Financial Lines—The New ART Frontier

Scope of Financial Lines

The financial lines market can be described as follows:

Surety: The surety market has long existed to provide performance guarantees for a variety of situations in which the obligee in some transaction wants a third-party guarantee that the obligor will be both able and willing to perform. The surety market is perhaps best known for its involvement in the construction industry, but surety bonds are also used for a variety of other types of transactions as well.

Surety underwriters typically have banking backgrounds and apply credit analysis processes to underwrite risk. While the surety business is often thought of as a segment of the insurance industry, the underwriting process is much more similar to a bank than to a property/casualty insurance company.

While it is a generalization, surety underwriters generally attempt to underwrite to a "zero loss ratio." This means that the surety does not so much see itself charging a premium that reflects the risk of loss. Rather, the surety bond is more like title insurance. The premium is really paid for the surety to conduct a thorough analysis of the obligor so that the surety ends up putting its "stamp of approval" on a company which it believes will be both willing and able to perform. As we will see, this concept of "stamp of approval" underwriting is important in understanding financial lines transactions.

Financial Guarantee Insurance (FGI): FGI is best known for guaranteeing the payment of interest and principal on bonds issued in the public securities market, especially bonds issued by municipal or other governmental entities. Here the idea is that the FGI does the work of performing an in-depth analysis of the financial condition of the borrower as well as the purpose and terms of the underlying debt issuance, so that investors, often individual investors, have the benefit of a guarantee issued by a third-party insurer.

Given the need to protect the interests of the public, the state of New York acted to draft a special licensing law for FGI companies. New York required that a company engaging in FGI should be solely engaged in that activity, so FGI companies are considered to be mono-line insurers.

Everything has its price, of course. Investors who buy bonds guaranteed by an FGI company receive a lower interest rate than they would have received if they had bought unguaranteed bonds. The interest rate they receive on the guaranteed bonds reflects the credit rating of the FGI company rather than that of the bond issuer. FGI insurers are generally highly rated (typically "AA" or even "AAA" by Standard & Poor's). The rate, for example, on a bond issue guaranteed by an AAA-rated FGI company will be only marginally higher than the rate paid on U.S. Treasuries.

The FGI company is paid based on the "spread" between the rate the bond issuer would have paid to issue non-guaranteed bonds and the rate they actually pay on the guaranteed bonds. The bond issuer keeps some of this spread, and some is paid to the FGI company.

Note that surety and FGI are conceptually similar; both are guaranteeing the performance of an obligor on financial obligations. FGI is more specialized in that it is designed to enhance the credit rated of publicly issued debt. As noted, the companies carry a special license and are expected to adhere to capital market standards for paying claims. This standard requires that the FGI company make defaulted interest and principal payments on time and without resort to the kinds of claims settlement delays that can occur with other kinds of insurance.

One important difference between FGI and surety, however, is the notion of risk-based pricing. The pricing of FGI is for the most part based on credit ratings as established by the major rating agencies, coupled with the FGI companies own credit analysis process. The ratings set by the ratings agencies are based on historical default rates for borrowers who, in the view of the rating agencies, bear similar characteristics.

As lower rated entities imply a higher risk of default, the FGI company will receive a larger spread for guaranteeing the credit. This injects the notion of risk based pricing, where it is ultimately known there will be some credit losses, and premiums are set to (hopefully) fund losses realized on the overall portfolio.

Credit Derivatives: Banks are, of course, heavily involved in credit risk as one of their principal activities is extending credit to borrowers. The banking industry has developed a field called credit derivatives, which is designed to facilitate the efficient transfer of credit risk among banks and other financial risk takers. Here, transactions are structured using International Swap Dealers Association (ISDA) documentation, and take the form of swaps or options. These transaction forms are more efficient that insurance contracts as they do not attract premium taxes, although banks face some other constraints that insurers do not.

One of the interesting aspects of the "convergence" between insurance markets and financial markets is the potential for insurers to consider taking risk in the form of a swap rather than in the form of an insurance policy. There are regulatory considerations as the relevant regulators generally have the power to consider substance-over-form issues.

There is also the issue of derivative accounting (FAS133) to consider, which can be problematic for some insurers. But, to the extent that insurers are permitted to engage in swap transactions, the ability to transact on either a derivatives platform or an insurance platform creates interesting and useful options for structuring transactions.

Structured Credit: While terminology can vary somewhat, structured credit refers to transactions in which the credit risk of several borrowers is pooled together. For example, a commercial bank might take the credit risk associated with 100 corporate loans and create a program to transfer the cumulative default risk of the entire portfolio. This results in the creation of what are called "tranches" of risk. The idea is that while it may be probable that at least one or two of the loans might default over the program period, it is assumed to be unlikely that all or even most will default.

The program might be structured so that the first tranche covers the risk of two or three defaults (typically referred to as the "equity" tranche), with other tranches taking the risk of successively higher numbers of defaults. When these tranches are themselves structured as bonds, the rate paid for the tranche will reflect the cumulative default risk associated with that tranche.

These programs can be based on pools of corporate bonds ("CBOs"), bank loans ("CLOs"), mortgages ("CMOs"), or other financial assets ("Asset Backed"). Structured credit deals are done either in the form of a swap or as a securitization. When the Securitization route is selected, the programs entail the establishment of a Special Purpose Entity (an "SPE," which is normally a corporation), which purchases the loans, bonds, etc., from whoever owns them. The SPE then issues new securities representing some defined interest in the pool of assets now owned by the SPE. (This process of creating new securities based on pools of underlying assets is where the term Securitization comes from.)

The interesting thing about all of this for readers of this column is that the investment bankers have learned to repackage some of this risk so that it can be underwritten by insurers and reinsurers as a form of insurance/reinsurance. This is rather clever (nobody ever said investment bankers are dumb) as it is often the investment departments of large insurers that buy the bonds issued by the SPEs. Now, the risk is being repackaged so that underwriters on the "liability side" of the insurer's balance sheet can take the risk.

This might seem a little surreptitious but for the following. First, an insurer that "insures" a tranche of risk is different than an investor that buys a bond representing a tranche of risk in that the insurance transaction is "unfunded." The ability to provide support for the securitization program on an unfunded basis also gives the deal structurers more flexibility, as well as access to professional risk takers who are potentially willing to deal with unusual or difficult-to-analyze risk problems.

So, the role played by insurers is often to provide coverage for the riskier tranches of the deal, making it easier to sell the rest of the program to investors. Note here that the insurers are not directly providing a guarantee to the investor. But they are reducing the investors' risk by taking the riskier tranches of the program.

Thus both FGI companies and insurers supporting securitizations are, in a real sense, essentially providing the same stamp of approval process that was described earlier with respect to sureties, but are also engaged in underwriting risk for a price, as is customary for insurance companies generally.

Structured Finance: Structured Finance is often used to refer to asset-backed securitizations of things like credit card receivables or automobile loans. It is designed to help a company raise special purpose financing for some defined area of activity (such as issuing credit cards or making automobile loans). In the context of this article, there is an interesting and growing area of ART/Financial Lines insurers helping companies achieve highly specialized financings for risks that would be difficult to place into the public securities market through securitization programs.

Project Finance: This refers to a strategy used by corporations to finance the construction of capital-intensive projects. An example might be a new oil refinery. The idea is that the sponsors of the project provide a specific amount of equity capital to form a new special purpose company. The rest of the financing is raised through debt (loans or bonds). The recourse of the lenders is limited to the assets and equity of the special purpose company and does not extend to the assets of the sponsor.

As a result, lenders to the projects are often interested in using insurance to provide protection against the default or bankruptcy risk of the project. They may seek to buy outright default/bankruptcy protection, or they may seek to obtain insurance for certain critical risks that could affect the viability of the project.

Conclusion

The intersection of the more traditional ART field with the financial lines arena represents the actualization of the convergence concept that is so often discussed. Given that the size and scope of the credit and financial risk markets is so large, this field presents new and important opportunities for growth for insurance companies who are willing and capable to invest the resources needed to properly evaluate the risks.