The growth of an insurance derivatives market in the UK is a possibility following the introduction of a new regulatory framework. But what are the advantages for insurers and investors?

On the 1st July 1994, the UK introduced a new framework for the use of derivatives by insurance companies in line with the European Union Third Insurance Directives. This could lead to an insurance derivatives market, as already exists in the US.

The best-known insurance derivatives are the catastrophe insurance futures and options traded on the Chicago Board of Trade (CBOT) (Risk September 1994, pages 82-89). These have gradually become more widely used in the US since their introduction in December 1992. There are now over 6,000 catastrophe insurance contracts open on the CBOT and an estimated additional capacity of $25 million has resulted from their creation.

Insurance futures are priced on the CBOT according to the movement of prices on an index, which is made up of consolidated catastrophe loss data collected by the Insurance Services Office from more than 20 US insurance companies across America.

UK insurers unused to derivatives should consider the experience of their US counterparts. Proper use of insurance derivatives can protect against catastrophe losses. But if they are to be used to full effect, they need to be well understood as full disclosure to those investing will be required. An index will have to be established in the UK for insurance derivatives to become a reality. But when this hurdle is cleared, how will insurance companies be able to benefit from the new opportunities?

The insurance industry's capital base has weakened in recent years. This has been followed by a contraction in insurance reinsurance capacity with a consequent hardening of premiums. Several insurance companies have raised capital through rights issues and further capacity has been introduced through the establishment of new reinsurance companies, particularly in Bermuda.

While the number of names at Lloyd's of London has fallen over recent years, Lloyd's has still managed to increase its own capital base through the introduction of corporate capital with effect from this year. However, the demand for world risk transfer is expected to develop faster than capitalisation of the insurance industry. For example, from 1992 to 1996, gross property claims in the UK are expected to grow by about 60%, whereas the main composite insurers' base is expected to increase by only 40%. Insurance derivatives are a flexible source of new capital which can allow supply to meet demand as it develops and a high-risk, high-reward investment for traders.

An insurer's ability to buy insurance derivatives will depend on regulatory requirements and its powers of investment under its constitution. These are usually broad enough to permit the use of derivatives.

But to what extent can derivatives be used for solvency purposes given that insurance companies have a statutory obligation to maintain a specified minimum ratio of assets to liabilities? Many investments are limited in the extent to which they can be used in this calculation or are excluded altogether. This is an indirect method by which the insurance regulator, the Department of Trade and Industry (DTI), can control insurers' investment policy.

Since July 1, insurance companies have been able to take advantage of new powers of investment in relation to derivatives, subject to certain controls. Another critical issue is the accounting treatment. These transactions will appear on the investment side of the company's books rather than the underwriting side, which means that recoveries on investments cannot be set off against claims.

New rules have been introduced to implement aggregate exposure for insurance companies, ie, the amount against which the asset admissibility limits are applied. These limits are used in relation to valuations for solvency purposes. For example, maximum limits apply to business which can be conducted with any one counterparty or connected company. The insurer's exposure needs to be accumulated for all types of investment, including derivative transactions, and for dealings with the relevant counterparty or any of its connected companies. This means that insurers will need to check if any of their counterparties are connected and ensure that any changes in the status of existing counterparties are notified.

The regulations require insurers to conduct their business in a sound and prudent manner. This means having adequate systems of control and conducting their business with due regard to the interests of policyholders and potential policyholders. Failure to comply could lead to intervention by the DTI and adverse changes to insurance authorisation.

Under the new framework, insurers must have management information systems in place to allow implementation of an appropriate investment strategy. This strategy must take account of the requirement that an insurance company carry out business which is "in connection with or for the purposes of its insurance business". This means that trading in financial instruments for speculative purposes would not necessarily be considered an investment activity and could put the insurer in breach of its statutory obligations.

Insurers are required to have appropriate procedures for assessing the creditworthiness of counterparties to which they are significantly exposed and to set lower internal limits in certain cases. They must have systems in place to monitor their aggregate exposure to different categories of assets or to particular counterparties, relative to the admissibility limits set out in the insurance regulations.

Derivative investments, in particular, need to be properly assessed and regularly reviewed in the light of changing market conditions and experience. The insurer's directors are required to satisfy themselves that management fully understand the nature of derivatives trading being undertaken by the company and the related risks. This includes the nature of the exposures and both counterparty and market risk.

Insurers will have to draw up objectives and policies for using derivatives and to monitor them, including carrying out compliance audits. Management must define the instruments that can be dealt with and any limits on exposures or volumes. In particular, they must pay due regard to uncovered transactions. In no circumstances can the insurer's minimum solvency margin be endangered nor, in the case of life insurance companies, can policyholders' reasonable expectations be adversely affected. Insurers must have adequate systems to prevent exposure to exceptionally volatile risks and to monitor transactions on a frequency commensurate with volatility and risk. These systems should trigger a strategy to hedge or close out transactions whenever adverse movements or events threaten worsening of the company's solvency.

The insurer's systems should be designed to cope adequately with the volumes and volatility of transactions. Statistics on trading volumes of derivatives need to be regularly provided. Derivative positions need to be independently agreed and reconciled and prices checked. Insurers will also need to test and approve models used for valuing open positions on derivative instruments. These should include an appropriate test of the robustness of the portfolio under stress in changing investment conditions. Insurers must ensure that those responsible for the control of derivatives investment are sufficiently independent from the day-to-day operations to ensure effective control.

The insurance company's directors collectively need sufficient expertise to understand the issues and should discuss them regularly.

Provided insurers can comply with these new regulatory requirements, how will the industry benefit? One advantage of purchasing future contracts or options is that the insurer can hedge against unexpected changes in the level of losses occurring during a given period. However, the success of this technique depends on whether the risks reported by insurers to the underlying index are appropriate to the purchasing insurer's own risk portfolio. The structure of a relevant UK index is crucial. The CBOT derivatives are based on losses in the insurance market as a whole so a correlation problem arises if risks written by a particular insurer are very different from those covered by the entire market. Problems can also occur if the insurer has a higher concentration in a particular area of risk, or does not even write a type of risk which is reported to the loss index. Regulations require that insurers diversify their investment portfolio so it is unlikely that insurers will expose their capital primarily to derivatives.

Attention will need to be focused on the data used for the relevant index. The CBOT uses loss ratios, including quarterly premiums. Whether the index should be based solely on loss experience rather than loss ratios including premiums, which are susceptible to rating changes, needs to be explored. As correlation is a potential problem, a series of indices or interrelating indices may be more appropriate. Another problem to be addressed is the lack of any standardised system of reporting. Market bodies such as the London Insurers and Reinsurers Market Association and the Institute of London Underwriters have merged their claims networks. The Association of British Insurers collates information from the company market for its quarterly reports.

One of the criticisms levelled at the CBOT in relation to its slow start-up was the lack of an over-the-counter market. Consideration should be given to an OTC market in the UK to enable derivative products to be customised to meet particular needs. This would help the new market flourish.

Insurance derivatives are not contracts of insurance and will not therefore be able to be written by insurance companies because of the statutory restriction on insurers to carry out only insurance business. Derivatives are categorised as "investments" under the Financial Services Act 1986 and as such are subject to a separate statutory regime applying to persons who buy, sell, arrange deals, give advice and manage these investments. Whether underwriting agents at Lloyd's can write insurance derivatives depends on the relevant Lloyd's bye-laws and regulations which, in practice, are more flexible to market requirements.

The introduction of corporate capital to Lloyd's has introduced new investors to the market and reduced the cost of raising capital. Lloyd's already has access to a statistical base going back several hundred years and its accounting and information procedures are subject to constant improvement. These factors combine to make Lloyd's ideally placed to set up the index. Lloyd's has a more flexible regulatory regime than the company market and underwriters should explore the possibility for writing insurance derivatives as a form of "reinsurance". One possibility is for underwriters to join forces with banks to form credit-enhanced derivatives trading joint ventures.

The development of a market in insurance derivatives is only likely to succeed if insurance derivatives deal with real market needs. Insurers will need to be persuaded that insurance derivatives are the most appropriate form of risk management and investors will need to perceive that they represent opportunities worth investing in. If derivatives are structured in the correct way, they will allow the injection of new risk capital into the insurance market, thereby enabling alternative and cost-effective risk transfer, including previously untransferable risks.

Jeremy Wood

Jeremy Wood is a corporate insurance partner at international insurance law firm Davies Arnold Cooper.

The contents of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances from Jeremy Wood (Tel. 071 936 2222).
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