Special Orders.

Some reinsurers are expanding into the capital-markets arena to bolster their business.

Roast beef sandwiches are the latest addition to a group--including credit-card receivables, catastrophes and song catalogs from recording artists such as David Bowie--that only recently have been recognized as insurable risks. Swiss Re New Markets has crafted a securitization that gave Triarc Cos., the holding company for the Arby's roast beef sandwich franchise, $290 million for the future revenue stream of the fast-food chain's royalty fees. The deal is just one example of how reinsurers are making a foray into investment banking.

The November deal demonstrates that the convergence of capital and insurance markets encompasses two sides of the same coin. This time a reinsurer, Swiss Re New Markets, transferred capital-market risk to the insurance market. Swiss Re New Markets surprised many in the financial community when it requested the first-loss position as reinsurer, a position traditionally reserved for others in the financial world.

As seen by the Arby's/Swiss Re New Markets transaction, reinsurers are branching out to fashion sophisticated financial deals, such as securitizations, to meet the changing needs of increasingly larger and more sophisticated clients and to keep up with their competition--fellow reinsurers as well as those in the financial-services community. The concept of securitization centers on selling investors paper backed by expected future payments. "There is only so much use for traditional rein surance products out there reinsurers are looking for new revenue streams," said David Greenfield, a partner in the New York insurance practice of the global consulting firm KPMG. Another industry analyst, Glint Harris, says the continued shrinking of the reinsurance industry due to consolidation and its cyclical pricing nature points to the need to get into new business. The top four reinsurers command roughly 33% of the global reinsurance market. "Reinsurers need to get into another part of the business or risk seeing decl ining markets over time," said Harris, assistant vice president for research and publications at Conning & Co.

It is unlikely that securitization will supplant insurance and reinsurance; instead, it will augment traditional programs to provide a more diversified and efficient risk-financing strategy, according to a September 2000 report on reinsurance by A.M. Best Co.

A report by Conning & Co., "Property-Casualty Reinsurance, Developing the Next Frontier," also asserts that one of the few new areas of opportunity for reinsurers is the alternative risk-transfer market. Alternative risk transfer includes captives, structured insurance contracts, securitization of insurance risk and the insuring of financial risks. The Conning study found that premiums on these products averaged 14.4% of the total written reinsurance premium for the industry in 1999, and long-term growth potential is promising. Primary insurers reported that 9% of their reinsurance premium for the same year was in alternative products.

Taking the Order

Swiss Re New Markets, a subsidiary of one of the world's largest global reinsurers, Swiss Re Group, always has feelers out for a cutting-edge deal. "We're always looking at unusual risks; our underwriting methods work well with new risks," said David Moran, associate director of Swiss Re New Markets.

Swiss Re New Markets' mission, according to the company, is to open new markets and to provide major corporations and insurers with integrated risk-management solutions consisting of traditional reinsurance complemented by innovative financial products. Soon after its inception, Swiss Re New Markets made news as the first capital-markets division to securitize Japanese earthquake risk and to underwrite the first catastrophe-linked bonds tied to the occurrence and severity of a physical event, rather than to actual insurance losses.

In the fall of 1999, Morgan Stanley Dean Witter approached Swiss Re New Markets with the idea about the Arby's deal. Triarc wanted to recapitalize its company, and instead of going to the capital markets, it shopped the reinsurance markets for a deal. Triarc is a holding company for subsidiaries that include a food division composed of Arby's, the Pasta Connection and T.J. Cinnamons, which sell food through 3,200 locations worldwide. In October, Triarc sold its Snapple Beverage Group's business to Cadbury Schweppes plc for about $1.45 billion.

"The Triarc company is a very, very clever financier; the idea of the deal is a result of their cleverness," said Jennifer Williams Costain, vice president of Ambac Assurance, a global guarantor of municipal and structured financial obligations.

"The deal is a groundbreaking transaction for the asset-backed market and operating companies. The notes are linked to the value of the intellectual property of the Arby's brand through the fees paid for the use of the brand name, as opposed to the physical assets, such as property and equipment, of the fast-food franchise chain," Costain said. Essentially, Swiss Re New Markets and Ambac, after doing a year's worth of research, placed their collective chips on the Arby's signature neon hat. "Trademarks are difficult to take and assign hard value to. The Arby's trademark has value, so we look and lend on that. Valuing an idea is more difficult; there is risk here, but insurers are trained to handle that," Moran said.

Although the deal's structure was similar to credit-card transactions, because Swiss Re New Markets was blazing new ground in securitizing the intellectual property of a fast-food brand name it had no similar financial history to analyze. Instead, Swiss Re New Markets approached it the way bond transactions are priced--comparing Arby's financial ratios and looking at its corporate credit and cash flows from franchise fees, "generally looking at Arby's history and the franchise industry's as well," Moran said.

The reinsurers felt comfortable with the risk, because the franchise business has a lot of data attached to it. "It fit well into our underwriting model; there is a limted set of risk drivers; and there was lots of data to support the analysis," Moran said. Because the partner who is closest to the client and the underwriting traditionally takes the first-loss position, Swiss Re New Markets felt comfortable in that unusual spot for a reinsurer, And it was looking for a partner that had a different risk appetite, who could offer a financial guarantee policy, thus broadening the potential market for the securities and increasing investors' comfort level with the complex details behind the deal. It found the fit in New York-based Ambac Assurance, which prefers low-risk, high-volume deals. "We felt better to have someone in front of us," Costain said.

So Ambac Assurance, reinsured by Swiss Re, underwrote Arby's private placement of a $290 million special-purpose vehicle. A special-purpose vehicle is an entity that is dedicated solely to business relating to the securitization. The notes were secured by franchise royalties and fees from Arby's franchises. Ambac provided a financial guarantee to Arby's bond holders, with Swiss Re New Markets taking a first-loss position and Ambac, the primary insurer, taking on excess risk, Moran said. The deal is different from other corporate-financing transactions, which have focused on protecting a company's earnings or credit ratios, Swiss Re New Markets said. This transaction instead focuses on measuring the growth and stability of a cash-flow stream driven by intellectual property--Arby's royalty revenues. The deal also is attractive to Swiss Re New Markets because franchise royalties haven't been securitized in the past, so the reinsurer has little exposure on the liability side. Now that the groundwork is done, Swi ss Re New Markets expects it will be easy to replicate the framework for the Arby's deal in future securitizations involving other industries' royalty streams and franchises.

Menu for Change

As in most businesses, changes occur that force the players to either retool or risk losing market share. Although there are many reasons for the growing convergence of reinsurance and capital markets, most important is that the demand for traditional reinsurance is declining, forcing reinsurers to broaden their product offerings. Total reinsurance ceded (risk transferred to reinsurers) as a percentage of total direct premium generally has declined since 1994, according to Conning's recent report. Conning theorizes that the decline in the use of reinsurance can be traced to the insurance industry consolidating and forming larger, more robust entities that can retain more risk. Add to that the continued hardening of the reinsurance market with rate increases to continue throughout the year, and it's a time ripe for product diversification.

The larger clients--such as the Fortune 500 and 1000 companies--are growing larger, spawning a need and appetite for sophisticated financial/reinsurance transactions. As they grow, large companies can retain more risk and raise deductibles. New exposures are coming to the forefront for companies that want to better predict their returns, and from an insurance standpoint there are new risks to control. One example would be arranging a combination insurance/financial vehicle for a grain storage business that would ensure an even revenue stream when yields are down due to bad weather. "There's a couple of things happening, recognition of a couple of different kinds of risk that companies want to be able to control and hedge against, but on the other hand a decline in the need for traditional insurance. That all equals a good combination for selling new products," Conning's Harris said.

More reinsurers are creating capital-markets divisions. Munich Re Group has its AmRe Capital Markets, which is part of American Re-Insurance Co.; Gerling-Konzern Globale Reinsurance Group introduced its Capital Markets Division in 1999; Zurich Financial Services Group has its Centre Solutions; and St. Paul Re created its St. Paul Financial Solutions in July.

"If you take on financial risk perils, it's a way to diversify your portfolio of risk beyond workers' comp and property/casualty," said John Rathgeber, executive vice president of St. Paul Financial Solutions.

This new unit of St. Paul Reinsurance Group., which ranks No. 21 among the top global reinsurers, according to A.M. Best data, was formed last summer to get involved in financial risks. The new entity will be dealing with credit enhancements and lease-revenue guarantees, and in the next five years it is anticipated to more than triple the company's current $300 million in nontraditional business. "We have the assignment to work with St. Paul on the primary side to sell nontraditional coverage on that side of the house as well as traditional reinsurance," Rathgeber said. St. Paul Financial Solutions' game plan is to provide a mechanism for providing products that cross different business units of the St. Paul and expand product offerings. For example, if a St. Paul customer, such as a medical-malpractice insured, needed coverage for interest rate fluctuations or other financial risks--this new capital-markets unit can step in to facilitate such a transaction.

AmRe Capital Markets, which made its debut in 1998 and is part of American Re Financial Products, focuses on three core businesses: entertainment and media, enterprise risk and securities. Its entertainment industry financing division is the leader in the capital-markets division, said Ken Bock, president of AmRe Capital Markets division. American Re can provide structuring and reinsurance to a variety of entertainment transactions. It has arranged film finance transactions in which its reinsurance products support credit enhancements and provide risk transfer for film slates at both the independent and major studio level. Most recently, it completed a $540 million deal to be paid out over 10 years to the Steven Spielberg/Jerry Katzenberg/David Geffen-owned Dreamworks movie studio. Chase Manhattan Bank brought the deal to AmRe Capital Markets, looking for the reinsurer to provide credit enhancements to the movie studio to change its subordinated debt--the equivalent of a second mortgage--to investment-grade level. Dreamworks will repay the "loan" from the revenues generated by movies it has placed into the Dreamworks Film Trust II, including "Saving Private Ryan" and "American Beauty"

Challenges

As the reinsurance industry marches into the capital markets, it faces the challenge of finding the intellectual capital to handle the sophisticated financial transactions.

"They have to have people who know what they are doing, and it's not a huge pool of people to begin with," said Conning's Harris. To solve this dilemma, reinsurers are plucking that expertise from the investment-banking world and--as in the case of St. Paul Financial Solutions--from its competitors, such as Swiss Re New Markets.

To stock the shelves of its new division, St. Paul hired Anthony Chiarenza as senior vice president-capital markets. Chiarenza previously was managing director and head of the capital-markets group at Marsh & McLennan Securities and has 20 years of capital-markets experience. St. Paul also hired Peter J. Gakos as senior vice president-corporate solutions. Gakos previously was director, financial solutions, at Swiss Re New Markets, where he was responsible for programs for corporate and insurance clients combining net risk transfer, sophisticated risk financing and capital market techniques. "In general, reinsurers playing in the capital-markets arena are at an information disadvantage. They probably don't know as much as the other parties and must hire people with capital-markets expertise in order to compete on a level playing field," Rathgeber said.

Chiarenza's job is to market sophisticated financial solutions, such as agricultural insurance, which provide price guarantees for commodities. The objective is to find opportunities where the risks covered by insurance and the capital markets are similar, exploit pricing differentials and manage that portfolio as an investment house would if it were trading interest-rate futures, Rathgeber said.

Reinsurers also are adapting to the changing role of risk managers, many of whom are graduating from college with a holistic approach to risk and a sophisticated knowledge of finance. "They are comfortable with the use of derivatives and are looking at different tools to mitigate risk," AmRe's Bock said.

Next Course

Reinsurers' role in the capital markets looks to be pretty secure. According to the Conning report, 71.4% of primary insurers responding to the study said they wouldn't consider replacing some of their reinsurance with capital-market products because traditional reinsurance continues to meet their demands and capital markets are too new and complex.

"They're essentially saying, 'Nah, not yet.' They're getting everything they want already, at prices they love," Harris said. "We'll find out in 2001 if that is good enough. It leads you to the speculation, though, that if the prices do change and reinsurers have to charge more than primaries want to pay, will they start looking at alternatives? I think so."

                           CENTURY SHARES TRUST
                          investing in banks and
                      insurance companies since 1928.
                        Performance as of 12/31/00
         Average Annual
             Return
1 Year       37.44%
5 Years      17.78%
10 Years     17.23%
20 Years     16.14%