Contingent Capital

Another illustration of securitization lies in contingent capital. Take as an example an insurer wanting to cover $100 million in losses from a major earthquake in California. Buying $100 million in reinsurance could cost as much as $7 million. For insurers, the real worry of such a big earthquake is that it wreaks enough short-term financial damage to cause them to lose their ratings, drop below regulatory levels necessary to do business, and make clients skittish. "The really critical issue is being in business the next day," says Kevin Callahan, president and chief executive of Aon Capital Markets in Chicago. So insurers might buy an option to access capital on prearranged terms in case of that earthquake. Instead of a $100 million payout, they’d get $100 million in preferred stock or subordinated debt, at less than one-fourth the cost of reinsurance. The insurer retains the risk, but locks in access to capital to keep going. Big catastrophes tend to let insurers eventually boost premiums, albeit on a lagged basis, so the insurer will likely have plenty of funds going forward with which to pay off its debt. And the guarantor has a stake in a company whose stock is likely poised to rise. "The development of some of these capital market alternatives is helping companies do a more efficient and effective job of managing capital," says Callahan. Though insurers stand to benefit most from contingent capital arrangements in dealing with catastrophes, corporate clients might use them to guarantee capital in the face of a computer collapse sparked by the Year 2000 problem or the 1999 introduction of the "Euro".

Most within the industry agree there’s great potential for securitized risk. "Bringing together the insurance market and the fixed-income market is the single biggest opportunity we face. There will be tremendous growth in the next three years," says Mike Normile, managing director and head of global insurance markets at Merrill Lynch. To be sure, many of these products are still on the drawing board. "It’s more in the thinking stage than the doing stage," says Elaine Miller, a senior manager in Arthur Andersen’s business risk consulting practice. "The insurance industry is being cautiously creative." Investing in risk-backed securities may sound good now; and the losses from Northridge and Hurricane Andrew may have faded from memory. But there’s no way of knowing the long-term fate of such innovations if another big disaster hits, causing investors to lose their principal. "Capital markets are definitely going to be there only when returns are adequate," says Standard & Poor’s Watson. Those in the industry argue securitized risk, by dint of being uncorrelated to the performance of the stock market, will always have some investor appeal.

These sophisticated new products would be impossible to develop without technology. "In the early days they had map rooms, which I picture as armies of people putting pins in the map to see where they had policies," says Heidi Hutter, chief executive of Swiss Re America. "If they saw they had a policy at 6 Elm Street, they wouldn’t write one for 11 Elm Street. Now computers are substituting for map rooms, giving us a better understanding of where the risks lie, a better understanding of the chances and potential magnitude of losses." And there’s still much potential for technology to change the way reinsurers do business, for example, in direct sales over the Internet. "Technology will be a business, not just a tool–Bill Gates could well become the biggest banker and insurer in the world!" says Ahlmann of Employer’s Re.

All these changes in reinsurance take place against the backdrop of a changing financial services picture, with increasingly murky distinctions between banks, insurers, reinsurers, and investment houses. As deregulation progresses and companies increasingly compete with each other for corporate and individual customers, competition is only likely to increase. And the insurance market, already competitive, will heat up even more. Reinsurers are in the position to offer flexible contracts structured to fill individual needs. "Fundamentally we believe it’s our responsibility to protect the balance sheets of our clients, whether we achieve that through traditional insurance, hedging, or securitization," says Ahlmann. As innovation continues and volume grows, prices of these new products will continue to drop, proving relatively inexpensive compared to previous methods of managing and financing risk. "This whole movement in the capital markets seems to have its fulcrum in the reinsurance industry," says Standard & Poor’s Levin. "The forces behind derivatives, insurance, and risk securitization are all coming together with reinsurance contracts."

The sleep insurance business looks pretty good.