The Alternative Risk Transfer Market
Thomas Passante, FCAS, MAAA
Swiss Re
Casualty Actuaries of Europe (CAE)
April 23, 2004
Definition
In this discussion, Alternative Risk Transfer (ART) shall be
defined as:
(I)
(II)
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Retrospective Reinsurance

Loss Portfolio Transfer

Adverse Development Cover
Prospective Reinsurance

Multi-year “Traditional” with special features

Aggregate Stop Loss

Finite Quota Share
ART vs. Traditional
What makes a contract qualify as “ART”?
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
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
Recent Changes
Recent changes that have affected the ART Market:
I.
Changes in Financial Markets
II.
Changes in Underwriting Markets
III. Increased Accounting Scrutiny
IV. Increased Regulatory Scrutiny
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Financial Markets
Decrease in interest rates*
0.07
0.06
0.05
0.04
1998
2004
0.03
0.02
0.01
0
Duration
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* Graph not to scale
Financial Markets
Examples:
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
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.
Financial Markets
Stock Market:

Some (more aggressive) players used Equity Market
returns to discount in the past.

Due to:
a) lower returns,
b) higher volatility,
these players now tend to move toward rest of market, i.e.,
risk free rates.
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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
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
Some reinsurers have exited the Finite market, e.g.,
GGFP, Centre, Stockton, OPL, PMA, etc.

Greater focus on reputational risk
Underwriting Market
Traditional Markets:
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
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!
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 (??)
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Accounting / Regulatory
The industry is experiencing an increased level of accounting
and regulatory scrutiny due the combination of:
a)
A number of abuses in the “financial reinsurance” market,
b)
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).
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
Good: “cleans” the market.

However, clients are more wary, thus making it more
difficult to close legitimate transactions in the short term.
Accounting / Regulatory
Example: HIH. A number of transactions engaged between
HIH and reinsurers raised the following criticisms:
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
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.
Accounting / Regulatory
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Accounting
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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:
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
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!
Accounting
Recently auditors have taken a tougher stance on Finite
Quota Share:
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
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.)
Accounting
FIN 46, prompted by the alleged abuses of Enron, constitutes
one of the latest attacks on off-balance sheet deals (FASB)
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
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.
Accounting
Ever-evolving International Accounting Standards are
increasingly migrating toward “Fair Value”.
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
Stricter enforcement of Premium Accrual on multi-year
deals, providing less smoothing benefit

Accrual of Profit Commission
Regulatory
Sarbanes-Oxley Act:
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
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.
The Future?
Still quite positive. Lots of ART products offer numerous
benefits to the client, in cases such as:
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
Purchase

Put bad results behind (e.g., new management)

Outsource claims management

Regulatory Capital Relief

Solvency Capital Relief

Smoothing Results

Make profit
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.*
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* source: BLG ARTscape