CONVERGENCE PRODUCTS

(May 2022)

Convergence can be understood as creating financial products which consist of elements from insurance companies and credit institutions. Instances of convergence surround us, particularly with how we are offered many products and services. It is typically the result of market demand for lower prices and more efficiency. Convergence appears to be driven by technology as well as by the embrace of a broader perspective in addressing and identifying loss exposures. Convergence also is a response to market demands for insurers to provide more to investors in order to attract more capital. It is likely to affect both insurers and reinsurers.

Convergence products are another example of using non-traditional methods to address an entity's various loss exposures. Convergence refers to either an event (act of moving closer together) or a location (point where two or more things meet each other). Therefore, a convergent product is some manner of combination. Such combinations are not formal; they may involve more than two features and "what" is combined is only limited by the imagination of the entity offering the product.

Product convergence is accomplished in a variety of ways, combining different coverage aspects such as length of coverage, mechanics of how coverage is initiated (triggered), scope of coverage and timing of payment. Non-insurance sources of capital (such as banks and investment houses) are now becoming providers of funds for handling loss exposures that used to be the sole domain of insurers.

Businesses that have embraced the notion of enterprise risk management are demanding more creativity in how various risks are handled. Such businesses are also more sensitive to returns on investments (ROI), including the returns they receive from using traditional insurance products. Insurers that can provide more product approaches to efficiently handle different levels of loss exposure are in a better position to provide a higher return on a client's insurance protection investment. Insurers and reinsurers are more motivated to travel down new product paths.

Types of Convergent Products

Emerging product examples include:

• Dual Or Multi-Trigger Coverage
• Industry Loss Warranty
• Multi-Line Coverage
• Multi-Year Coverage
• Post-Loss Funding
• Sidecars

Related Article: Securitization

Dual or Multi-Trigger Coverage

Under traditional insurance, such as a commercial property policy, coverage is triggered by a single, eligible event.

Example: Acme Communications Manufacturers has a Commercial Property Policy from Same Ol' Fire and Casualty. It provides $10,000,000 coverage on a blanket basis to its three plants. Coverage is triggered by the occurrence of any eligible peril during the policy period, if the loss exceeds the $100,000 deductible.

Under a dual or multi-trigger arrangement, coverage is triggered by two or more events stipulated in the negotiated contract (a deductible may apply).

Example: Acme Communications Manufacturers negotiates a customized commercial property contract with Flexible Mutual. It has arranged for $10,000,000 in coverage. The coverage becomes effective if Acme suffers a loss in excess of $5,000,000 at its main plant and, at the same time, a business interruption loss exceeding six months occurs at its secondary plant on or after June 1st. Note that the secondary plant has a completely different set of suppliers and customers than the main warehouse that is located in a different region of the country.

The use of such triggers has become increasingly important in the design and issuance of catastrophe bonds that, commonly, provide excess of loss protection for catastrophic weather events, such as hurricanes or earthquakes but which are also used for other lines of coverage. Whether an insurer or a non-insurance entity provides multi-trigger coverage, the triggers are uncorrelated. The lack of correlation substantially reduces the probability that all of the qualifying events will take place. The lower probability increases the insurability of a given exposure and the cost is substantially less than what is available under comparable, single trigger policies. Typically, multi-trigger arrangements involve pairing an insurable event with some form of financial index rather than two or more insurable events. Under the former arrangement, there's a chance that the product will be treated as a financial derivative rather than an insurance policy (even if the contract is provided by an insurer).

The use of trigger combinations allows parties to better predict and price such arrangements using events that can be quantified and measured. The fact that the events are uncorrelated (and less risky), has opened gateways to capital markets that, in the past, were not accessible to insurers. Types of event triggers include:

• Indemnity trigger – activated by an actual, eligible loss.
• Industry index trigger – activated by an industry loss index (typically from a credible, industry publisher), such as an index of personal auto losses for a given year.
• Modeled loss trigger – activated according to the results of a parameters used in a given model that calculates a loss amount the contracting parties deemed is large enough to act as a trigger.

Example: Farmatron Inc. is a huge manufacturer of large farm machinery. It wants to protect itself against catastrophic losses that occur when the company may be particularly vulnerable. It arranges a policy with Outtabox Mutual that will pay for property losses in access of an aggregate of $20 million for a given year, but only if, in that same year, Farm machinery sales for the entire industry fall by more than 15% from the previous year.

• Pure parametric trigger – activated by the occurrence of a given event at a level of strength such as hurricane class, wind speed or earthquake magnitude
• Parametric index trigger – modification of the pure parametric trigger (see above), activated by a given event and a given level, but the event is more refined, for instance, applying to a certain location and more variables are used to determine the triggering event.

Related Article: Double-Trigger Contracts

Multi-Line Coverage

Essentially this refers to any coverage option that packages two or more lines of business that, traditionally, have only been offered as single line coverage. Various carriers, usually large line and niche (specialty) companies, provide such packages. Multi-line protection typically combines several coverages for a given client.

Example: Arky-tecks Consultants, Inc. has a "Consult-a-Pro" policy from Arkycaz Ins. Co. The package includes:

• Business travel
• Commercial property
• Employers liability
• Personal accident
• Professional Liability

The benefits of such coverage exist for both the insurance provider and the purchaser. Such packages often involve reduced underwriting cost, improved coordination of coverage (fewer gaps or redundancies), coordinated territorial coverage, higher account retention, improved loss handling, etc.

Multi-Year Coverage

This is another insurer option that was a common feature several decades ago and, in limited circumstances, is again available from certain providers. Multiple year policies usually involve single line coverage, but for up to three to five years. The chief benefit to a carrier is that it may help preserve market share and reduce policy production expenses. The greatest advantage to a purchaser is that the price and protection are locked in for the term of the contract. While the coverage and coverage cost are guaranteed, the market for such coverage is usually limited to cover narrow exposures since the applicable carrier would want to avoid long-term liability for volatile and expensive sources of loss.

Related Article: Finite Risk Reinsurance

Post-Loss Funding

These arrangements are usually (or ideally) pursued by large and well-funded entities. They may involve either a guaranteed loan or an addition of equity. Prior to a loss, a company may pay a commitment fee to a commercial bank (or other financial institution) in exchange for a guaranteed loan, large enough to handle specified losses in the future. Should a loss occur, the loan must be provided, regardless of the entity's creditworthiness at the time of loss. The borrowing company would be obligated to pay back the loan according to the repayment schedule previously negotiated.

Another form of post-loss funding is an injection of equity. In this instance, after a loss occurs, a financial firm issues shares and uses the proceeds to assist a company in handling certain losses. In either case, the funds are not arranged until after a loss occurs. The entity with the obligation to provide funds often hedge their position by arranging for separate reinsurance.

Industry Loss Warranty

This is a type of cat bond that is triggered by a combination of a given loss event (indemnity trigger) with an event that is tied to a given industry’s loss data that is used to create a loss threshold. This approach is similar to what has been used by the U.S. Government to provide a catastrophic layer of terrorism coverage. Its provisions are partially based on a given, high level of aggregate loss that must occur before excess protection is triggered.

Related Article: Terrorism and Insurance