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 = f[PV(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., “let’s 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 FSA’s 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