The Alternative Risk Transfer Market

1
The Alternative Risk Transfer Market
Thomas Passante, FCAS, MAAA Swiss Re Casualty
Actuaries of Europe (CAE) April 23, 2004
2
Definition

• In this discussion, Alternative Risk Transfer
  (ART) shall be defined as
• Retrospective Reinsurance
• Loss Portfolio Transfer
• Adverse Development Cover
• Prospective Reinsurance
• Multi-year Traditional with special features
• Aggregate Stop Loss
• Finite Quota Share

3
ART vs. Traditional

• What makes a contract qualify as ART?
• Experience Account with explicit recognition for
  investment income
• Profit Commission
• Aggregate, Finite Limits
• Option Features
• Additional Premiums
• Any coverages/triggers not normally covered by
  the traditional market

4
Recent Changes

• Recent changes that have affected the ART Market
• Changes in Financial Markets
• Changes in Underwriting Markets
• Increased Accounting Scrutiny
• Increased Regulatory Scrutiny

5
Financial Markets
Decrease in interest rates
Graph not to scale
6
Financial Markets

• Examples
• Multi-year Finite Explicit credit for interest
  is lower therefore, to achieve the same
  economics, must charge more up-front premium
• Loss Portfolio Transfer Less discount
  available to be released i.e., Premium
  fPV(Reserves) is higher. For long tailed lines
  this can be significant.

7
Financial Markets

• Stock Market
• Some (more aggressive) players used Equity Market
  returns to discount in the past.
• Due to
• lower returns,
• higher volatility,
• these players now tend to move toward rest of
  market, i.e., risk free rates.

8
Underwriting Market

• Reinsurer Practices
• Reinsurers are less willing to write all-risk
  type policies which had been typical for Finite.
  e.g., lets dump everything into the finite
  cover
• Post Sept. 11th, terrorism sublimits
• Asbestos continuing to haunt reinsurers
• Med-mal severity and frequency and soaring
  defense costs
• Some reinsurers have exited the Finite market,
  e.g., GGFP, Centre, Stockton, OPL, PMA, etc.
• Greater focus on reputational risk

9
Underwriting Market

• Traditional Markets
• On the other hand, traditional reinsurance
  markets have hardened, which have directed
  companies to search for alternative finite
  structures.
• Note Property market already appears to be
  softening again!

10
Underwriting Market

• Unique Risks
• Tougher stance on more unique or unusual risks
• Residual Value very little seen in the industry
  today
• Loss Portfolio Transfers for Corporate Clients
  causes problems due to Information Asymmetry.
• Liability arising out of a specific product
• Construction Defects
• Asbestos
• Mold (??)

11
Accounting / Regulatory

• The industry is experiencing an increased level
  of accounting and regulatory scrutiny due the
  combination of
• A number of abuses in the financial reinsurance
  market,
• A number of failures in the industry,
• especially where it can be concluded that (a)
  disguised the eventual occurrence of (or even may
  have caused) (b).
• Good cleans the market.
• However, clients are more wary, thus making it
  more difficult to close legitimate transactions
  in the short term.

12
Accounting / Regulatory

• Example HIH. A number of transactions engaged
  between HIH and reinsurers raised the following
  criticisms
• Side letters being used to negate risk transfer
• Backdating of documents
• Inclusion of sections not intending to be called
  upon
• Using triggers for additional cover that were
  unrealistic
• Appearance of risk transfer where there was none.

13
Accounting / Regulatory
14
Accounting
15
Accounting

• FASB 113 must provide reasonable possibility
  of significant loss. Although never explicitly
  stated, this has led to numerous interpretations,
  increasingly more conservative over time
• P(Loss) 10
• E(10 worst cases) (-) 10 of premium, e.g., a
  shortfall type measure
• 10/10 Rule The 10th percentile (-) 10 of
  premium
• Recent talk of a 15/15 rule with one auditor!

16
Accounting

• Recently auditors have taken a tougher stance on
  Finite Quota Share
• Loss corridors are often a red flag
• Limits need to be very high
• Virtually nothing can be sublimited
• In one instance, deeming reinsurance to be
  collected was difficult to get through. (Auditors
  wanted full coverage for uncollectible
  reinsurance.)

17
Accounting

• FIN 46, prompted by the alleged abuses of Enron,
  constitutes one of the latest attacks on
  off-balance sheet deals (FASB)
• Seeks to determine who must consolidate the
  Special Purpose Entity (SPE.)
• A variable interest entity or VIE is an entity
  that may be consolidated. The party that must
  consolidate the VIE is called the primary
  beneficiary, i.e., whoever holds the majority of
  the risk of loss or the upside/residual returns.
• Reinsured may have to consolidate furthermore,
  consolidating companies may change from year to
  year, depending on whether the primary
  beneficiary changes, causing further complication
  / confusion.

18
Accounting

• Ever-evolving International Accounting Standards
  are increasingly migrating toward Fair Value.
• Stricter enforcement of Premium Accrual on
  multi-year deals, providing less smoothing
  benefit
• Accrual of Profit Commission

19
Regulatory

• Sarbanes-Oxley Act
• Adopted by SEC, requiring disclosure in a
  separate part of the Management Discussion and
  Analysis section of SEC reports of all material
  off-balance sheet transactions, arrangements,
  obligations (including contingent obligations),
  and other relationships of the issuer with
  unconsolidated entities that may have a
  material, current or future effect on financial
  condition...
• Another outcome closer monitoring of control
  functions within an organization, i.e., to ensure
  independence.

20
The Future?

• Still quite positive. Lots of ART products offer
  numerous benefits to the client, in cases such
  as
• Purchase
• Put bad results behind (e.g., new management)
• Outsource claims management
• Regulatory Capital Relief
• Solvency Capital Relief
• Smoothing Results
• Make profit

21
Conclusion

• The ART market not dead! Far from it! Rather,
  it has changed. Still seen as a viable set of
  products. When financial reinsurance is properly
  used, it has a legitimate and beneficial part to
  play in the financial management of reinsureds.
• The trenchant comments made by the HIH Commission
  Report about certain financial reinsurance
  transactions and the FSAs proposals to further
  regulate these products are, therefore, not the
  death knell for financial reinsurance, but are
  simply a wake-up call to practitioners to comply
  with a stricter legal, regulatory and accounting
  regime.
• source BLG ARTscape