Rob Tucker explores the arcane world of Alternative Risk Transfer (ART) and Alternative Risk Finance (ARF) and its application within property and other structured finance deals.
Encouraged by politicians who have embraced a whole new lexicon of hip phrases such as "stakeholder" and "joined up thinking", the insurance industry now confidently pronounces on the wisdom of Alternative Risk Transfer (ART) and Alternative Risk Finance (ARF). Are these really new and innovative concepts? And how useful are they in practice?
It's refreshing to see that things are changing, and that insurers and brokers are working together to offer something other than the standard "grudge covers" - the ones which clients must have but don't really want. Using insurance as a deal winner or a means of reducing costs moves it from this grudge category into the "tell me more" class.
Many factors have driven this change. Companies are responding to accounting rules that prevent financial reserving for uncertain risks. They have to deal with credit agencies which use sophisticated models to evaluate risk. Insurers too are responding to pressure from many clients, frustrated that major exposures have historically been uninsurable.
Also, we are seeing "smarter" procurement by organisations, placing emphasis on fixed-price deals linked to output specification. This procurement, which is akin to "corporate private finance initiative" (PFI), focuses attention on "whole-life-costing" and encourages voluntary risk acceptance as a means of adding value to bids.
Additional drivers
Other factors behind the search for new techniques are:
ART or ARF?
Alternative Risk Transfer suggests that an insurer accepts the risk. Alternative Risk Finance, in contrast, implies that the arrangement contains a high degree of self-funding, such as finite, time and distance, captive or retrocession arrangements. The distinction maybe academic, since most ART deals include a mix of true risk transfer and risk retention. In part, accounting rules influence this mix, requiring demonstrable risk transfer in order for a contract to enjoy legitimate "insurance" status.
Both ART and ARF risk solutions use techniques that are "alternative" because they need to solve problems for which there is no standard insurance product and because they frequently contain unusual features. These may be a range of risks combined in an unfamiliar blend, protection of financial risks, such as traded power prices, multiple claims triggers, or premium structures that offer underwriters "upside".
Similarly, they may accommodate insurance periods of three, five or more years, or protection against a variety of risks, some of which may previously have been considered uninsurable. They may even involve aggregate cross class claims deductibles, or deductibles that rise or fall in line with the policyholder's profitability.
In practice, the end is frequently more important than the means, and many problems require a blend of alternative and traditional solutions. What matters is that the solution works, whether through application of some stunningly clever technique or by the imaginative application of an old solution in a novel format. However, clients can be quite cautious when confronted with new ideas, tending to take the view that, while they do not mind being at the leading edge of innovation, they prefer to avoid being at "the bleeding edge".
Alchemy
We think of alchemy as the ability to achieve a spectacular conversion of base metal into gold. Here are some "insurance alchemy" examples that relate to project financing:
This has transformed the motor industry, to such an extent that, for many motorists, vehicle purchase price has become secondary to the monthly fixed leasing charge. The insurance industry supports many of these deals, which work well for assets that won't be quickly outdated, have a high labour content and a long life. Real estate fits this specification - rather better than cars, as those who underwrite motor RVI deals may soon discover.
RVI will, in theory, enable a bank to lend significantly more against the value of a property than it would otherwise. Recently, the magazine Estates Gazette suggested that the application of RVI to property was largely theoretical, arguing that, although there were deals brewing, none has yet been closed. However, Willis closed such a deal last year.
The article also stated that: "The insurance industry is keeping tight-lipped about the product. Those who are developing it do not want business rivals to steal a march on them - a secrecy that indicates there is potential to write some big business in this area." This is a fair observation. The question is, will RVI contracts transform the property market as they did the motor industry?
This is a source of some debate, with many insurers unwilling to contemplate risk some 25 years hence. Others are prepared to participate, recognising that demand will be strong, stimulated by significant financing benefits as costs can be amortised over longer periods. We have recently received interest from insurers for a 25 year policy, although lenders are becoming increasingly brave in assuming risk for pre-agreed levels of residual value. If insurers are to develop this market, they will need detailed research (or crystal ball gazing) to establish what the future holds for commercial property. There are already two large London-based chartered surveyors offering advice on future property value.
This can be used to facilitate securitisation. While financial instruments are being developed to allow securitisation of rental streams, the architects of these schemes are inherently risk-averse and may demand (or offer) better returns when the tenant default and credit risks have been eliminated.
The simple act of using a triple A rated insurer to protect a double B rated tenant could bring cost benefits. Property developers are seeking methods through which they can work their rental streams to better advantage. Innovative insurance arrangements will facilitate this.
We are currently handling a rail project where line closure and unavailability could result in multi-million fines being accrued within days. The contracting joint venture regards insurance support for this weighty liability as a "must-have" and a potential deal-maker.
This protection can enable greater bank or sponsor support. With some bids taking a year or more to close, the stakes are high. The market can accommodate sums insured of up to £10m and will provide protection in circumstances where a bid is abandoned for reasons beyond the control of the insured.
Originally designed for engineering projects, this cover is vital where soft-loans or grants are conditional on completion by a long-stop date. It has an application in PFI and equivalent procurement methods where delayed completion denies access to income.
Applying this cover can offer budget certainty for pollution remediation contracts. It could also be used to secure a cost-cap for facilities management or similar multi-year service contracts.
PFI has helped to generate a 25 year market for protecting both structural and non-structural defects.
Insurance against uninsurability may seem an unlikely proposition, though companies Can use insurance option contracts to cap premium increase risk and provide security in the event of partial or wholesale uninsurability -another PFI related exposure. Companies have also used these contracts to protect finite aggregate deductibles within captive programmes.
Working with a "soft-services" provider who needs to offer financial indemnities in the event of contractual default, we are negotiating a five to seven year reducing term surety bond. If successful, the facility will enable the client to secure desirable work and release over £lm back into the business at a cost of one per cent per annum. The advantages are clear to a business earning returns on capital of between 10% and 15%.
An example of this was the conversion of a parent company guarantee, offering an indemnity associated with the long-term performance of road-tolling equipment, into an insurance contract. This enabled purchasers to accept historic liabilities, allowing the vendor a clean exit, and made it possible for the buyer to negotiate an appropriate reduction in his offer price.
Placing an unemployment related risk in the insurance market eliminated the risk for a banker lending to a business where income was directly related to the number of benefit claimants. Similar applications are feasible for developers of sports stadiums, looking to enhance bank lending by guarantees of patronage and minimum-spend per customer.
A word of caution
Before embarking upon the journey into the more esoteric areas of risk financing, there are some important considerations. Negotiating bespoke cover will be complex and time-consuming for everyone involved, and premiums for the deals will be greater than those associated with standard insurance. Further, such arrangements tend to have a high casualty rate prior to implementation. Consequently, it's normal for at least one or more of the following conditions to be satisfied:
Developing a convincing broking presentation often involves external research and development. Brokers may expect clients to fund or at least share these costs prior to inception date.
While it isn't entirely accurate to say that you can insure anything, it is perhaps true that you can insure almost anything. While insurers remain hungry for income, true risk transfer often makes more sense.
As direct insurers and other financial institutions erode the broker's traditional client base, the shrewd broker will increasingly focus on creating bespoke risk solutions that add real value to ever more sophisticated deals. Some of these structures may not be true ART but, as Damian Hirst knows very well, art is in the eye of the beholder!
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