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New trends in financial reinsurance.

Although the continuing soft insurance market may create the impression that insurance is easy to obtain, many risk managers are finding that the coverage available for risks such as catastrophes, medical malpractice and certain environmental liabilities is either not available or that it is excessively expensive.

In light of this fact, many risk managers, searching for innovative ways to protect their companies against these costly risks, are finding that certain types of financial reinsurance products can help them achieve coverage at the price they need. "With the increasing sophistication of the insurance market and the difficulty of obtaining coverage for some risks, there's a growing corporate market for these products," declares Steven M. Gluckstern, president and chief executive officer of Centre Reinsurance Holdings Ltd. in Bermuda. "Companies with potentially large risks can use financial reinsurance products to avoid significant losses in the same way that insurance companies use the products."

Although in recent years risk managers have become increasingly savvy about using alternative approaches for coverage, it is important to realize that financial reinsurance is an amorphous term, and has meant different things to different people -- and been referred to as financial reinsurance, finite risk, structured products, funded covers or balance sheet management. What all of these products have in common is that they constitute a sophisticated financial tool that risk managers can use to cover their high-risk losses. "Besides providing coverages that are difficult to obtain through traditional insurance, financial reinsurance allows buyers to transfer elements of their risks while providing financial stability for the business," says Mr. Gluckstern.

The Past Situation

HISTORICALLY, FINANCIAL reinsurance has been used for certain balance sheet transactions that are not permitted by today's accounting rules. In the early 1980s certain types of financial reinsurance transactions were purchased by fiscally troubled insurance companies in order to create a false impression of their financial position; in these instances, reinsurers wrote policies that transferred little or no actual underwriting risk. Since these transactions protect the insurer against all risks, including the risks associated with investments and the time periods that claims are to be paid out, some observers have argued that such arrangements are better characterized as financing contracts than insurance.

As a result of this situation, insurance regulators now carefully examine these arrangements in an effort to determine whether a sufficient amount of risk is transferred to actually qualify the product for the financial statement and tax treatment that is needed to make it a bona fide reinsurance transaction. Because of these requirements, financial reinsurance products have to involve an actual transfer of risk to constitute a true insurance product.

However, over the last several years, a number of reinsurers have begun to develop new products for corporations that, although useful for balance sheet management, also involve a true transfer of risk. Although these products cover a broad range of structures, they generally utilize one of two funding approaches. The first type, loss portfolio transactions, allow the reinsured to transfer some or all of its past claims liabilities to the reinsurer; in these policies, there must be real risk transferred, and the risk must be very carefully controlled. The second type of funding approach allows the reinsured to cover itself for losses that cannot be insured through the traditional market. Products with this type of funding structure can be used to fill in the gaps of existing coverages, or can allow for the prefunding of anticipated future losses that are too expensive or impossible to insure any other way. "A major motivation for buying these products is to cover the losses under a multiyear agreement," says Joseph Umansky, president of AIG Reinsurance Advisors Inc., located in New York City. And because financial reinsurance products are designed to be sold to insurers, corporations must use an alternative mechanism such as a captive insurance company, risk retention group or risk pool in order to purchase them.

High-Cost Risks

TODAY, CERTAIN TRENDS are helping to create a climate that makes financial reinsurance products attractive to corporations. "The use of financial reinsurance as a risk management tool is increasing," says Mr. Umansky. "The increase in risks that are difficult to insure is, of course, one of the main reasons. For example, the current shortage of catastrophe coverage is causing some companies to look to financial reinsurance as a way to fill in the holes of their coverage." Mr. Umansky says that the devastating effects of Hurricane Andrew could lead to an even further tightening of the catastrophe market. Mr. Gluckstern adds that today's world is "less predictable. Some coverages are hard to get in the traditional market, and others, such as certain environmental liability covers, may not be available at any price."

Additionally, the enormous increase in the costs associated with products liability has also contributed to the need for some risk managers to turn to financial reinsurance for adequate coverage. "There are some risks that insurers won't take on," says Peter Gentile, senior vice president at Atrium Corp., a pioneer in the creation of risk management products. "In today's highly litigious society, product liability concerns make some insurers reluctant to provide coverage for certain products."

In response to this trend, reinsurance companies are devising methods to create financial reinsurance products for the needs of corporations with so-called uninsurable risks. "These products are tailored to the needs of individual businesses," says Mr. Gluckstern. "They are designed to cover the risks that certain institutions have; the coverage, say, for medical malpractice will be different than it would be for environmental coverage." According to Mr. Gentile, "at present, it's a fairly discreet marketplace. There are very few packaged products, so they have to be designed for particular client needs. But there's definitely a market out there."

Mr. Gluckstern says that the future could bring about two types of financial reinsurance risk products. "Due to certain enormous risks, you could see one type of product that performs risk transfer and other financial functions, and another type of product that offers real protection against catastrophic risks."

The interest among corporations in financial reinsurance products is likely to increase. "The insurance market is becoming increasingly sophisticated," says Mr. Gluckstern. "As a result, risk managers will find that they need to utilize increasingly sophisticated financial approaches to cover their risks." In today's tumultuous and ever-changing world, risk managers who must protect their companies from difficult risks may find that financial reinsurance products provide just the type of coverage they need.
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Author:Christine, Brian
Publication:Risk Management
Date:Oct 1, 1992
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