In Case of Emergency.

Contingent capital, a line of credit accessible when a trigger event occurs, is gaining popularity as a hedge against disaster.

Contingent capital is a flexible hedge against balance-sheet risk that is gaining in popularity because it is relatively cheap and predictable, a Swiss Re New Markets executive recently told attendees at an alternative-risk seminar.

Speaking at the "New Developments and Directions in ART: Alternative Risk Transfer and Integrated Capital Management" conference, hosted by the Institute for International Research, Markus Schmutz, associate director of financial products, said that contingent capital, which he described as a "multiyear option to raise capital after a trigger event," is "a very flexible product that can take many forms and solve a variety of problems."

"In the past year or so, we've seen a lot more use of these products among insurers, reinsurers, banks and corporations in general," said Schmutz.

Various Trigger Events

Contingent capital (Schmutz said Swiss Re New Markets prefers the term "committed" capital) is basically a line of credit made available to the client that is accessible only when a trigger event occurs. The trigger event depends on the company's unique form of business and can include a large underwriting loss, a poor loss ratio, a drop in the stock market, a rise in interest rates, certain changes in economic conditions, a liability event and many other specific conditions.

The contingent-capital arrangement allows the company to raise capital quickly once the trigger event occurs. Schmutz said the method of raising capital can be a "hybrid" form, consisting of senior or subordinated debt, preferred shares, other methods or some combination of several of those.

The advantages of a contingent-capital arrangement for the client, said Schmutz, include few or no conditions outside the trigger event, as well as financing terms that are fixed in advance. "Under such an arrangement, you can basically lock in the cost of capital in advance," he said.

One advantage of a contingent-capital arrangement compared with a reinsurance contract is that the client doesn't have to pay in any funds ahead of the trigger event, said Schmutz. If the trigger event doesn't occur, no transaction takes place.

Schmutz said the contingent-capital strategy is used by a number of "quasi-government" insurance entities, including the California Earthquake Authority and the Florida Windstorm Underwriting Association. "These groups have limited cash but do have the ability to access insurers and issue bonds," said Schmutz. "They are not concerned with leverage and are insuring a relatively predictable situation. The financial solution for them would be a triggered option to issue senior unsecured debt. The option is triggered if the company incurs losses above the amount of cash available."

Schmutz said contingent-capital arrangements are "like balance-sheet reinsurance," in that the capital the company can access after an adverse event serves to shore up the balance sheet. "The cash doesn't flow to the income statement but to the balance sheet," he said. "It is basically like a loan, but is not recorded as a loan."

Contingent capital is superior to bank facilities, said Schmutz, because it has few, if any restrictions. "Credit facilities like those from banks typically have a lot of restrictions or covenants," he said. "But since contingent-capital facilities are tied to a specific trigger, and the arrangements are made ahead of the event, the company does not need to go through all those restrictions, which can be expensive."

Catastrophe Bonds Getting Warmer Reception

Catastrophe bonds are enjoying better days, compared with a few years ago, and it appears their attractiveness to investors as an alternative to traditional risk retention will continue to grow, according to an alternative-risk executive.

John Kiernan, senior vice president with Lehman Bros., said the investment bank's Lehman Re subsidiary successfully marketed a California earthquake catastrophe bond, a good example of the strong market for such bonds.

"The cat bond market is in the best shape it's ever been," Kiernan said at the "New Developments and Directions in ART: Alternative Risk Transfer and Integrated Capital Management" conference hosted by the Institute for International Research. "For the first time, deals are being done for economic and not strategic reasons."

Kiernan said the dual effects of multiyear coverage and competition have served to make cat bonds more efficient. "For once, there appears to be a healthy capital-markets segment," he said. "Cat bonds have turned the corner and are poised to live up to all the hype from a few years ago.

Lehman Re's own experience in the cat bond market is a good illustration of the market's strength, he said. The reinsurer had substantial California earthquake risk capacity in 2000--$200 million worth--and was looking for retrocessionaires to take on some of its risk capacity. "The traditional market was very tight; pricing was very high," said Kiernan.

California Earthquake Risk

Lehman Re's solution was to set up Seismic Ltd. in March 2000. Seismic floated a $150 million cat bond to cover California earthquake risk. Through the bond, Seismic was exposed to insured losses in California from earthquakes and resulting fires, from March 2000 to year-end 2001.

Payment of interest on the bond is tied to Property Claim Services' reported cumulative estimated losses for the 22-month risk period. "This has a cumulative element to it," Kiernan said. "If you have a lot of small earthquakes, the bonds could get tilt."

Property Claim Services, he said, is widely seen as the "gold standard" for providing catastrophic loss measurements. "Usage of PCS loss estimates in industry loss warranty contracts underscores legitimacy of our risk index in the eyes of investors.

At the time the deal was done, it was the only single-risk cat bond in the market," Kiernan said. "When you bring new risk to the market, it trades significantly better, because buyers are looking for a variety of bonds to spread their risks."

While the California Earthquake Authority was paying a premium to Lehman Re to shift the risk, Lehman used the bond money to invest. "You have $150 sitting in a collateral account, but it doesn't just sit there. It has to be invested," he said. That investment was achieved through a swap counterparty--third parties willing to take on some of the risk in return for a chance to invest some of the bond money.

Kiernan said the cat bond worked for several reasons, most notably that it was transparent, relatively simple and had a good risk-to-reward ratio.

Easy to Digest

"Most importantly, capital markets like things that are easy on your stomach; they like transparency," he said. "Seismic closely resembles an industry loss warranty. These bonds closely resemble something in the traditional insurance industry."

Another positive, he said, is that this type of bond is issued at a tighter spread than indemnity reinsurance, making it a less risky investment.

"From cedants' point of view, the value of a collateralized structure is very underrated," he said. "We're talking about a very major earthquake here, so that collateral becomes very important.'

Motivations for the investor, said Kiernan, include an attractive risk-to-reward relationship. "Its a single-risk, California-only bond, a noncorrelated asset, and it is transparent," he said. "As a single-risk bond, it had a scarcity value."

By its transparency, the cat bond produced a certain comfort factor among investors, said Kiernan. "Investors like to see what it's all about," he said. "In the cat bond market, complexity will cost you."

Investors, he emphasized several times, are willing to pay for transparency.

Insurers Seek New Weather-Risk Strategies

People here always talked about the weather, but it has only been within the past five years or so that insurers, capital markets and various corporate entities have been converging in their efforts to contain the costs of weather events and conditions, a risk manager for a major energy company said.

Valter Stoiani, a manager of weather risk management for energy powerhouse Enron, said weather modeling and financing strategies for managing weather-related risk are exploding in importance.

"Weather risk is no longer acceptable," Stoiani said at the "New Developments and Directions inART:Alternative Risk Transfer and Integrated Capital Management" conference hosted by the Institute for International Research. "It may be the oldest risk ever in human activity. Up until about 1995, the general opinion was that there was nothing you can do about the weather.

"Today, there are already equity analysts and players in the international markets that are aware of weather risk management," he said, "It is being recognized by investors as a very favorable thing to do."

In August 1997, Enron was involved in the first weather-indexed commodity transaction, Stoiani said. "Today, more than 4,800 weather-related transactions have been completed involving Enron," he said.

Just last year, Enron began trading weather contracts online, he added.

"Before last year, insurance companies were writing risks that the traders had taken on from the user market;' he said. "There was so little liquidity, it was hard to engage in transactions.

"At this moment, there is a change in the interaction between insurers and trading companies.The deals are coming together to best handle those risks:'

Loss of Profitability

Traditional risks, such as earthquakes, hurricanes and tropical storms, tend to be less frequent but more severe. Hail, precipitation and temperature changes are more frequent, if less severe. From the point of view of a company as an insured, the first three entail great loss of property, while the latter three are characterized by loss of profitability, said Stoiani.

"As they become more sophisticated at sorting out and assessing the impacts, costs and predictability of those risks, insurers and capital markets are beginning to move toward each other in their efforts to find weather-related risk-management solutions," said Stoiani.

The convergence of weather risk management between the capital markets on one side and insurers on the other is accelerating, said Stoiani. Diversification of the risk in capital markets is through an investor pool, while on the insurance side, diversification is achieved through the insurance portfolio.

In what Stoiani called the "traded market," where capital markets and insurance markets come together, various weather risks are being mixed and matched to the particular needs of investors and insurers with increasing sophistication.

As far as weather risk-management markets are concerned, Stoiani said the traded markets are very strong in North America only. Europe is developing such markets but is lagging. The capital markets in both North America and Europe aren't well developed for weather risk management. Europe leads in weather risk management within the insurance markets, followed closely by North America.

Mixing Weather Risks

In the energy industry, the past two years have seen accelerating developments in weather risk management, including more end users and the emergence of complex, cross-commodity derivative products that "mix and exchange weather-related commodity risks," Stoiani said.

He added that the energy industry is developing more sophisticated modeling methods for determining the tricky relationship between pricing pressures and weather-related pressures on energy suppliers.

"Everybody talks so much about what we and others are doing to California, but that is a power-trading issue, not a weather issue," said Stoiani. "What we are concerned with is what the weather does to power generation and supply?'

For example, Sacramento Municipal Utility Dam, which generates hydroelectric power, had to make arrangements to trade future profits for gas-generated power if rainfall in its watershed area falls below certain levels for certain time periods, preventing the utility from operating at full capacity.

The calculations that go into such risk management are extremely complex. Stoiani said the Sacramento utility must also factor in temperature ranges-affecting use of heating or air conditioning-that might coincide with drought conditions.

Throw in fluctuations in natural gas prices unrelated to weather, and it's a formidable, moving target, he said.

Companies Need an Integrated Risk Program

When a company seeks insurance solutions for its many risk exposures, a partnership with a global, experienced carrier that can command a variety of risk-transfer strategies is critical, a Chubb Corp. executive said.

Neal Enriquez, assistant vice president and alternative risk manager for Chubb, said there are pros and cons that go with any single corporate insurance solution. The key is partnering with a carrier that can find innovative ways to pare down the negatives while holding the line on the positives.

"What is an integrated risk program? It's a partnership between the carrier and the insured that leverages a variety of risk solutions," Enriquez said at the "New Developments and Directions ART: Alternative RiskTransfer and Integrated Capital Management" conference hosted by the Institute for International Research.

"The best-selling single risk-retention mechanism is a large deductible," said Enriquez. "A traditional insurance transaction in which the insured takes a deductible in exchange for coverage of large losses is popular, but it can become costly with rising claims frequency," he said.

An alternative strategy is self-insured retention, which is very popular with workers' compensation and general liability coverages, said Enriquez. A self-insured retention plan normally saves on claims-handling costs and "frictional" costs (taxes and residual market charges), he said.

Other advantages include complete control by the insured over claims handling. A self-insured retention also doesn't reduce policy limits.

Some Drawbacks

Among the self-insured retention strategy's drawbacks, said Enriquez, is the fact the claims-handling costs that are saved can end up going to a third-party administrator. "In some cases, TPA fees could outweigh premium savings," he said.

Also, many states require insureds to maintain a deposit or post a bond to cover a self-insured retention. States also generally don't allow companies to self-insure auto liability.

One of the biggest drawbacks, said Enriquez, is that self-insured retention programs normally don't satisfy insurance requirements when dealing with creditors, municipality or real-estate transactions, or equipment leasing. "This is one of the biggest drawbacks for businesses," he said.

Another risk-retention strategy is a "retro program," in which an insured divides risk among layers of retrocessionaires. Generally, no collateral is required, and premium adjustment isn't due until after the first 18 months, and every 12 months thereafter. On the downside, retros require a significant premium deposit, and the premium adjustment, when it comes due, is highly uncertain.

In a captive reinsurance program, said Enriquez, the insured usually pays a slightly higher premium for coverage than with a large-deductible program, but there are benefits. Among those, there is an "entrepreneurial" approach to managing and financing insurance; gross insurance expenses are budgeted; net insurance costs reside in a distinct center (the captive), and funded insurance costs earn investment income.

Another big advantage of the captive, said Enriquez, is that it "provides a vehicle for consolidating retention of all insurable risks," such as general liability, workers' comp, and directors and officers.

Seamless Reinsurance

Reinsurance by a captive is also "seamless," he said. "Policies clearly show first-dollar coverage, and a captive's tax status or domicile do not affect the policies," Enriquez said.

Among a captive's disadvantages are the fact that frictional costs are generally higher; collateral requirements aren't as flexible and generally aren't negotiable; captive formation can be complex and expensive (unless a rent-a-captive is involved), and unwinding a captive arrangement is complicated.

Most of the drawbacks in these strategies can best be tackled through an "integrated risk program" structure, said Enriquez. Under such an arrangement, the insured contracts with a single carrier, which manages the insured's risks through the use of various captive and reinsurance arrangements.

"The advantages of an integrated risk program are that the carrier can integrate all claims management, coordinating and global-tracking functions and design flexible claims procedures," said Enriquez.

When a company seeks a carrier for integrated risk management, some of the qualities to watch for are expertise in the insured's industries; a global presence that brings to bear multinational resources, and a global claims-management approach, he said.

"The integrated risk partner should be a one-stop shop for the insured, supplying the experience and resources to provide a variety of insurance strategies," said Enriquez.