Convergence comes together
The insurance and banking industries are finding the benefits in adapting each other’s techniques and structures. By Ron Liesching
The buzz word in insurance is convergence: convergence between insurance and financial markets. Convergence has two aspects. One is finance in insurance. This brings capital market structures and finance analytics into insurance. The most visible area is catastrophe bonds and insurance derivative contracts. The other is insurance in finance. This is a broad range of activities where insurable risk is explicitly identified in financial structures. This is driven by unbundling: separating the insurance component out of the financial transaction. For example, in the US there are synthetic investment contracts (SICs), where there is an insurance ‘wrapper’ so that a fixed-rate investment can be valued at book value. Other examples are insuring the credit or political risk in investments or securitisation structures.
Returning to finance in insurance: there has been a rapid growth in issuance of catastrophe bonds. These investments pay a high yield, but part – or all – of the principal will be lost if there is an insurance loss above some high threshold level. The insurance industry has found issuance attractive. The industry’s entire capital is small relative to the extreme losses that could occur if, for example, the San Andreas fault really went. Catastrophe bonds are a new reinsurance market.
Investors want catastrophe bonds as a new, diversifying, source of return. However, there is a lack of historical data on insurance rates. Working with data provided by insurance broker Guy Carpenter, Professor Kenneth Froot at Harvard concluded that insurance was indeed a zero-beta asset class: losses are not correlated with equity returns. However, a real selling point for catastrophe structures is hunger for yield in today’s low interest rate environment. But we have not – yet – had major catastrophic losses. As Warren Buffet has pointed out, it may be misleading to use the name catastrophe bond, when there may be no return of principal. This comes back to the core reason for the existence of insurance companies. A catastrophic loss will never be covered by the individual claimant’s future insurance premiums. Only holding a diversified portfolio of insurance exposures provides a stable aggregate return stream.
Value creation via unbundling and diversification is the most interesting aspect of convergence. Insurance companies (first XL Capital, then SwissRe and ZurichRe) have introduced insurance covering multiple exposures: one contract providing excess cover for general liability property and casualty, directors’ and officers’ liability, product recall and even exchange rate risk, and so on.
In financial market jargon this is an “out-of-the-money basket option”. The rapid growth in this activity reflects increased sophistication of insurance buyers: A large company may have expected annual insurance claims of $10m. Insurance of this expected loss layer is like a bank deposit: it pays insurance premiums, but expects to get most back in claims. What really concerns corporate treasurers is the unexpected earnings impact of major insurable loss.
At today’s elevated share price multiples, any large unexpected earnings loss can cause a dramatic share price plunge. Whether loss is due to product recall or foreign exchange, it is the unexpected nature of the loss that unnerves investors. Hence insurance is viewed as a key tool for corporate earnings management: reducing the investors’ exposure to extreme specific risks.
This runs directly counter to the Modigliani–Miller theory in finance: specific risks can be diversified away. So, theoretically, such insurance should have no value. But a weakness in the theory is that the real world is run by agents. Agents cannot diversify their own specific risks. Plus the theory ignores the credit market impact of specific risk on companies.
This points to the way that convergence in insurance is heading. Many major institutions are examining their balance sheets to see what insurable risks should be unbundled. Removing uncertainties hanging over balance sheets can be very rewarding.
Manufacturing companies do not want extreme specific risks. Equally banks, still recovering from Russian and Far East write-downs, realise that a small chance of near total loss does not lie comfortably in their balance sheets. But, properly priced, these financial risks can truly diversify – and thus enhance results – in an insurance book. Convergence can truly be a win-win-win outcome.
An example of this was shown in a landmark deal last year. British Aerospace took £2.4bn (e3.6bn) of aircraft leasing risk off its balance sheet. The excess loss layer was taken by the tenth largest US property and casualty company, XL Capital. XL was happy: its diversified its insurance book at good returns for risk. British Aerospace was happy: it had insured a risk that had derailed its core business in the early 1990s. Investors were very happy: the British Aerospace share price rose nearly 15% after the announcement of the deal. Convergence is here to stay.
Ron Liesching is managing director of research at Pareto Partners in London