Expert Commentary

Contingent Risk Capital

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.


June 2007

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.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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