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Transferring risk to capital market -- An alternative to reinsurance

B. Venkatesh

COMPANIES are gung-ho about privatisation of the insurance market. More than half a dozen companies are offering or proposing to offer consumers various insurance products. This augurs well for consumers, as competition will drive down their prices. But the growth of a competitive market rests on removing a major structural impediment -- the absence of a deep reinsurance market.

Reinsurance is a process by which private insurers transfer some part of their risk to reinsurers. That is, the reinsurer reimburses the private insurer any sum paid to the policyholders against the claims lodged.

The need for reinsurance assumes importance given the increasing uncertainty faced by individuals and businesses. Consider, for instance, the earthquake in Gujarat that has left millions homeless and damaged property worth crores of rupees. Will the priv ate insurers be in a position to honour claims of such magnitude?

The answer is No. The reason? The policy premiums are priced by the insurers based on the probability of claims. But if the man-created stock market is itself so difficult to predict, how can the insurance company predict with any reasonable degree of ce rtainty the quantum of claims that could arise due to natural causes?

This means private insurers need to maintain adequate contingency funds to honour such claims. But there is a limit to the amount of contingency funds private insurers rack up. Why?

Being an extremely uncertain business, private insurers cannot resort to high levels of debt to finance their business. At the same time, there is a limit to how much equity an insurer can raise: for the earnings uncertainty will dampen the returns on eq uity if the insurer resorts to a large equity base.

Thus, it is of utmost importance that private insurers reinsure their risks. But the point is: Will private insurers be able to transfer their risk to reinsurers? That is, indeed, a moot point, for two reasons.

First, the basket of insurance products is likely to expand once private insurers enter the market. The rationale is this: at present, General Insurance Corporation (GIC) offers products of a general nature, such as theft and accident insurance. The corp oration may enjoy a price advantage over the private insurers, as it is not compelled to work on a profit motive, thanks to being a government arm.

Besides, GIC has a widespread network that private insurers may find hard to rival. Given this, one way private insurers can take on the might of GIC is to offer new products, such as calamity insurance. Now, it may not be easy to find reinsurers willing to assume such risks; for it will be difficult for the reinsurers to estimate the quantum of claims that will be lodged, as the underlying event has to do with nature. The few reinsurers who may be willing to take on the risk of private insurers will de mand a high reinsurance premium.

And second, it is unlikely that the reinsurance market will match the pace of the insurance market. The reason? If a natural disaster occurs, the losses suffered on account of the claims can cripple the reinsurers. This factor could inhibit the growth of reinsurers in the country. So, what can the private insurers do?

A viable risk transfer mechanism is the capital market. This is because the capital market is huge and can comfortably take on the risk that insurance companies run. The question then is: How can risk be transferred from insurance companies to the capita l market?

The solution lies in structuring instruments such as asset-backed securities (ABS). A private insurer can, for instance, bundle off policies with similar maturity and quality and sell them as securities to retail investors.

Here is how the ABS can be structured: The private insurer can float a special-purpose vehicle (SPV) and sell the policies concerned to this entity. The SPV can bundle the policies and sell them as securities to retail investors at attractive yields. The premium received on the policies underlying the ABS can be invested by the SPV in low-risk, highly liquid instruments.

But why float a SPV for the purpose? Consider the benefits. One, the SPV is considered a separate entity from the insurer. This enables easy rating of the ABS as the credit rating agency will able to identify the underlying assets (policies). Two, by sel ling the policies to the SPV, the insurer removes the assets from its balance sheet. This means that the private insurer frees capital that can be used for further business. And three, the SPV is not affected by the financial health of the insurer.

So, what happens when policyholders (underlying the ABS) lodge claims with the private insurer? The private insurer simply passes on the claims to the SPVs. The SPV, in turn, will liquidate its investments and meet the claims. But it will not go bankrupt . Why?

The SPV will stop paying interest on the ABS. The retail investors, therefore, bear a sizable portion of claims of the policyholders. There can, of course, be many variants to the ABS. The most risky ABS, from the investors' angle, will be those that sto p interest payments and delay principal repayments if claims are honored.

But why would investors buy ABS? After all, they run the risk of not receiving interest, not to mention delay in principal, if claims on the policies underlying the ABS are honored. The reason is that buying ABS helps retail investors truly diversify the ir portfolio. This is because the probability of claims from, say, a hurricane is largely unrelated to the economic factors or industry-specific factors that drive equity and bond values. Besides, investors get attractive yields for taking the risk.

Having said that, there are two factors that may work against the ABS becoming popular with the retail investors. First, investors may be unable to measure the risk of the ABS. After all, computing the probability of a hurricane hitting, say, Andaman Isl ands requires some skills in mathematical modelling. And second, there is the problem of adverse selection. It is in the private insurers' interest to transfer policies that carry high probability of claims to the SPV. This imposes great risk on the reta il investors, for claims paid to policyholders mean loss of interest, not to mention delayed principal on the ABS.

Both problems, however, have workable solutions. If mutual funds invest in ABS, retail investors need not estimate the risk associated with the investment; the fund manager will do the needful. The problem of adverse selection, on the other hand, can be reduced if the ABS are credit-enhanced by a third party and rated by a credit rating agency.

But, wait. There is still a problem. Our debt market is not deep and liquid enough to receive products such as asset-backed securities. Moreover, regulatory restrictions, such as high stamp duty and a not-so-efficient judicial system, may act as deterren ts. This brings us back to the original question: How will private insurers manage their risks? It appears that, as with everything else, the alternative risk transfer market will only develop once the need for such risk transfer assumes importance some time in the future.