Contingent Cover Insurance: Options on Future Insurance Contracts

Book: Structured Finance and Insurance: The ART of Managing Capital and Risk Author: Christopher L. Culp Publisher: Wiley Finance, 2006 ISBN: 978-0-471-70631-1

This is a shorter chapter, but the concept is neat. Contingent cover is basically an option to buy insurance. You pay a fee now. In return, you get the right to enter into a (re)insurance contract later at a prenegotiated premium on predefined terms.

Think of it like locking in your rent before the landlord can jack up prices. Except the “rent” is your insurance premium, and the “landlord” is the entire insurance market shifting into a hard cycle.

Why Companies Want Price Protection on Insurance

Insurance premiums are not stable. They swing through underwriting cycles. In the US, the peak-to-peak cycle runs about six years. During soft markets, premiums are low and capacity is abundant. During hard markets, premiums spike and coverage gets scarce.

Several things drive these cycles. Equity market returns affect insurers’ reserve portfolios. Business cycle downturns raise the riskiness of underwriting. And large catastrophic loss events, things like 9/11, drain aggregate industry capital and force rates up across the board.

For companies buying insurance, this creates a real problem. Your risk hasn’t changed, but your insurance costs just doubled because a hurricane wiped out someone else’s portfolio.

Culp notes that while in theory insurance rates should be forward-looking (based on expected future losses), practitioners know that recent big losses absolutely push rates up. Sometimes this is rational: expected future losses genuinely increased. But sometimes it’s just the industry replenishing capital after a hit.

Multiyear Coverage as Price Protection

The simplest form of contingent cover is just buying a multiyear policy. Lock in today’s soft-market rates for three to five years. It’s the insurance equivalent of issuing long-term fixed-rate debt instead of rolling short-term floating.

But there’s a catch. You can’t easily “swap” insurance maturities the way you can swap interest rate exposure with derivatives. There’s no liquid forward curve for insurance rates. So getting a multiyear quote requires negotiation, and the reinsurer may not want to extend current low rates.

Despite this, many reinsurers are surprised that companies don’t explore multiyear coverage more often. Companies tend to assume they’ll get bad terms and never ask. Culp thinks that’s a mistake.

Stand-Alone Price Caps

During the 1999-2002 soft market, several insurers offered stand-alone price protection products. These were separate contracts, essentially options, that referenced the terms of another policy. If premiums spiked, the option protected the buyer.

Sounds great, right? Almost nobody bought them. Risk managers apparently didn’t take advantage despite the obvious appeal. Reinsurance price caps existed too and saw essentially zero usage.

I find this fascinating. The demand for price protection should have been huge going into the post-9/11 hard market. But the products just didn’t get traction. Maybe risk managers didn’t believe the soft market would end. Maybe the premiums for the options seemed like wasted money during good times. Either way, it’s a missed opportunity that a lot of companies probably regretted later.

Contingent Cover Embedded in Multiline Programs

The more practical applications of contingent cover show up as features bolted onto multiline programs. Culp covers several types.

Optional reinstatement lets you pay a premium to reset an exhausted policy limit. This is critical in multiyear programs. If a massive loss wipes out your coverage in year one, you’re staring at two or three years with no protection. Optional reinstatement is your escape hatch. It’s basically an option to repurchase the same coverage after you’ve used it up.

Aggregate retention protection addresses the problem of many small losses that individually fall below the deductible but collectively add up to something painful. Say your multiline program has a $100 million per-occurrence deductible. You get hit with ten $50 million crime and fidelity losses. None of them trigger the policy. But you’ve just lost $500 million. Aggregate retention protection lets you pay extra premium to activate a new excess-of-loss layer specifically for that risk, with a lower deductible.

The nursing home example from the previous chapter used exactly this feature. It was comfortable with a $20 million retention but wanted protection in case a bunch of sub-$20 million claims collectively exceeded $40 million.

Optional limit acceleration lets you borrow coverage from future years. If your five-year program provides $40 million per year but you get hit with an $80 million claim in year one, you can accelerate limits: take $60 million this year and reduce a future year to $20 million. When that future year comes, if coverage is too thin, you can use optional reinstatement to top it back up.

Nth aggregate limit cover provides additional coverage after the program’s aggregate limit is exhausted. If your three-year program has a $400 million aggregate and you hit it after just two catastrophic losses, an Nth aggregate limit cover drops down additional capacity. You still need to exceed the per-occurrence deductible, but no new aggregate deductible applies.

Contingent Insurance-Linked Notes

The most sophisticated form of contingent cover is the option to issue cat bonds. Culp uses the Allianz example.

Allianz was worried that a major catastrophic loss would harden the reinsurance market and dry up retrocession capacity. Rather than scramble for coverage after a disaster, they wanted to lock in their options ahead of time.

Through an SPE called Gemini Re, Allianz sold investors subscription agreements in 1999. For an annual commitment fee, investors agreed that if Allianz exercised an option within three years, they would purchase three-year insurance-linked notes. The trigger: European windstorm and hailstorm losses reaching a specified level.

If exercised, the deal functioned like any cat bond. Note proceeds go into a collateral account, get swapped into LIBOR-based cash flows, and fund claims through a retrocession agreement. Noteholders bear the risk that principal and interest get diverted to pay claims.

The beauty is that Allianz arranged this during calm times. When a storm hits and reinsurance markets tighten, they can exercise the option and get coverage on terms negotiated before the panic.

Compare this to the Reliance III deal discussed earlier in the book. Reliance III was both contingent capital (new debt) and contingent cover (principal diverted to fund claims). The Allianz/Gemini Re structure was purely contingent cover without creating new debt on Allianz’s balance sheet.

My Take

Contingent cover is the insurance world’s answer to “I want options, not obligations.” Every embedded feature Culp describes, reinstatement, retention protection, limit acceleration, is really just an option. And options have value precisely because the future is uncertain.

What strikes me most is how underused the stand-alone price protection products were. The insurance underwriting cycle is well documented. Everyone knows hard markets follow soft markets. And yet when someone offered tools to hedge against premium spikes, almost nobody bought them. It’s the same behavior you see everywhere in risk management: people underestimate the value of protection when things are going well.

This wraps up Part Four of the book on structured insurance and ART. Starting next, we move into Part Five: case studies and issue studies from practitioners working in the field. Less theory, more real-world wrestling with the details.

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