While the insurance industry may seem awash in capital at the moment, it would not take much to radically alter that perception.

As chief deputy director of the Illinois Insurance Department, Arnold Dutcher has played an active role in promoting the securitization of risk insurance primarily through his efforts to pass the legislation that permits Illinois domestic insurers to securitize through so-called protected cells, which comforts investors who seek to avoid assuming an entire carrier's liability to take part in the offering.

Speaking at the fall conference of the National Association of Insurance Commissioners, Dutcher painted a picture of a vengeful Mother Nature quite capable upsetting the industry's financial apple cart with barely a moment's notice.

"The event that woke us up was a little storm called Andrew," Dutcher said. "According to computer modeling, had it gone ashore about 40 miles north it would have cost about $50 billion rather than the $16.5 billion, so it becomes just a matter of luck as to the magnitude of those losses."

He noted that the Insurance Services Office predicted that about 36% of the carriers covering the losses would have been made insolvent as a result of such a storm, leading to an exhaustion of state guaranty funds and up to $54 billion in unpaid claims.

"The conclusion is that the capital out there dedicated to catastrophic events is simply not sufficient to fund the kind of events that might occur in this country," he said.

And while earthquakes may seem a part of the California lifestyle, Midwesterners are not immune. Dutcher noted that if the New Madrid Earthquake of 1811, which registered 7.6 on Richter scale, took place today, it would have devastated the metro areas of St. Louis, Indianapolis and Memphis as well as disrupted east-west commerce to an unthinkable extent. Some computer models have estimated a replay of that disaster to incur losses of up to $100 billion.

While securitization may provide some answers, other factors must be taken into the equation.

Statewide building codes must be beefed up and the ISO is studying a ratings system similar to the fire codes in which building owners who keep up to code are rewarded with lower earthquake rates.

"But this will be quite a political process in the states," Dutcher said.

Other steps to increase the availability of capital include government-sponsored pools, pre-loss reserves and state and federal disaster relief.

While the current soft reinsurance market may seem to preclude the necessity for developing the securitization alternative, Dutcher said such an environment is ideal for working out the kinks of any new system.

"Right now is a very good climate to develop and mature securitization, to get investors comfortable with it and get the structure in place," Dutcher said.

The appeal of the securitization market is obvious. "We see it as a tremendous source of capital because there is an excess of $30 trillion that would be tapable by insurers compared to only $350 billion net worth of capital in the industry."

Today Illinois and Rhode Island are the only states with protected cell legislation, but that could change as the NAIC Financial Conditions Subcommittee recently adopted a model law that could spur other states into action and help capture some of the market for domestic carriers that has been going offshore for the past three years.

"The statute isolates the insurance company and has legal authority to transfer insurance liabilities into that protected cell," Dutcher said. "If the insurance company itself enters into insolvency proceedings these assets are walled off and may be used for only one of two purposes: to pay back the debt or in the event of a catastrophic event, to pay off the policy holder obligations."

The protected cells require no additional capital and since the interest earned on the assets offset the interest credited on the debt issue there is no tax factor, Dutcher said.

Securitization does not constitute the business of insurance except for the one kind of an indemnity triggered debt security in which there is a counter party risk.

"In other words, the investors have not fully funded the transaction and actually purchased the bonds, they enter into an agreement whereby after an event the investors become obligated," Dutcher said.

All this is necessary to satisfy investors, said Dutcher.

"They like these because they act as a hedge to an economic portfolio. This is the only financial instrument out there whose performance is not tied to the economy of the country or what the federal reserve does or unemployment or inflation," Dutcher said. "It is being looked at by managers of portfolios of pension funds or life insurance companies as a very good hedge against a downturn in the economy. So there is a lot of interest in the investment community for reasons other than wanting to go into the insurance business."

Protected cells are not the only mechanisms being looked at by regulators for expanding the securitization market in an orderly fashion.

The special purpose reinsurer is formed for the sole purpose of the issuance of an insurance-linked bond and retains the insurance risk by entering in an excess of loss reinsurance arrangement with a U.S. commercial carrier that is regulated in the U.S. as an unauthorized reinsurance transaction.

All such transactions but one have been through a special offshore reinsurance company.

"To do it in the U.S. it would have to be formed as a regular insurance company which means it would be subject to rather material capital requirements and stringent accounting rules making the transactional cost to do it in a U.S.-based location very expensive," Dutcher said.

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