Why a Producer’s Understanding of Risk Securitization is Important

In today’s Insurance Outsourcing market, the wholesaler or agent’s production role has remained traditional: prospect, service and understand the needs of existing clients, and perform the necessary due diligence to verify that the policy issued by the insurer is the one intended originally by the client. These activities are undertaken in an environment that is always being perturbed, from technological advances that permit producers to spend more time to write more business, to the current state of the insurance cycle to changes in the legal environment that alter affect how policy language should be interpreted. A rising wave that we believe will be enduring is risk securitization and its impact on insurance markets is now being forecast. In this note, we call upon the recent work of J. David Cummins of Temple University and the Wharton School along with Philippe Trainar of SCOR in Paris, entitled “Securitization, Insurance and Reinsurance,” published in a September 2009 article in the Journal of Risk and Insurance, and give some background on risk securitization including how we interpret its impact for the insurance production community of MGAs, brokers and independent agents.

What is risk securitization?

When an insurer agrees to take on a risk from a firm or individual, the insurer simultaneously makes a decision about how to diversity the risk just accepted internally. The traditional form is to pool all risks of similar loss producing characteristics and the ability of the insurer to gain market share is limited by the size of its balance sheet. Enter reinsurance. The reinsurance tool permits the insurer, among other benefits, to share its pools (and perhaps individual risks assumed) on a piecemeal basis or according to treaty. In this fashion, the insurer frees up capital to expand in its primary markets and any primary risk “catastrophes” are shared secondarily with other insurers. Cummins and Trainar view an insurer as a “risk warehouse” and conceptualize risk securitization as the selling of financial instruments to investor (popularized by “CAT Bonds) who agree to share the costs of claims Outsourcing at the risk warehouse, but in exchange are paid a higher rate of return on their bond investment if claims of the insurer are not triggered by certain events, e.g,. catastrophes. The impact on an insurer’s balance sheet of the risk securitization alternative is similar to reinsurance. Losses are shared and an insurer’s capital base is expanded. While Cummins and Trainor detail the costs and benefits of reinsurance and securitization, they make the case that securitization may be a preferred risk-handling substitute for large, catastrophic loss events; however, only larger insurers will utilize securitization directly because of the transaction costs of structuring the issuance of a catastrophic bond offering.

What will be the impact on producers?

As risk securitization expands we think the likely impact on the insurance market will be to moderate any prospective growth in guaranteed cost premiums. In turn, while we expect that a producer’s revenue per premium dollar to remain stable, lower overall premiums will keep firms from tending toward higher retentions. Thus, while prices for insurance are likely not to leap, quantities may indeed increase slightly placing the producer’s income stream in a slow growth mode across existing renewals. One implication for agencies is that overall revenue growth may have to come from a larger market footprint, whether by bringing experienced producers on board with or by acquisition of competitor agencies. The, growth in overall agency valuation per dollar of revenue will be enhanced more likely by expense reductions.

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