Last July, the folks at Toyota Motor Corp. were getting nervous about the mountain of North American lease deals they had signed. Leasing is a lucrative business if you can sell the vehicles for a good price when they come off lease. But if the used-vehicle market is in a slump at that point, you're stuck with a parking lot full of white elephants.
What to do? In similar circumstances, some executives resort to prayer. Toyota shopped for specialized property and casualty insurance but couldn't find any that fit its needs. So it chose a third route. With the help of Goldman, Sachs & Co., it set up a special company to issue a $566 million series of bonds with an unusual payoff plan: If the residual value of 260,000 leased Toyotas is high, bond buyers will get all of their principal and interest payments. If the residual value falls below a certain threshold, payments will be cut. Bondholders could even lose all of their principal. These structured bonds, which mature in 1999, 2000, and 2001, took part of the risk of the leases away from Toyota and put it onto the backs of sophisticated institutional investors, who were happy to accept it in return for attractive yields (table, page 118).
Toyota and Goldman are in the vanguard of a movement that is beginning to shake the business of insurance to its foundations. Until now, nearly all underwriting has been done by insurance companies and reinsurance companies. In the new deals, by contrast, the ultimate guarantors of risk are the deep-pocketed world financial markets. Toyota tapped the markets directly. More often in such new deals, insurers and reinsurers are doing the tapping--selling special securities that transfer risk exposure from themselves to investors who have an appetite for it.
This transformation has benefits all around. For one thing, people who need insurance get a new source of capital competing for their business. That should drive down premiums and could someday make it possible to obtain coverage for massive risks once considered uninsurable.
Investors benefit, too, by becoming underwriters. "Risk securities" constitute a new class of investment whose performance isn't correlated with stocks, bonds, or other holdings in their portfolios. Even though some risk securities are volatile, they add stability to a portfolio if they tend to zig when everything else is zagging. That's what diversification is all about--and it explains whyinstitutional investors flocked to Toyota's bond issue.
WHO LOSES. Even insurance companies can benefit from the new wave of risk securities if they play their cards right. To be sure, the securities make it possible to cut insurers out of the picture. But if smart insurers use the new tools to reduce their own risk exposure, they can afford to write more policies than ever before. They can make their money from drumming up business, assessing risk, processing claims, and so on.
The losers? Well, the opening up of underwriting doesn't look like a healthy development for reinsurers, which insure insurance companies. Once insurance is sold off to investors, who needs a reinsurer? Just ask David Wasserman, president and CEO of Centre Solutions Holdings Ltd., an innovative player that changed its name from Centre Reinsurance to reflect its expanding role in the financial markets. "It's bad news for reinsurers," says Wasserman. "They could be disintermediated right out of the picture." Recognizing that, reinsurers are madly hiring investment bankers and doingdeals to become leaders in the new field.
Risk securities are still in their infancy. Although more than $3.5 billion of insurance risk has been sold in the market to date, that pales into insignificance compared with the $2.1 trillion of conventional insurance that's purchased worldwide each year. Still, the enormous potential is attracting big players. Goldman, Merrill Lynch, and Lehman Brothers have already set up subsidiaries to design products that mimic insurance. Predicts Scott C. Stevenson, vice-president of Merrill's Alternative Risk Markets Group: "This won't take over the whole insurance industry, but it will be many, many multiples of its current size."
Indeed, legislators are making moves that could fuel an explosion in domestic deals. Today, most deals are done offshore, in places such as Bermuda. But Illinois Governor George H. Ryan has said he will sign a law giving catastrophe-bond issuers tax and accounting treatment similar to what's available offshore, and similar legislation is being debated in other states. A committee of the National Association of Insurance Commissioners recently approved model legislation.
For investment bankers, it's just another opportunity to exercise their skills. Last year, Wall Street sold some $200 billion in securities backed by mortgages, consumer loans, credit-card receivables, and the like. This bundling and reselling is what's commonly called securitization. To date, few deals of that kind have been done in the insurance field. Instead, "securitization" in insurance typically refers to the selling of new types of securities, such as Toyota's structured bonds that transfer risk to the market. Says Jim Ament, vice-president for operations at State Farm Fire & Casualty Co., which has been involved in some deals: "Technically, you could transfer all kinds of risks that are not in the market today."
HAVOC. Risk securities really got their start after Hurricane Andrew tore through South Florida in August, 1992. The windstorm whipped up $15.5 billion in losses and put several insurers out of business. Other insurance companies tried to raise their rates. Still others sought protection on the reinsurance market. For higher-risk customers, premiums shot through the roof.
The havoc got many people wondering just how reliable their insurance companies were. And it drew attention to a bigger, less visible problem: Most risks simply go uninsured. Sometimes it's because people don't mind bearing the risks themselves, but often it's because there's simply not enough capital in the insurance industry to insure everything out there. There is up to $25 trillion worth of property in the U.S., but the insurance industry has only $250 billion in reserves to cover possible losses. The imbalance is worsening as more people come to live in hurricane-prone Florida and earthquake-ridden California.
That has given impetus to catastrophe bonds, which are usually issued by insurance companies as an alternative to buying reinsurance. The bonds' payoffs are tied to indexes such as, say, hurricane wind speeds along the Louisiana coast. Oriental Land Co., owner of Tokyo Disneyland, recently issued $200 million in catastrophe bonds whose payoffs are structured to protect Disney's revenues in case of an earthquake.
Insurance companies can buy catastrophe-index call options, traded on the Chicago Board of Trade. When a hurricane or earthquake hits, the gains on their call options offset their losses from claims. There are even catastrophe equity puts--which entitle the holder to raise money on a moment's notice by selling a block of equity to another party at a set price.
As investors grow more familiar with catastrophe bonds, they're willing to accept lower yields. The average spread has shrunk from about six percentage points more than the benchmark London InterBank Offered Rate (LIBOR) for the first wave of bonds to less than 2 1/2 points over LIBOR for recent transactions. Investment bankers have been slicing the risk into different tranches, with bonds that offer a range of risks and returns to investors.
One pioneer is the United Services Automobile Assn. (USAA), which was a beneficiary of the first large-scale cat bond in June, 1997. The San Antonio company insures U.S. military families and has about one-third of its customers located in the states of California, Florida, and Texas. That leaves it especially vulnerable to natural disaster claims, which can be costly to hedge through traditional reinsurance.
HARD TO PREDICT. So the USAA approached several investment banks, which established Residential Reinsurance Ltd., a company in the Cayman Islands set up specifically to design and sell cat bonds to investors. The first deal sold $400 million of hurricane-risk bonds for about 6% more than LIBOR. Residential Reinsurance issued $450 million in bonds in 1998 and $200 million in June, 1999, both at lower rates. Each time, private investors have snapped up the bonds. "We're very happy with the level of protection this gives us," says USAA spokesman Thomas D. Honeycutt. "A very sizable event could mess your calculations up if you just go with reinsurance."
But catastrophe bonds have problems. Despite sophisticated modeling software and other tools, catastrophes remain hard to predict. That makes it tough to put a price on some of these bonds and even tougher for investors to know how much risk they face.
That's why plain-vanilla policies such as auto, life, and homeowners' insurance may be even more promising targets to slice, dice, and sell as securities. "For a lot of us, catastrophes were the last thing that should be securitized," says Peter R. Porrino, national director of insurance-industry services at Ernst & Young. He says securitization works best where it tackles basic bread-and-butter businesses that are easy to predict and divide into different risk levels. Last year, Germany's Hannover Re and Britain's National Provident Institution sold off part of their life-insurance portfolios, following the standard pattern for asset-backed securities. Experts say similar deals in the U.S. are only a matter of time.
SWOLLEN RESERVES. Like most new trends, the advent of new risk securities has its naysayers. "There's a lot more talk than action at the moment," says Brian Duperreault, president and CEO of Ace Ltd., a reinsurer in Hamilton, Bermuda. "The product can't get mature if there's no demand for it."
In truth, only a few dozen deals have hit the news in recent years. It's hard to compete with the deals being offered by conventional insurers these days. Insurers and reinsurers are caught in a vicious price war--one they can afford to wage, however, because their reserves are swollen from booming markets and because there have been few costly natural disasters in the past few years. Customers don't need to look anywhere else. "If the cost of doing a bond is greater than any insurance premium, why would we do it right now?" asks David Burr, assistant vice-president for risk management in the Schaumburg (Ill.) office of Burlington Northern Santa Fe Corp.
Fair enough. But how much longer will insurers be willing to wage a price war? Analysts say insurers are bound to raise their prices in the next few years, perhaps because of an industry shakeout, a setback in the stock market, or a series of natural disasters. Says Chubb Corp. Chairman Dean R. O'Hare: "Once you see [insurers] charging the type of prices they should be charging, you'll see securitization take off like a bat out of hell."
To thrive in this world, insurers will have to embrace a new vision of their business. They will continue to identify risk, measure it, and even help price it, but they will be less and less likely to hold it on their books. The transformation just might energize some parts of the industry--and shatter others.