Financial Lines—The New ART Frontier
December 2001
In this article, Brent Clark explains how
the blending of classic financial guarantee and surety markets with the alternative
risk transfer (ART) field is resulting in the creation of a market willing to
take a customized, problem-solving approach to unique risk financing problems.
by Brent
Clark
Strategic Risk Solutions
Those of us with insurance backgrounds tend to think of alternative risk
transfer (ART) in terms of captives, finite risk, and deals involving corporate
liability or property risks. In recent years, however, there has been a blending
of the ART field with what is often referred to as "financial lines."
Financial lines are based in the surety and financial guaranty insurance
markets. They mainly involve the risk of payment default or bankruptcy of corporations
or governmental entities, but have evolved to address a variety of financial
risk issues. The blending of classic financial guarantee and surety markets
with the ART field is resulting in the creation of a market of insurance companies
that are willing to take a customized, problem-solving approach to some very
unique risk financing problems.
Scope of Financial Lines
The financial lines market can be described as follows:
Surety: The surety market has long existed
to provide performance guarantees for a variety of situations in which the obligee
in some transaction wants a third-party guarantee that the obligor will be both
able and willing to perform. The surety market is perhaps best known for its
involvement in the construction industry, but surety bonds are also used for
a variety of other types of transactions as well.
Surety underwriters typically have banking backgrounds and apply credit analysis
processes to underwrite risk. While the surety business is often thought of
as a segment of the insurance industry, the underwriting process is much more
similar to a bank than to a property/casualty insurance company.
While it is a generalization, surety underwriters generally attempt to underwrite
to a "zero loss ratio." This means that the surety does not so much see itself
charging a premium that reflects the risk of loss. Rather, the surety bond is
more like title insurance. The premium is really paid for the surety to conduct
a thorough analysis of the obligor so that the surety ends up putting its "stamp
of approval" on a company which it believes will be both willing and able to
perform. As we will see, this concept of "stamp of approval" underwriting is
important in understanding financial lines transactions.
Financial Guarantee Insurance (FGI): FGI
is best known for guaranteeing the payment of interest and principal on bonds
issued in the public securities market, especially bonds issued by municipal
or other governmental entities. Here the idea is that the FGI does the work
of performing an in-depth analysis of the financial condition of the borrower
as well as the purpose and terms of the underlying debt issuance, so that investors,
often individual investors, have the benefit of a guarantee issued by a third-party
insurer.
Given the need to protect the interests of the public, the state of New York
acted to draft a special licensing law for FGI companies. New York required
that a company engaging in FGI should be solely engaged in that activity, so
FGI companies are considered to be mono-line insurers.
Everything has its price, of course. Investors who buy bonds guaranteed by
an FGI company receive a lower interest rate than they would have received if
they had bought unguaranteed bonds. The interest rate they receive on the guaranteed
bonds reflects the credit rating of the FGI company rather than that of the
bond issuer. FGI insurers are generally highly rated (typically "AA" or even
"AAA" by Standard & Poor's). The rate, for example, on a bond issue guaranteed
by an AAA-rated FGI company will be only marginally higher than the rate paid
on U.S. Treasuries.
The FGI company is paid based on the "spread" between the rate the bond issuer
would have paid to issue non-guaranteed bonds and the rate they actually pay
on the guaranteed bonds. The bond issuer keeps some of this spread, and some
is paid to the FGI company.
Note that surety and FGI are conceptually similar; both are guaranteeing
the performance of an obligor on financial obligations. FGI is more specialized
in that it is designed to enhance the credit rated of publicly issued debt.
As noted, the companies carry a special license and are expected to adhere to
capital market standards for paying claims. This standard requires that the
FGI company make defaulted interest and principal payments on time and without
resort to the kinds of claims settlement delays that can occur with other kinds
of insurance.
One important difference between FGI and surety, however, is the notion of
risk-based pricing. The pricing of FGI is for the most part based on credit
ratings as established by the major rating agencies, coupled with the FGI companies
own credit analysis process. The ratings set by the ratings agencies are based
on historical default rates for borrowers who, in the view of the rating agencies,
bear similar characteristics.
As lower rated entities imply a higher risk of default, the FGI company will
receive a larger spread for guaranteeing the credit. This injects the notion
of risk based pricing, where it is ultimately known there will be some credit
losses, and premiums are set to (hopefully) fund losses realized on the overall
portfolio.
Credit Derivatives: Banks are, of course,
heavily involved in credit risk as one of their principal activities is extending
credit to borrowers. The banking industry has developed a field called credit
derivatives, which is designed to facilitate the efficient transfer of credit
risk among banks and other financial risk takers. Here, transactions are structured
using International Swap Dealers Association (ISDA) documentation, and take
the form of swaps or options. These transaction forms are more efficient that
insurance contracts as they do not attract premium taxes, although banks face
some other constraints that insurers do not.
One of the interesting aspects of the "convergence" between insurance markets
and financial markets is the potential for insurers to consider taking risk
in the form of a swap rather than in the form of an insurance policy. There
are regulatory considerations as the relevant regulators generally have the
power to consider substance-over-form issues.
There is also the issue of derivative accounting (FAS133) to consider, which
can be problematic for some insurers. But, to the extent that insurers are permitted
to engage in swap transactions, the ability to transact on either a derivatives
platform or an insurance platform creates interesting and useful options for
structuring transactions.
Structured Credit: While terminology can
vary somewhat, structured credit refers to transactions in which the credit
risk of several borrowers is pooled together. For example, a commercial bank
might take the credit risk associated with 100 corporate loans and create a
program to transfer the cumulative default risk of the entire portfolio. This
results in the creation of what are called "tranches" of risk. The idea is that
while it may be probable that at least one or two of the loans might default
over the program period, it is assumed to be unlikely that all or even most
will default.
The program might be structured so that the first tranche covers the risk
of two or three defaults (typically referred to as the "equity" tranche), with
other tranches taking the risk of successively higher numbers of defaults. When
these tranches are themselves structured as bonds, the rate paid for the tranche
will reflect the cumulative default risk associated with that tranche.
These programs can be based on pools of corporate bonds ("CBOs"), bank loans
("CLOs"), mortgages ("CMOs"), or other financial assets ("Asset Backed"). Structured
credit deals are done either in the form of a swap or as a securitization. When
the Securitization route is selected, the programs entail the establishment
of a Special Purpose Entity (an "SPE," which is normally a corporation), which
purchases the loans, bonds, etc., from whoever owns them. The SPE then issues
new securities representing some defined interest in the pool of assets now
owned by the SPE. (This process of creating new securities based on pools of
underlying assets is where the term Securitization comes from.)
The interesting thing about all of this for readers of this column is that
the investment bankers have learned to repackage some of this risk so that it
can be underwritten by insurers and reinsurers as a form of insurance/reinsurance.
This is rather clever (nobody ever said investment bankers are dumb) as it is
often the investment departments of large insurers that buy the bonds issued
by the SPEs. Now, the risk is being repackaged so that underwriters on the "liability
side" of the insurer's balance sheet can take the risk.
This might seem a little surreptitious but for the following. First, an insurer
that "insures" a tranche of risk is different than an investor that buys a bond
representing a tranche of risk in that the insurance transaction is "unfunded."
The ability to provide support for the securitization program on an unfunded
basis also gives the deal structurers more flexibility, as well as access to
professional risk takers who are potentially willing to deal with unusual or
difficult-to-analyze risk problems.
So, the role played by insurers is often to provide coverage for the riskier
tranches of the deal, making it easier to sell the rest of the program to investors.
Note here that the insurers are not directly providing a guarantee to the investor.
But they are reducing the investors' risk by taking the riskier tranches of
the program.
Thus both FGI companies and insurers supporting securitizations are, in a
real sense, essentially providing the same stamp of approval process that was
described earlier with respect to sureties, but are also engaged in underwriting
risk for a price, as is customary for insurance companies generally.
Structured Finance: Structured Finance is
often used to refer to asset-backed securitizations of things like credit card
receivables or automobile loans. It is designed to help a company raise special
purpose financing for some defined area of activity (such as issuing credit
cards or making automobile loans). In the context of this article, there is
an interesting and growing area of ART/Financial Lines insurers helping companies
achieve highly specialized financings for risks that would be difficult to place
into the public securities market through securitization programs.
Project Finance: This refers to a strategy
used by corporations to finance the construction of capital-intensive projects.
An example might be a new oil refinery. The idea is that the sponsors of the
project provide a specific amount of equity capital to form a new special purpose
company. The rest of the financing is raised through debt (loans or bonds).
The recourse of the lenders is limited to the assets and equity of the special
purpose company and does not extend to the assets of the sponsor.
As a result, lenders to the projects are often interested in using insurance
to provide protection against the default or bankruptcy risk of the project.
They may seek to buy outright default/bankruptcy protection, or they may seek
to obtain insurance for certain critical risks that could affect the viability
of the project.
Conclusion
The intersection of the more traditional ART field with the financial lines
arena represents the actualization of the convergence concept that is so often
discussed. Given that the size and scope of the credit and financial risk markets
is so large, this field presents new and important opportunities for growth
for insurance companies who are willing and capable to invest the resources
needed to properly evaluate the risks.
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