Contingent Risk Capital
June 2007
We generally assume that managing risk boils
down to only two options: retain it or transfer it to another balance sheet.
We evaluate and scrutinize retained risk, trying to determine the most efficient
point at which risk transfer should occur. Once we figure that out, we then
purchase enormous amounts of insurance limits, the vast majority of which we
never use.
by Donald
J. Riggin
Albert Risk
Management Consultants
Mile-high limits of liability might permit everyone to sleep well, but when
viewed from the perspective of probable outcomes, the majority of excess insurance
limits have no economic value whatsoever. While statistical probabilities in
concert with market competition permit multiline insurers to earn little if
any annual underwriting profits, those dynamics have no impact on an insurance
buyer's probability of incurring a catastrophic loss. This means that the premiums
paid for largely unused excess insurance limits helps to subsidize insurer losses.
This is especially true in an extremely soft market.
Our propensity to buy far more insurance than probabilities suggest stems
from a number of factors—mostly cultural. Ours is a very litigious society.
Plaintiff attorneys often peg damage awards to the defendant's insurance limits.
In fact, insurance companies, the plaintiff's bar, and American business appear
to have an oddly symbiotic relationship. While insurers do not welcome multimillion
dollar claim settlements, just the possibility of such claims forces businesses
to purchase huge amounts of mostly unused insurance limits. Insurers sell a
lot of insurance, businesses pay for protection that they'll most likely never
use (but which provides them with a good night's sleep), and the plaintiff lawyers
hit the jackpot just often enough to keep them coming back, especially those
who specialize in class actions. In whose interest is it to break this unholy
alliance? Certainly the insurance companies and the plaintiff's bar have no
incentive to upset the status quo. However, if business (the insurance buyers)
purchased insurance limits more in line with probable loss outcomes, think of
the ensuing dislocations in the insurance and legal industries.
Kick the Habit
So how do we convince American business to kick the habit? In a world of
ultra-efficient just-in-time inventory supply chains and financial institutions
that routinely convert assets (loans, etc.) into fungible securities, the vast
majority of businesses still warehouse enormous amounts of insurance. The notion
that we "warehouse" insurance is an apt description. How else could we define
holding a huge amount of a commodity with no secondary market value (we cannot
sell it to someone else, even at a loss), one that we must purchase anew every
12 months, and one that has little real economic value? Unused excess insurance
limits are like crack cocaine: once we experience the euphoria, i.e., the sense
of security, we find that we are indeed addicted.
I am not advocating that businesses foreswear purchasing all excess insurance.
Jackpot claims, while rare, do occur. However, I know of no rule that says excess
protection must come in the form of insurance. Perhaps if we cannot break the
crack habit, we can switch to a less expensive drug with fewer side effects.
Contingent Capital Options
The use of contingent capital is one way to finance statistically improbable
losses without incurring the costs of warehousing excess insurance limits. In
fact, insurance limits are also a form of contingent capital, albeit an owned source of risk capital that remains
off-balance sheet. When we purchase insurance, we own it. By the same token,
retained losses also represent owned risk capital, albeit on-balance sheet (and
a burden on equity). By definition, owned capital is more expensive than non-owned
capital. This leads us to the argument for contingent capital, a non-owned source
of just-in-time risk capital.
Contingent capital is a form of securitized capital. Through an options contract,
a contingent capital product permits access to risk capital only if the "covered"
event transpires. Contingent capital is not insurance, so losses are not covered
as such. A contingent capital transaction does not meet the minimum standard
tests to be insurance. No risk is actually transferred from one balance sheet
to another; because it is an option, it is only exercisable if both counterparties
agree that a predefined trigger has occurred. This trigger is, of course, a
financial loss. Moreover, if the option buyer exercises the option, it must
make the other counterparty whole. This is usually accomplished through the
issuance of preferred shares of stock (no dilution), or some form of subordinated
debt. Of course, to some, the potential (however remote) of having to issue
new debt to pay for an insurable loss is anathema, but this is just another
symptom of the "this is how we've always done it" mindset.
The inherent value of the options transaction at the time of a loss is that,
like insurance, funds become available immediately. Unlike insurance, a contingent
capital deal can be used for almost any risk, insurable or not. We know that
capital is most expensive when it is needed the most. A few years ago the Royal
Bank of Canada effected a contingent capital arrangement with Swiss Re to support
its loan reserves. It allowed the bank to manage the volatility (credit risk)
in its loan portfolio associated with general economic downturns or a slump
in the housing markets. Having a contingent capital product at the ready relieved
the bank of having to raise expensive capital in a recession.
The costs associated with contingent capital arrangements are far lower than
insurance premiums. The option buyer pays a fee, also known as a premium, to
the option seller. If the option expires without being exercised, the fee becomes
the buyer's only expense.
We can affect contingent capital transactions either on or off-balance sheet,
however, since the adoption of Internal Revenue Service (IRS) Accounting Research Bulletin 51 (ARB 51),
which defines consolidation of variable interest entities; forming a special
purpose entity (SPE) to keep the transaction off-balance sheet may prove difficult.
However, like insurance premiums, the fees associated with contingent capital
arrangements may be booked as a tax-deductible expense. If the buyer exercises
the option, the incoming cash is booked as an asset, offset by the issuance
(to the counterparty) of preferred stock or some other form of subordinated
debt.
Because options contracts involve two counterparties, the buyer must remain
cognizant of the potential for credit risk. When we purchase insurance, we generally
rely on an independent evaluation of the insurer's credit worthiness, e.g.,
A.M. Best or Standard & Poor's. While the option's sellers are usually highly
rated insurers or reinsurers, anyone can, theoretically, sell a contingent capital
option.
Summary
Contingent capital arrangements can be an attractive alternative to high-priced
excess insurance. They are less expensive than insurance, and when used to cover
high excess loss events, they can be a more efficient method of protecting against
a contingency with an extremely low probability of occurrence.
Consider what happens when you present a potentially significant directors
and officers (D&O) liability loss event to your insurer. Aside from the notion
of whether coverage applies to the loss (you assume it does at the onset), you
must navigate through the process of filing the claim and taking the necessary
steps to satisfy the policy's conditions in the event of loss. However, you
changed D&O insurers at the last renewal to take advantage of a lower premium.
As a condition of providing coverage, the new insurer required that you disclose
any circumstance that could result in a loss reported during the policy period—a
standard condition in claims-made policies unless all prior acts, disclosed
and undisclosed, are covered. In your internal investigation, you discover that
others knew that this D&O claim was brewing, but it was not disclosed to the
new insurer. Of course, this scenario could never happen, right? If an excess
layer of this exposure were financed through a contingent capital arrangement,
no such coverage limitation would exist.
Although insurance is fraught with potential missteps as described above,
it remains a very efficient tool for managing risk, and will most likely never
be rendered obsolete. However, intelligent and creative risk managers generally
find that a combination of risk financing and transfer techniques produces the
best use of their company's risk capital. Risk managers should consider contingent
risk capital among the various financing options.
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