Alternative Risk Transfer Products
Financial Products That Serve as Alternatives to Reinsurance
Matthew Glans
August 27, 2010
The following post contains a letter from Heartland Institute Senior Fellow Eli Lehrer, the national director of Heartland's Center on Finance, Insurance and Real Estate to the Florida Senate Banking and Insurance Committee responding to a request for comments on the Florida Senate Interim Project: "Financial Products That Serve as Alternatives to Reinsurance."
In the letter, Lehrer makes several suggestions on how alternative risk transfer products can provide a sound alternative to reinsurance and recommends that experimentation within the market with these products by insurers should be encouraged by the Office of Insurance Regulation.
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Mr. Steve Burgess
Staff Director
Senate Banking and Insurance Committee
The Capitol
Tallahassee, FL 32399
Dear Mr. Burgess:
The Heartland Institute is thankful for the opportunity to provide comments on the Florida Senate Interim Project: "Financial Products That Serve as Alternatives to Reinsurance."
Founded in Chicago in 1984, the Heartland Institute is a national nonprofit research and education organization, tax exempt under Section 501(c)3 of the Internal Revenue Code. It is not affiliated with any political party, business, or foundation. Heartland's mission is to discover, develop, and promote free-market solutions to social and economic problems. In the realm of insurance we favor sensible, minimalist, pro-consumer regulation of insurance markets. We have long taken a strong interest in Florida's insurance environment and maintain an office with a full-time staffer in Tallahassee. We have noted with concern the ways in which recent regulatory actions have tended to deemphasize the Florida Office of Insurance Regulation's proper core role of regulating the solvency of Florida insurers in favor of actions which serve the political interests and ambitions of the state's chief executive. In this context, we offer guidance and advice for your next project in the form of four major comments:
1. Alternative risk transfer products have a valid and valuable role to play in Florida's insurance markets.
Nearly all large and sophisticated insurers use means of risk transfer other than reinsurance in order to manage their risk portfolios. Florida's high level of exposure to hurricane risk and the current administration's political efforts to suppress insurance rates have placed many Floridians in danger and led to a flight of capital from the Florida market. Quite simply, politics is not currently allowing the Florida insurance market to work. Encouraging market experimentation with alternative risk transfer products is healthy and we wholeheartedly commend OIR Commissioner Kevin McCarty for encouraging it. Florida should continue to allow and even encourage their use by insurers.
2. The intrinsically uncertain nature of pricing for weather derivatives and other instruments deserves a high level of regulatory scrutiny in the context of solvency regulation.
Other comments you will receive point out that the possibility of gains from the use of derivatives and other means of alternative risk transfer, and how this possibility undermines the traditional understanding of insurance. This is true and worth considering. But it may not be that important: after all, returns on investment are the lifeblood of any business and insurers that can figure out ways to make gains are better competitors. A financial instrument whose only "disadvantage" was unexpected gains would actually be very attractive to just about everyone.
But these increases and decreases-and even the range of expected increases and decreases-will not necessarily correlate to the losses sustained by an insurance company's policyholders. This means, as a practical matter, that regulators can never accurately determine how much capital a given weather derivative or other, similar alternative risk transfer vehicle will actually add to an insurers' claims payment ability following a catastrophe. This is a major problem. The entire practice of solvency regulation, after all, relies on regulators ability to determine that insurers will be able to pay claims. Allowing an asset whose value is literally impossible to determine in advance to be used as a core source of capital for a company undermines the entire idea of what constitutes capital in the first place and brings into question the idea of solvency regulation.
3. Adopting different accounting rules than those used elsewhere in the country would likely continue the isolation of Florida's insurance market from the rest of the country.
As a result of burdensome regulations, political meddling, and overt government intervention in the market, Florida's insurance market is already characterized by a shortage of international and out-of-state capital. Nearly all national and international insurers operate in the state through separately capitalized "pup" companies and none are looking to write significant new homeowners' insurance business. If it adopted fundamentally different accounting standards, Florida would deepen the isolation of its insurance market from those elsewhere. Doing so would continue the trend of focusing Florida's risk on Florida.
4. If Florida is to change its treatment of alternative risk transfer products, the legislature should make the decision itself.
OIR's commissioner has asserted that he has independent power to allow reinsurance accounting treatment of alternative risk transfer products. Such a decision would be a truly radical step that would make Florida accounting standards unique in the world. Such a decision would intrinsically be a political one and any decent defense of its own prerogatives obligates the legislature to reserve this power for itself.
Conclusions
Alternative risk transfer products deserve additional consideration. Florida should work to promote their use. Particularly in the excess and surplus lines markets (where an increasing number of Florida's wealthier residents should purchase their coverage), greater use of such instruments could have a salutary effect for the state as a whole. But the legislature should be aware of the significant downside risks of allowing them to be treated in the same manner as reinsurance.
Yours truly,
Eli Lehrer
National Director
Center on Finance, Insurance and Real Estate
The Heartland Institute
1728 Connecticut Ave N.W.
Washington, D.C. 20009
(202)525-5719 / elehrer@heartland.org