The convergence of the insurance industry and the capital markets may be inevitable, but when and how it will happen is anyone’s guess. Excerpts from a recent roundtable discussion, sponsored by PricewaterhouseCoopers.

MODERATORS

Ed Berko, head of derivatives systems practice, financial risk management group, PricewaterhouseCoopers Joe Kolman, editor, Derivatives Strategy

PARTICIPANTS

Yogesh Attre, vice president, Societe Generale Jean-Pierre Berliet, consultant, Tillinghast-Towers Perrin Bryon Ehrhart, managing director, Aon Capital Markets Morton Lane, president and CEO, Lane Financial LLC Markus Rohrbasser, chairman and president, Centerprise Services Inc. Richard Sandor, chairman and CEO, Environmental Financial Products LLC, and chairman, Hedge Financial Products Inc.

Ed Berko: Many people believe the insurance industry and the capital markets are set on an inevitable path toward convergence. How far apart are the two markets today, and how long will true convergence take?

Richard Sandor: We are witnessing what economists would term an inchoate market—a market that’s in formation. We’ve seen an enormous degree of success despite an unfriendly environment, particularly in terms of the quiescent catastrophic market of late. The cat market was sparked by a series of catastrophes in the late 1980s and early 1990s—Hurricane Hugo, Hurricane Andrew and the Northridge earthquake. At that time, a scarcity developed in the reinsurance market, and the problem was solved by securities—in the form of equities. There was a flow to Bermuda and a slew of catastrophic reinsurance companies started up, resulting in an enormous amount of capacity entering the market. The markets have been quiet since then, and reinsurance rates ultimately fell.

Yet that falling of rates, much to the surprise of many of us in the industry, hasn’t stopped securitization, which began with catastrophe options on the Chicago Board of Trade. The historical pattern is that fledgling exchange-traded products are eventually dwarfed by an over-the-counter market, and that’s what’s happening now in insurance. The reinsurance market is extremely competitive, yet firms continue to issue catastrophe-indexed bonds and other products.

Issuance is predicated on the fact that insurers want to keep their options open in case reinsurance rates increase dramatically. A barrier to that growth has been the cumbersome structure that exists in setting up a special-purpose vehicle offshore that has the collateral necessary to ensure that if a catastrophic event occurs, the people who, in effect, have bought this synthetic reinsurance don’t have credit risks. While this has been a barrier, it has also been a double-edged sword. It has been a big opportunity, because smaller reinsurance companies that don’t have AAA ratings now can issue AAA reinsurance. So issuance is facing less than true support by the firms that have the credit, but it’s motivating those that don’t have the credit to compete on an equal playing field with those that have strong balance sheets.

Citigroup is perhaps the best example of the trend we’re seeing. After all, what is the difference between investment banking, commercial banking and insurance in today’s world? We’re recognizing that those lines are getting blurred, and that the people who have the financial engineering skills can engineer mortgage-backed securities, credit card receivables or catastrophe insurance. And it really is not relevant who your regulator is and what your particular focus is in financial services—you can deliver high-value-added services to an industry that might need a significant amount of capital, if not now, then later.

Markus Rohrbasser: I’m slightly more cautious on the pace of convergence, but I certainly do not dispute the direction. When I think of convergence, I think of the collapse of the traditional definitions of the industries of banking, insurance and perhaps asset management. But I do not necessarily see the emergence of extremely large conglomerates that provide a lot of integrated capabilities and services. I think there are powerful forces at work that, on the one hand, stimulate aggregation, but I also believe there are powerful forces at work that stimulate disaggregation.

Where I see convergence taking place most dramatically right now is in the area of management practices. In the insurance industry, we’re seeing the development of insurance management, capital markets, derivatives and investment management skills at a faster rate than ever before. And for the first time, in my view, there is a systematic effort across the board to price insurance products relying heavily on derivatives methodology.

“How far apart are the insurance industry and the capital markets today, and how long will true convergence take?” —Ed Berko PricewaterhouseCoopers

In terms of the theme of convergence, however, I see different potentials for convergence in different risk areas. In the corporate market, the forces of aggregation are much stronger than they are in the retail market. I think over time the forces of disaggregation may actually play out in the latter. In retail insurance, it will probably prove to be much more rewarding to package product in the savings and asset-accumulation markets. I think that one of the great opportunities in the business today is in the area of providing simple, cheap products at the most efficient cost base, through the most efficient distribution channel, exploiting state-of-the-art technology. This, to me, is one of the disaggregating forces, particularly in the retail-oriented markets. I look at convergence as a process of redefinition of the industry across the spectrum of the four traditional service providers in the financial services industry.

Financial engineering is often praised as one way of protecting the margin in the business. This holds true in some market segments but not in others.

In terms of the packaging of capital markets and insurance risk, particularly from a funding or corporate problem-solving point of view, a lot of innovation is taking place. Lots of new transactions have taken place. But I would also say that if you strip out all of those transactions that are accounting-arbitrage-driven and tax-arbitrage-driven, the development has probably been slower than most people would have expected over the past few years.

Berko: Another way of approaching the issue is asking, Is there enough traditional insurance capital to cover existing property exposures adequately?

Jean-Pierre Berliet: There is too much capital, and that’s a real problem, because too much capital has brought prices down. If you look at the change in leverage over the last few years, between what happened on the asset side and the absence of cats, what you have is an industry situation that I never thought possible in 1992. At that time, many industry executives were panicking. Now you have companies that are flush with capital, and executives are wondering cautiously if things will ever change. The industry needs to move to a situation in which its permanent capital is appropriate in relation to normal losses. Catastrophe risk would be better financed through contingent structures that do not exacerbate overcapacity year in and year out.

Bryon Ehrhart: In an alternative view, I think that while there is a lot of capital, clients have recognized that reinsurers are not willing to sell parts of that capital—or options on that capital—in aggregated areas such as Florida and California. There’s plenty of capital out there generally, but if we went to reinsurers in these concentrated areas, we would be likely to find “capacity charges” for attachment points of less than 1 percent. Of course, capacity charges are different for investors and reinsurers, and when comparisons are made between reinsurer capacity charges, reinstatement premiums and payback expectations, on the one hand, and a collateralized reinsurance agreement that’s made possible through securitization, real possibilities of complementing—not replacing—the underlying reinsurance program become apparent. This explains the accelerated deal flow in the face of a soft market.

In the lower layers, reinsurance is clearly an efficient form. People are not worried that if such a layer of reinsurance did not pay in an event that they would be faced with ruin. Above 1 percent, however, people think that’s possible. They begin to question the recoverability of some of those covers. And a lot of those fears are driven into them by ratings agencies, which sometimes question recoverability in mega-events.

Morton Lane: Convergence is not a one-way flow. What we’ve talked about so far is a one-way flow. Risks have been taken from the insurance and reinsurance market and packaged for distribution in the capital markets. This was precipitated by high catastrophe prices, a shortage of capacity and a need for new people to take those risks.

“If you take a look at the development of new markets on a historical basis, a 10- or 20-year horizon is quite reasonable. We are six or seven years into this one.” —Richard Sandor Environmental Financial Products

I think that we are now seeing a reverse flow. Risks that occur in the capital markets—that is, credit risks—are being absorbed into the reinsurance market. If you accept the hypothesis that convergence must come from two directions, then what are the characteristics of the risks that are being transferred, either from the capital markets to the insurance market or from the insurance market to the capital markets?

As with almost everything in economics, convergence will be driven by price. Higher prices lead to demand both inside and outside traditional markets. But price is only a stimulant. What’s fascinating is that the distinguishing feature of the risks being transferred is that they are asymmetric in nature. I believe this presents a partial explanation for why convergence has not taken off like a rocket ship. The transferred risks are long-tail risks that have peculiar distributional characteristics. Reinsurers are generally familiar with these distributions, but the capital markets are not. Credit risk is an asymmetric risk; political risk is an asymmetric risk; catastrophe risk is obviously asymmetric. What the market is doing is grappling with a new form of risk that it had not previously faced. The risks with which we are familiar in the capital markets are symmetric—risks that can be modeled and displayed on an efficient frontier diagram. You can’t easily do that with asymmetric risks. The same intellectual framework might not be appropriate. This is why convergence has been slow. It requires an intellectual investment as well as a financial investment.

Sandor: From the investor’s side, these are noncorrelated risks, zero-beta assets. For the investment community that wants to take on risks that aren’t correlated, this is a good vehicle to do it. It provides a pure play. We certainly learned in the Asia meltdown that the world equity and bond markets tend to move together. They don’t move together with tornadoes or airline crashes or hurricanes. So there’s a big pool of capital out there looking for those kinds of assets, and investors are indeed taking them.

Joe Kolman: The diversification argument seems to be driving a lot of the thought in this area—the notion that Wall Street firms are eager to add insurance risk to their portfolios because it offers a diversification effect. What are the diversification effects of holding both banking and insurance risks in a single portfolio? Do they really reduce volatility? And is that ultimately going to reduce the capital required to back the risks?

Ehrhart: In the third quarter of 1998, the insurance-linked-note asset class as a whole was the second-highest-performing asset class in that quarter. The number one performing asset class, not surprisingly, was the U.S. Treasury bond.

Berko: Given these advantages, what is keeping the critical mass of the convergence from taking place rapidly? There seems to be interest, but something seems to be holding things back—the spark to make this asset class take off. What has been delaying the progress?

Sandor: To state the obvious, we’re living in a world in which communication is extremely fast. We expect and want instantaneous gratification. We watched something called financial futures take a decade or more to mature. Ginny Mae started in 1970, and we’re just getting around to developing a fully securitized commercial real estate market. The mortgage-backed market took 20 years. Junk bonds took from the mid-1970s to the early 1990s. If you take a look at the development of new markets on a historical basis, a 10- or 20-year horizon is quite reasonable. We are six or seven years into this one.

Ehrhart: Just to add some statistics to this part of the discussion, the growth has been slow but steady. By my count, about $7.2 billion in capacity—38 transactions—has been added by both risk transfer securitization and contingent capital transactions since 1994. While only 15–20 insurers and reinsurers have tapped this market, all significant buyers of reinsurance have benefited from the existence of this market. Its existence has helped to drive pricing down in the reinsurance market. This remains a market in its infancy.

“For the first time, there is a systematic effort across the board to price insurance products relying heavily on derivatives methodology.” —Markus Rohrbasser Centerprise Services

Berliet: Let’s examine why the market might have gotten off to a slow start. Consider the development of the larger securitization market in the late 1980s and early 1990s. The Basle Accord was being discussed, creating the need to raise more capital. Banks that couldn’t raise huge amounts of capital couldn’t grow. Most insurance companies, by contrast, are not in that position—the leading companies tend to have too much capital. Therefore, while the securitization ideas are interesting and important, they will not solve a problem that is as urgent as the banks experienced 10 years ago.

Sandor: I feel obliged to respond, because I think many of us have heard similar arguments about the banking industry in the 1970s, and certainly the savings-and-loans. There was no problem as long as the yield curve didn’t invert. Once the yield curve inverted, 5,000 S&Ls and 4,000 banks were lost over a period of six or seven years. Every historical measure said they were adequately capitalized—2 percent or 3 percent was all they needed. When short rates were 2.5 percent and mortgage rates were 5 percent, they borrowed all they could at 2.5 percent. If there were an event in the insurance world similar to the inverted yield curve in the banking world—say, an earthquake in San Francisco during working hours—what would the amount of exposure be?

Yogesh Attre: From an investor’s perspective, the biggest thing that concerned the buy-side in the past was liquidity. Bryon Ehrhart mentioned 38 deals. The perceptions were that some of the first deals were from issuers with interests that were asymmetric with investors’ interests, and that a few deals were completed by people who were subsidizing their friends—that these were getting done on a directed basis. Such impressions could lead investors to believe that this would not be an extremely liquid market—as compared with, say mortgage-backed securities.

Greater standardization of deals and the diversification of risks, as well as symmetrically aligned interests of issuers and investors, ought to attract more liquidity providers and long-term investors to this market. You need to have long-term investors buy into the concept that these are the kinds of things they can get into and out of when they want to.

Sandor: There’s no question that there’s a liquidity premium right now, because the market isn’t far out along the learning curve. But there’s a certain class of investors that wants to get paid a liquidity premium and is willing to say, 2 percent of my portfolio can be illiquid for four months if I get paid 200 basis points. For that, I’ll take it.

Kolman: What sorts of events will cause liquidity to improve?

Sandor: It generally takes a couple of shocks to make a market go. Let me offer two examples. Interest rates had one shock in 1973 with the first oil embargo. As a result, a bunch of risk management tools—financial futures and a few other things—took off. By the second shock, when Paul Volker tightened interest rates, it really came alive. In that particular instance, Salomon Brothers had hedged, and there was a big front-page article about how they bought an IBM bond, the first of its time. Everybody got rich, and that solidified the market.

Energy futures were born as a result of the first energy crisis, but they didn’t get going until the second crisis. I would say a quick start to the insurance market may still be a while off. The next big whack might take 10 years, but it will happen. When the next major catastrophic event occurs, some young trader at some particular Wall Street firm or insurance company will get written up on the front page for being hedged.

“There is too much insurance capital, and that’s a real problem, because too much capital has brought prices down.” —Jean-Pierre Berliet Tillinghast-Towers Perrin

Berko: Does the convergence of the two markets mean that the long-observed cycle in insurance and reinsurance pricing is now going to be dampened and flattened? In the past—with Hurricane Andrew and the Northridge earthquake, for example—there was a real lack of capacity, and the reinsurers that did have good balance sheets were able to charge high rates on-line, and provide cover that no one else could provide. The capital markets were really not geared up—they didn’t have a set of products and they didn’t understand the risks. There’s been that initial shock, and now one could argue that in the event of a second or third big shock, the capital from traditional capital markets will be able to go into the reinsurance markets more quickly and dampen the cycle in which a big event leads to high rates on-line, which slowly drop 10 percent or 15 percent per year over some period of time. Perhaps we’ll have a flatter cycle and possibly a lower rate on-line on average over time.

Sandor: I think flattening will occur, and I agree with your analysis. There is one other situation that comes into play that a mature capital convergence model would eliminate. If you drive the price of any commodity below its cost of production, whether it’s copper, corn or crude oil, at some point you will see speculative inventories build up. But a company can’t buy insurance unless it has an insurable risk. It can’t speculate the way it can in other markets because of the nature of financial regulation. So there really isn’t a natural buyer—a Warren Buffet—on the downside of insurance pricing. A mature capital market would bring this to the market, and would be another driver for longer-term stability.

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