Canadian Underwriter

Thinking outside the Canvas

August 1, 1999   by Lowell Conn

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The early 20th century was a revolutionary time for the fine art community, with “modern artists” such as Henri Matisse carrying forward the early exploration attempts of the impressionist painters in testing conventional “realist” theory. In many respects, the modern art movement lead by Matisse — dubbed “the fauvists” (the primitives) by shocked French critics — today serves as the foundation of fine art theory. Similarly, the innovations currently occurring in risk management and risk transfer bear strong resemblance to the “push-pull” creative forces that launched the modern fine art movement. Has risk management reached its own revolutionary turning point at the beginning of yet another millennium? Many in the profession believe so.

Traditional property and casualty insurers and reinsurers have long bemoaned the pressure exerted on their earnings as a result of the soft market. Now, with a growing number of companies calling for a hardening of rates, industry optimism is running high of a general increase occurring across the commercial lines next year.

However, unfortunately for insurers, the latest Conning & Company study of North American risk managers indicates a strong resistance to any hardening of rates. The study — titled “Alternative Markets: An Evolving Mosaic” — warns insurers against attempts at implementing any significant rate increases, at least if they wish to retain the premium in the traditional market.

Captive and alternative risk transfer (ART) mechanisms have grown substantially over recent years, the Conning & Company study also observes (also see the April 99 issue of CU — Insight). Initially focused at the top-end corporate echelon, the move from traditional insurance is spreading to the middle-tier company level, the study says. Insurers have taken notice of this shift, particularly of the more innovative risk solutions to come to the market from non-traditional players. In response, the traditional market has come up with “new innovative product lines” of their own under finite programs.

In that respect, a marketwatcher observes, the traditional insurance sector is experiencing its own “art revolution” with the convergence of financial pillars drawing new entrants into their turf. The advances made into risk transfer by capital market players, the growth of offshore captive domiciles combined with other alternative forms of “self insurance” risk transfer, have opened up the field of insurance for risk managers.

The finite programs being punted aggressively in the U.S. and Europe by reinsurers and brokers provide additional risk transfer options to risk managers. And, although the popularity of finite has not as yet taken in Canada, most respondents in this article agree that it is only a matter of time.

Finite programs are often mistaken for the hybrid risk transfer products being pushed by the non-traditional market, namely investment bankers. However, finite covers are a blending of traditional coverages with built-in self-insurance options. In a nutshell, the latest financial risk transfer products allow corporations through their risk managers to better manage their capital and cashflow relative to their risk exposures. This definitely is not a market where risk managers can complain of lack of choice, notes one commentator, if anything selecting the right product or mix thereof from the broad range available is the real issue.

In that vein of thought, Matisse once stated (paraphrased), “a painting should be like a good armchair,” suggesting that a work of art should have appeal and comfort for all those who view it. Risk managers in the U.S. are only now slipping into the comfort of their “ART armchair”, the important factor being that this innovation in risk management is not just a popular fad that will fade, but a real movement in the risk transfer business, the Conning & Company study points out.

Finite or not

With today’s risk finance offerings, an investment institution on Wall Street is just as likely to accept a company’s risk as an insurer. To protect their turf, traditional insurers are beginning to fight back with blended financial and traditional risk programs. Finite is closer in format to traditional insurance than to its other alternative cousins, explains Brian Gray, vice president of underwriting at Swiss Re. “Finite and capital markets are absolutely different types of solutions. Capital markets define where the risk ends up, while finite describes the limits of the coverage.”

In some circles, this product has been called enterprise–wide or holistic risk management. Which, according to market observers, is one of the reasons finite has not as yet hit its stride in Canada. “I have been to conferences and seminars where risk managers are taught about these products in a way that confuses them more than it informs them. Jargon like ‘holistic’ and ‘enterprise-wide risk management’ is bandied about, all of which really describe finite insurance. Risk managers think these products are far more complex then they need to be,” says an observer.

Norma Neilson, professor of insurance and risk management at the University of Calgary’s faculty of management disagrees with this perspective. She believes Canadian risk managers have been learning about finite alongside their more ART-embracing U.S. counterparts. “I wouldn’t think the knowledge gap is a fair argument as Canadian risk managers attend the same North American seminars as U.S. risk managers. It’s true that non-traditional players come from different financial backgrounds and as a result, often speak a different language. But, most risk managers are capable of dealing with that,” she notes.

The amount of ART — in particular finite — transactions to have taken place in Canada are negligible. Neilson, along with several risk managers, reinsurers and brokers, suggest this is largely a result of the soft insurance market, uncertainty over regulation of finite products, and unknown cost factors associated with constructing these deals.

Soft market

Respondents in this article all believe the decade-long soft insurance market is precluding Canadian risk managers from seeking out finite solutions. According to Gray, consolidation at the reinsurance company level has been responsible for a protracted soft market, which, based on the cyclical nature of the business, will inevitably change. This, however, is holding back the finite market, he believes. “A large percentage of big corporations self-insure and utilize other programs, but in a soft-market the companies that would do so just don’t bother. As the market hardens, you’ll see more risk managers in Canada move towards non-traditional offerings and self-retention,” Gray predicts.

Ken Hague, senior vice president at AON Re Canada Inc., says the soft market makes alternatives cost-prohibitive for risk managers. “I don’t think these products have developed yet to a form where they are particularly as cost-effective as existing forms of reinsurance or insurance.”

Mark Mulville, senior vice president of Towers Perrin Reinsurance, says an over-capitalized reinsurance market means heavy competition and rates that will keep traditional insurance as a first option. “There is a tremendous amount of surplus in reinsurance ranks, even though the sector’s return on equity (ROE) has dropped dramatically. You can currently go out and buy something on the traditional side for a good price. Most finite coverages involve a significant up-front premium outlay which can deter some buyers, even thought it may prove to be the best long-term solution”, he remarks.

When carriers find a way to make finite more accessible, risk managers will flock to the market, Neilson affirms. “A lot of the current finite deals are expensive, they have not yet gotten an off-the-shelf product and price. Risk managers are waiting for that to happen.”

With the soft market making traditional carriers more flexible in their pricing and terms of cover, Susan Meltzer, assistant vice president and risk manager at Sun Life Assurance Co. of Canada, says risk
managers will most likely continue supporting the traditional market — should the current pricing environment continue.

Meltzer infers hybrids of traditional programs, such as finite, have more potential for the Canadian market than capital market alternatives. “It’s hard to look at something more complicated and probably riskier than insurance as a mode of risk transfer. Having investigated the capital ART market, I have not been successful finding a solution where I can transfer the risk I want to.”

Adverse regulations

Critics say Canada’s regulatory environment is deterring risk managers from finite-type products. Mulville places the blame squarely on the shoulders of regulators for the lackluster market response to finite-type products. “Regulators here are not as in sync [to U.S. regulators] with market innovations. They discourage elaborate risk transfer…from that point of view, Canada is not yet ready for finite.”

Mulville describes the situation as a classic case of “the chicken and the egg,” where the volume of finite risk transfer has been minimal due to regulatory stodginess while regulators have not responded to the market because not many deals have been done. “Obviously regulators are still going to lean to the more conservative approach”, he notes. To illustrate the point, Mulville says he has only structured two finite-based deals in Canada over the past year.

John Thompson, deputy superintendent at the Office of the Superintendent of Financial Institutions (OSFI), admits his office has not been overly reactive to finite and other ART risk transfer products. OSFI has reviewed few of these deals, mainly due to the inactive market, he says. “OSFI doesn’t drive the bus — the innovation has to come from the industry — we merely react to events. We haven’t seen many of these programs being brought forward.”

However, Thompson points out, OSFI’s prime concern with finite and other ART products is that the risk is not sufficiently transferred from the buyer to the underwriter. “Our concern is that, if a company is going to transfer risk from its balance sheet, we’ve got to be satisfied that it is indeed the case.”

Worldwide, only U.S. regulators have established clear governance on ART products. Is Canada lagging from a regulation perspective? In a sense, “yes,” Thompson concedes, “there’s probably a need to lay down regulation for consistency in this issue. There has not been any official contact between Canadian regulators to deal with this…the U.S. has been more active on regulations as it is a more mature market. The U.S. market also offers greater diversity, this pressure has not been as heavy on regulators in Canada.”

Risk managers take tentative steps

While the product makers of finite programs are optimistic of their future in Canada, risk managers are less confident. Brad Silver, NOVA Chemical Corporation’s risk manager, says his company does utilize some capital market tools to manage interest rates and off-set fluctuating costs of chemical supplies. “On the operational sides, though, most of our risk protection is through self-retention with our own capital or through traditional insurance.” That said, Silver has examined finite alternatives as a contingency in the event of rise in traditional rates, and reasons most risk managers should do the same.

Nowell Seaman, manager of insurance services at the University of Saskatchewan, says his organization does not utilize finite risk, relying on traditional products and membership in the Canadian University Reciprocal Insurance Exchange which helps universities access reinsurance and self-retention markets. “Maybe it is something we should be looking at,” he adds. Seaman points out, however, that a university is not a typical corporation and might not benefit to the same extent from alternative programs. Neither he nor his broker(s) have breached the subject. “Our brokers have always opened the doors to talking, but they’ve never mentioned finite risk coverage. The only time I’ve been exposed to these type of products is when consultants have approached me.”

Meltzer, who believes risk managers will mainly stay within traditional insurance confines, concedes that the changing legislative environment in Canada might merit more companies looking toward combining risks in a finite format. Furthermore, she notes that a more activist style investor environment is making public companies more cautious of covering their financial liability exposures — typically in the area of ART coverages.

Market size constraints

There is a convincing argument coming from some circles suggesting Canada’s corporate environment does not merit full-scale finite integration. The Conning & Company study found that in the U.S., 80% of the risk dollars spent by national corporations were in the alternative markets, dwarfing the involvement in these products by middle market and small commercial corporations. Canada, with significantly smaller population and economy — and having significantly fewer large “home grown” corporations — might not be as ripe for the picking in finite as many of its proponents believe.

Hague points out that there may be too few top-layer companies in Canada to support the growth of finite and ART programs. “I think risk managers for some of the larger public utilities or multinationals such as Bombardier and Alcan are capable of taking on these deals. But, once you get past the fifty companies in that category, there is big market drop-off.”

In addition, Hague believes the combination of the smaller Canadian commercial market plus the more loyal approach of insurance players to traditional relationships will restrict the growth of alternative risk transfer products — primarily as ART tended to grow in U.S. from direct writing operators.

However, Mulville contends, “there are just as many critics who believe Canada’s corporate environment is ready for finite risk programs. I wouldn’t agree with the ‘America-is-bigger’ argument. I think just the opposite — a lot more middle and smaller-sized companies are now accountable for financial management competency than was previously the case. They are looking at ways to stabilize exposures and better manage their business. If you bring a good idea to risk managers, they will look at it.”

Gray agrees with the latter view, ultimately these products will flow into Canada from the U.S., he predicts, there is simply too close a relationship between Canadian business and companies south of the border. “Over the next five years I’m predicting a bullish market for finite and ART products in Canada,” he states.

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