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Insuring ideas: a blueprint for IP coverage in a knowledge-based economy.

For decades, conventional thinking has been that the United States is the world repository for intellectual property. The Baby Boomers of the Post-War Era developed into a highly skilled and educated workforce and national consumption changed the dynamics of production from rugged, durable items to more sophisticated stream-lined comfort products. The walkie-talkies of the past gave way to portable, battery-operated radios. Nylon parachute fabrics gave way to fashionable clothing, and synthetic rubber compounds found new uses in high-speed tires.

University enrollment soared and the United States began its ascent the top of scientific and technological achievement. Government money was diverted from war-time research to peace-time endeavors with companies springing up and wing for both marketshare and government funds. Even the Korean War did little to impede the momentum of the American intellectual property explosion and by the late 1960s the United States had put a man on the moon.

In the meantime, former adversaries rebuilt and began producing the everyday goods once made within U.S. borders. The U.S. educational system attracted people from around the world. Most never returned to their homelands and thus began a brain drain from foreign countries to the United States.

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Some foreign nations struggled with the production cast-offs of the United States, which were being replaced by the latest, high tech innovations. Selling older model items overseas provided the perfect way to maintain a supply of replacement parts for those sold in the United States while more advanced models were being introduced domestically.

Low cost labor and lack--or non-enforcement--of intellectual property laws abroad, however, soon fostered a flood of "look-alike" products coming back to the U.S. markets. Then, as the skills of those making the knock-offs improved, there was a transition in intellectual property protection with one foreign country after another beginning to adopt and enforce intellectual property rights for the benefit of its own innovators.

The negative connotation of "Made in Japan" label soon eased. Then, the stigma disappeared entirely and, eventually, came to denote the highest quality of certain products, namely electronics. During this transition, Japanese innovators began to acquire patents in the United States at an alarming rate. In fact, almost 25% of all patents issued by the U.S. Patent Office are now granted to Japanese inventors or their employers. Likewise, the European patent system found its legs and the collective intelligence of the European Union countries mushroomed. China is progressing similarly in the new millennium and now boasts a greater rate of increase of U.S. patents to its inventors and innovators than any other country.

The world economy is quickly becoming a knowledge-based economy and while the typical life, health, property and casualty risks remain, the insurance industry should recognize the need to insure this vast intangible asset called intellectual property. In an October 2005 article, "A Market for Ideas," The Economist reported that "in recent years intellectual property has received a lot more attention because ideas and innovations have become the most important resource replacing land, energy and raw materials. As much as 75% of the value of publicly traded companies in America comes from intangible assets, up from around 40% in the early 1980s."

In short, intellectual property has become the new economic foundation of the United States. There is no reason to believe the same does not hold for foreign countries as well. In fact, the focus throughout Asia and the European Union has increasingly been directed toward patent protection of intellectual property. From 1991 to 2005, for example, there have been 49,430 patents registered through the Indonesian Directorate General of Intellectual Property.

One organization that facilitates worldwide patenting is the World Intellectual Property Organization, which administers the Patent Cooperation Treaty (PCT) that allows an inventor to maintain patent coverage in multiple member countries with one application. The Organization of Islamic Countries also participates in patent acquisition and includes Indonesia, Turkey and the United Arab Emirates as member states. Malaysia, Saudi Arabia, Kuwait and Egypt have also been active in patenting inventions and procuring U.S. Patents through the PCT.

In an increasingly knowledge-based global society, the question then becomes: How does the insurance industry fit into a world where 75% of corporate value is intangible intellectual property?

Thus far, several insurance companies have been involved in issuing highly specific policies for patents, copyrights and trademarks. Connecticut Indemnity Specialty was the first to offer a pursuit policy in the United States in 1989 with Lumley General Insurance following suit soon after in 1991. These offerings came in the aftermath of several early court cases holding insurance companies liable for the defense of patent, copyright and trademark lawsuits against their insureds.

The subsequent response to these holdings was for carriers to quickly exclude such coverages, leaving a market for specific policies. Companies such as Allianz, AIG, Chubb, Gerling and some syndicates at Lloyds then began offering the coverage in the United States, the United Kingdom, Germany, Sweden and Belgium. Tokio Fire & Marine also offered similar defense coverage in Japan, but the high combined ratios for the products lead to a number of insurance companies exiting the business in the late 1990s, leaving just a handful of carriers with any appetite for the coverage.

In the last few years, however, interest has rekindled and new carriers have begun entering the field. Moreover, the flood of exclusions has subsided and carriers have become more comfortable insuring copyright and trademark infringement, at least in the context of advertising as well as various other exposures associated with websites and online services.

None of the insurance policies provided to date, however, address the problem of insuring the intellectual property asset itself. Based upon the global knowledge explosion, it is reasonable then to conclude that the relation of a new class of asset-backed securities with intellectual property (chiefly patents) as the underlying asset will occur in the next few years.

A convergence of global factors is expected to drive the creation of new securities including an increase in technology creation, a greater number and scope of patents, and an environment of expanding--but very cautious--capital markets.

This new securites creation will be promoted by a desire for wealth creation in markets other than stocks and bonds or mortgage-backed securities. Irrespective of the bursting of the technology bubble, the growing realization is that intellectual property in general--and patents in particular--represent sources of strategic advantage that, when viewed as financial assets, can greatly impact market value and be the platform to launch these new securities.

It is interesting to note that securitization of intellectual property has been recognized as a promising way to leverage it ever since 1997's introduction of the "Bowie bonds," securities backed by revenues generated by the first 25 albums of musician David Bowie. Unlike securitizations backed by mortgages, automobiles or credit card debt, however, intellectual property revenues are more variable and more speculative than any of the foregoing.

Because insurance companies are now more capable of predicting the frequency and severity of IP litigation and settlement and consequent royalty flows, they are the ideal candidates to apply the same underwriting techniques to backing the securitization of intellectual property. The end result is a win-win situation where the insurance industry is rewarded for assuming risk in a new-found area of expertise while owners of intellectual property across the world are able to collateralize their largest asset to use as a financial tool, much like they now use "bricks and mortar" and accounts receivable.

Moreover, investors are able to invest in the technology itself rather than assuming the additional risks associated with the competence of management to run the company and develop the technology. Beginning with the Bowie bonds in 1997 and continuing to the present time, interest has escalated in intellectual property asset-backed securities. As one insurance industry leader once commented, "If I can insure the intellectual assets of corporate America, I can throw the rest of the business away."

Assuming the desire for a new type of asset exists, how can the underlying coverage of a policy foster the creation of intellectual property-backed securities, and what form would the coverage take?

Insurance would provide a vehicle through which parties with an interest in a patent or patents can insure their minimum financial worth. The insurance would back the asset as collateral to a loan, which in turn would be backed by the patents. The asset-backed intellectual property insurance should be structured to reimburse the lender (as distinguished from the intellectual property owner) for loan failure caused by the legal risk of the patents being invalidated. And it would also cover the commercial risk that the underlying patents would become valueless through obsolescence or regulatory action. The insurance is envisioned to be excess to the lender attempting to collect on the defaulted loan from the borrower through every legal means.

Moreover, the policy would not respond to default caused by strictly commercial perils, such as slumping sales, crime, fraud or bad managerial decisions. The coverage would, in essence, create a secondary market for patents and cover only those commercial risks attributable to the intellectual property characteristics of the collateral supporting the loan. Primarily, these include infringement, invalidity, obsolescence and regulatory prohibition. So while the policy would cover these risks, the lender would be responsible for all other defaults, thus making its decision to loan money similar to all other commercial lending decisions.

The coverage would permit companies to borrow money against their own intellectual property as opposed to soliciting venture capital markets for financing. For the financiers, early- stage loans during the company's development would become particularly attractive since early venture capital financing usually requires divestiture of a very significant ownership position--one that could later be sold for a much greater sum.

Asset-backed intellectual property insurance permits IP owners to work with insurance companies and financial institutions to truly use their intellectual property assets as financial tools. The policy could then be marketed to third parties with a financial interest in the patent. A bank, for example, may require the purchase of such a policy in its name because of a loan made, based upon the licensing royalties of a patent or based upon a valuation of the patent itself. The policy would respond only after the intellectual property had been transferred with clear title to the insurance company, which would book the intellectual property as an asset and depreciate it until it could be disposed of privately or through sale at a public auction.

Protections for the insurance carrier would include the transfer of the intellectual property asset to a bankruptcy remote company and the borrower being required to acquire underlying enforcement and defense intellectual property coverage as well. The protections may also include a contractual agreement specifying the use of the funds and including benchmarks regulating the withdrawal of the loan money based upon performance. The loan value would be based upon a valuation of the patent in accordance with a value of the patent if it were to be sold in an orderly liquidation. Once insured, the royalty streams or loan payments can be tranched into investment vehicles that are well known in the financial community.

The challenge and opportunity lies squarely before the industry. It can and will respond.
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Title Annotation:intellectual property
Comment:Insuring ideas: a blueprint for IP coverage in a knowledge-based economy.(intellectual property)
Author:Fletcher, Robert W.
Publication:Risk Management
Geographic Code:1USA
Date:Oct 1, 2008
Words:1876
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