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What are the alternatives for the alternative markets?

What are the Alternatives For the Alternative Markets?

Throughout history, man has created devices to provide funds to pay for unexpected or random events without disturbing the normal operating process. One device is insurance. For almost 200 years the insurance industry has flourished by accepting funds from purchasers in a budgetary cycle that resulted in the accumulation of large assets within the industry itself.

These assets were employed in the economic growth of our society and multiplied more rapidly than the costs for which they were accumulated. The time cycle in the investment arena was significantly more advanced than the social results of this economic expansion. The fiduciaries of these funds concluded that they belonged to the insurance industry and not to those who had the foresight to insure against any potential liabilities incurred by their endeavors.

This point can be easily illustrated by looking at recent developments in the plastics industry. During the past few decades, plastics have become an enormous growth industry. Investments made at the outset of plastics development and retained (in some of the larger established companies) have shown dramatic exponential increases in value. Unfortunately, not much thought was given to the disposal of these products and, as a result, many of these companies have incurred serious pollution liability.

The insurance industry has worked closely with plastics manufacturers by providing the necessary protection from the potential hazards of their products. However, the financial benefits received by the insurance industry through its investments were considered profits. This brought about an inevitable clash between economic developers and their fiduciaries when the purchasers of insurance tried to recover some of their costs.

Although the process of accumulation of funds was established to provide for unforseen liabilities, and the insured was entitled to a reasonable return along the way, insurance companies have reacted as though they were investment companies and have withdrawn their original promise.

The breakdown in the relationship between insurer and insured has been going on for over 20 years. Many industries such as gas and electric utilities and the airlines began to see drastic increases in insurance rates. They often stood idly by as their insurers reaped the financial benefits of investing their premiums. As a result, many members of these and similar industries turned to self-insurance in order to benefit from investing their own capital. In this way, the financial growth would remain within a specific industry and not dissipate by the investment rewards claimed by the fiduciaries.

Alternative Markets

About ten or fifteen years ago fiduciaries would not consider the present value of funds accumulated to pay for long-term injury payments from the workers' compensation system. In this instance, many insureds turned to the creation of captive insurance companies to take advantage of the accumulation of funds for the benefit of the individual or organization paying the premiums. In many ways this was the beginning of the captive insurance movement.

The response of the insurance industry to the captive insurance movement has been, in essence, to start from scratch with the creation of alternative markets. Regarding less difficult risks, many insurers will probably offer to provide retroactive coverage to fill the void of those moving from claims made policies. It is too early to predict whether these alternative markets will also respond by offering price reductions, but if they do, the changes that have taken place in the last few years may prove to be an expensive lesson.

Presently, the accumulation of assets is taking place almost exclusively within the alternative, rather than the traditional markets. In addition, these assets must be used for multi-purposes within the traditional markets.

The U.S. Congress, aware that these assets have been diverted from their original purpose, has made some recent changes in the taxation laws. They have recognized that, for the most part, these investment funds belong to the payment of the unforseen events for which the premiums were paid and have required the insurer to discount for the investment income which would be earned along the way. If done correctly, the interest earned income should be offset by the increase in reserve because the time of remaining accumulation is shortened. If the expected payouts are to be higher, the premiums must be higher or the profits lower. One would be hard pressed to find a single instance in which this has been accepted by the management of a traditional company.

Congress has also recognized that the alternative markets, since their creation, have demonstrated a distinct advantage over the traditional markets. Hence, the creation of Related Party Insurance Income (RPII).

New providers are frequently forming overseas and, as a result, the premiums and investment returns of a user, rather than an owner, can be accumulated without being subject to taxation. Since these accumulations are not taxable, their use for losses are not directly deductable.

There are a number of forseeable changes and moves to be made in the alternative markets in the near future. First, alternatives should continue to expand to fill voids that have recently been created. They may even provide pollution insurance for future, but not past liabilities. Alternative markets may also leverage their assets by adding new exposures without necessarily adding in kind to their accumulated asset base.

Insurers should also expand their offerings in the alternative markets by relying more heavily on reinsurance. This should only be attempted by insurers who can retain the necessary assets to continue if the reinsurance disappears. Individual insurers may also begin to treat more of their accumulated assets as profits and divert much of these funds into their traditional markets.

If this entire evolutionary process sounds rather dire, it really is. The only relief is in the fact that this process should take place over a period of at least 20 years, if not longer. By then, the entire process will have come full circle and there will be new problems to solve and new markets to create.

John R. Cox is chairman of ACE Limited in Hamilton, Bermuda.
COPYRIGHT 1989 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1989 Gale, Cengage Learning. All rights reserved.

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Title Annotation:insurance markets
Author:Cox, John R.
Publication:Risk Management
Article Type:column
Date:Sep 1, 1989
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