Insurance-Linked Securities Report 2008 - Aon

Insurance-Linked Securities 2008
22
Contingent Capital: Poised for a Comeback
Conditions favor the inclusion of this diversifying solution
As enterprise risk management becomes more prominent, insurers are actively managing
the accumulation of correlated exposures while maintaining financial flexibility and the
ability to withstand multiple catastrophes in a single period. However, given the relatively
benign wind seasons in the United States since 2006, coupled with the fact that many
recent catastrophes have resulted in little insured loss, many companies find themselves
in a strong capital position. These companies may find this an ideal time to implement a
contingent capital program.
External forces are also pointing to an increased use of contingent capital, as regulators
and rating agencies focus on risk mitigation and capital adequacy at much more remote
return periods. This, combined with the changes made to the catastrophe models
since Hurricane Katrina, has resulted in greater capital requirements and a need for
more comprehensive capital solutions. These trends have sparked greater interest in
insurance-linked capital market solutions.
Structural changes to the form and source of contingent capital, including the expansion
of trigger options, may make this solution more attractive to all counterparties.
The Capital Conundrum: A Balancing Act
Capital preservation is fundamental to protecting policyholders and providing adequate
returns to shareholders. Management teams grapple with how best to maintain a
strong balance sheet and provide adequate returns to shareholders while retaining
financial flexibility.
In a favorable balance sheet environment, corporate boards often consider returning excess
capital to shareholders by repurchasing stock. Today’s low price-to-book multiples heighten
the attractiveness of this option. Repurchases, however, ultimately weaken the balance sheet
and expose the company to distress after a large event, when recapitalization may be more
costly and difficult.
Post-event flexibility is paramount; it is the time when companies take advantage
of a hardening market to recoup losses and refortify the balance sheet. Risk transfer
solutions, such as traditional reinsurance, provide protection from extreme losses and
aim to prevent surplus erosion, but do not explicitly provide post-event flexibility.