates jump sky high," Crouse says.

"In the last soft market cycle, these companies had taken the property premiums out of their captives and used it to buy inexpensive insurance from traditional markets. The deals were so good, who could blame them?" Crouse says. "Now that things are tightening up, we're seeing the premium coming back into the captives. Ventris concurs, noting that some companies that deactivated their captives during the soft market "are turning the green light on now."

Jill Husbands, senior vice president of business development at Marsh Management Services, a Bermuda-based captive manager, says an increase in captive formations is likely worldwide. "We're expecting growth in the more than two dozen domiciles in which we manage captives for our clients," says Husbands. "The hardening market seems to be affecting our clients globally."

Husbands estimates new incorporations of captives in Bermuda alone totaled roughly one hundred in 2000, a "modern record," she says. "This is by far the most incorporations since the last hard market in 1984, when one hundred and ten captives were incorporated on the island." 

While the current hard market is not expected to be as severe as the last one in the early eighties, the captive market has more to offer this time around, observers maintain. "As companies analyze the captive market they will find more alternatives to choose from," says Westover. "For example, the middle market didn't have much recourse other than joining a group captive back in the last hard market cycle. With the emergence of sponsored captives and rent-a-captives, small businesses and middle market companies can now join a captive without the need to share risk with other companies in a group situation. It is much easier for them to jump right into a quick fix captive program."  

Offshore rent-a-captives are utilized by brokers as a way to lease a captive's risk transfer capital on behalf of clients. Each client is treated as a separate insured, standing on its own. Insurer-sponsored captives in Vermont and other domestic domiciles are similar, with separate "cells" representing each insured that are not affected by the success or failure of the other participants.

All in all, the hard market promises to be hard on few, given the many alternatives available to risk managers. And, since many insurers and insurance brokers are intimately involved in the ART market, the loss of market share from traditional means will be made up by new sources of income. Says Clouser from Zurich, "We've got a lot of aces up our sleeves."