Graduate School of Business Administration University of Virginia CATEX

Transcription

1 Graduate School of Business Administration University of Virginia CATEX The Catastrophe Risk Exchange (CATEX) ( had found a strategic niche, to say the least. Not only had the company created a profitable Internet site, but it had also managed to add value to an industry without displacing any of the traditional players and had done so without attracting competitors. The goal of CATEX was to bring global insurance buyers and sellers together via a common electronic trading floor and to automate the flow of information and transactions between CATEX trading partners. The company was founded, by Frank Fortunato and Frank Sweeney in 1996, in response to the increased risk faced by insurance companies because of a series of catastrophic events. The insurance industry, as a whole, found itself in a changing environment in the early 1990s owing to a significant rise in the magnitude of insurance losses from natural disasters. Fortunato and Sweeney recognized that if insurers could find additional ways to diversify their risk, they would be less exposed to large losses from any single disaster. CATEX was originally designed to be a place where property and casualty insurers could go to swap risk with other insurers an infrequently used mechanism for reinsurance. Over time, however, it had evolved into a marketplace where bearers and insurers of risks could meet and negotiate a wide range of traditional reinsurance contracts. CATEX was originally created before the advent of the Internet. In the original system, each subscriber was given a software package that it used to dial in to CATEX. If the subscriber wanted to shop a risk for sale, it would have to poll every other subscriber individually. The Internet provided CATEX with the ideal forum for a full-featured risk exchange. Subscribers could post a risk for sale and reach every other subscriber with virtually no effort. Before CATEX moved to the Internet in late 1998, the company had approximately 50 subscribers representing 300 users. The 15 months after the Internet version was released saw tremendous growth in the number of subscribers, to 170 representing 2,000 users. Advances in technology were key to the success of CATEX. This case was prepared by Carolyn Cooley, Pam Smeder, and Amy Zahratka under the supervision of Professors Dana R. Clyman and Kenneth M. Eades and is intended for illustrative purposes only. We gratefully acknowledge the sponsorship of PricewaterhouseCoopers. Copyright 2000 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an to dardencases@virginia.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the permission of the Darden School Foundation.

2 -2- Reinsurance The traditional players in the reinsurance industry were insurance companies, reinsurance brokers, and reinsurance companies. Some large firms, typically Fortune 1000 companies, would self-insure to a certain extent and then use reinsurance for higher levels of risk. (Exhibit 1 displays a breakdown of the CATEX subscriber base.) Eighty-two of the world s largest reinsurance companies were CATEX subscribers as of late These companies represented more than $350 billion of premium capacity, a significant percentage of the world s reinsurance market. 1 Moreover, 26 of the world s major insurance and reinsurance intermediaries (brokers) were also CATEX subscribers. These companies had complete access to the system and could post and respond to offerings on behalf of their clients for both ceding and assuming risk. There were 46 companies subscribing to CATEX under the Buy Only subscription package. These companies included the risk managers of Fortune 1000 companies and primary-insurance companies representing an estimated $770 billion of assets at risk. These subscribers used the system to cede their risk exposures to the CATEX markets, both directly and via the subscribing intermediaries. They could post offers to cede risk only; they could not offer capacity to sell coverage themselves. CATEX helped its trading partners (the subscribers to its marketplace) increase revenues, increase operating efficiencies, lower costs, and efficiently manage their relationships with their trading partners. In particular, buyers and sellers of risk benefited from reduced search costs. Identifying a party to assume risk, which once took considerable time and money, could now be done with the click of a mouse. Buyers benefited because they had more choices, and sellers benefited because they had access to more buyers. Because the industry did not typically trade risk through swap transactions, the types of transactions on CATEX evolved from the swaps to the more typical transactions used by the industry to buy and sell risk. The exchange also evolved in another way. Many of the early transactions executed on the system involved small portions of risk. For instance, if an insurance company had $100 million of risk to sell, it might sell $90 million through its traditional reinsurance brokers, and post only the remaining $10 million on CATEX. As users became more familiar with the CATEX system, however, more and more of the risks were posted to CATEX. 1 Each reinsurance company had a certain amount of risk it could take on. For this risk, the company received a premium. The premium capacity was a measure of the total amount of premium the company would receive for the risk. This measurement was significantly smaller than the size of the actual risk taken on.

3 -3- Example of a traditional reinsurance contract The following example describes one of many possible transactions in the reinsurance industry s retrocessional chain. An insurance company (e.g., State Farm) insures 10,000 homes in Dade County, Florida, for $50 million. State Farm then assesses its risk portfolio and determines that it is exposed to more risk in Dade County than it can afford. The company determines that it will retain the first $20 million of the $50 million and sell the residual $30 million as shown below: $50-million State Farm risk $30 million sold to reinsurer $20 million kept by State Farm In exchange for accepting the $30 million of risk, the reinsurance company charges State Farm a monthly premium. If there were a disaster in Dade County resulting in $35 million of damage, State Farm would be responsible for the first $20 million and the reinsurance company would be responsible for the remaining $15 million. The reinsurance company, however, might not retain the entire $30 million of this risk, but instead might only keep the first $10 million and sell the risk above $30 million to another reinsurer. $30-$50 mill. $20-$30 mill. $0-$20 mill. Selling the higher levels of risk in this case, the $30-$50-million layer would usually be fairly easy to do because it would be unlikely that this high level would be pierced. There could be 7 to 10 parties involved in a typical retrocessional chain for any particular set of risks, and the risks might be subdivided in a variety of ways. For example, not only could the risks be split into layers, as described in the preceding example, but the layers could also be sold in proportional slices. Primary-insurance companies and large companies seeking reinsurance normally went to a reinsurance agent, who found a reinsurer for the risk. The broker fees for typical transactions ranged from 5 to 15 percent for providing these services and brokering the deal, as the reinsurance business was predicated on broker relationships with underwriters at the various

4 -4- reinsurance companies. Because the industry lacked pricing transparency and access to information was limited, brokers commanded substantial power within the value chain. The CATEX Model CATEX provided a neutral setting where all the players could look for information. Membership in CATEX was open to risk bearers and their subsidiaries and affiliates, as well as to reinsurance intermediaries. Subscription fees, CATEX s primary revenue source, included an annual subscription fee and a trading commission of 0.1 percent of the premium on the sale of reinsurance. Reinsurers and brokers could purchase a seller s license for $2,000 a month. The seller s license allowed the subscriber to post a risk to be traded (swaps were occasionally done) or sold on the system. Primary-insurance companies and self-insured companies could obtain a buyer s license without charge. The buyer s license gave subscribers access to the postings of sale items and the ability to negotiate through the system to purchase them. As of late 1999, approximately 90 percent of the company s revenues still came from subscription fees. As more transactions were completed, however, this percentage would continue to decrease. In essence, CATEX functioned as a listing board where sellers and buyers could meet, negotiate, and subsequently close transactions. A typical transaction began when a seller posted a risk on the system. An important feature of the system was the preservation of anonymity for both the seller and all potential buyers. Each subscriber was given a username upon becoming a member of CATEX. When a user posted a risk for sale, however, neither the seller s name nor username was posted with the transaction. Anonymity helped to move bids competitively, which in turn helped to create a more efficient market-clearing price. Potential buyers then logged on to the system and could look through the posted risks. The buyer could find details about the risk, including what type of market it was in, the type of risk instrument, where the risk was located, the currency, and term. If a buyer was interested in learning more about the particular risk, the buyer could send an , through the CATEX system, to the party who posted the risk. CATEX also offered real-time text dialogue, online conferences, and collaborative document processing to facilitate negotiations between parties. The parties could either continue to negotiate anonymously or, at any point, request that CATEX reveal their identities. If the parties continued to negotiate anonymously, there was an automatic disclosure point before the close of the transaction where the parties identities were revealed. When an agreement was reached, the terms of the agreed-upon trade could be finalized by traditional paper methods or through the CATEX Deal Mail facility, which could be used to construct an electronic proposal or slip. All transactions completed through CATEX were posted real-time, including such details as strike price and deal size. This feature created pricing transparency, which greatly benefited

5 -5- an industry plagued by inefficiencies arising from lack of accurate and timely information. Thus, a subscriber could go to CATEX and find information on transactions similar to the ones that the company subscriber was involved in information that simply was not available anywhere else except anecdotally through personal relationships with reinsurance brokers. This new information source changed the way reinsurance risks were negotiated and transacted; and while this information was a great benefit to the subscribers, even greater was the benefit associated with conducting transactions on CATEX, where more than 90 percent of subscribers had completed transactions. The marketplace also provided subscribers with access to valuable research tools and related information sources, including insurance- and financial-news services and ratings and financial data for individual companies. Because the system brought together buyers and sellers directly, it was a potential threat to reinsurance brokers. CATEX worked diligently, however, to include brokers in its family of trading partners and to help them become beneficiaries of the system as well. CATEX afforded brokers a global distribution channel for their products and services. Data mining of the CATEX market board gave brokers the opportunity to develop new relationships with insurance carriers, risk managers, reinsurers, and risk bearers. The system also provided a forum for brokers to explore new products or coverage opportunities with the trading community. Brokers remained an important link in the retrocessional chain because they continued to advise clients on ways to structure risk, a service that CATEX did not provide. One of the greatest benefits provided by CATEX was the new ability to shop a risk to hundreds of potential buyers at once. Prior to the exchange, a company would rely on a broker to sell risk, but the broker might have contacts with only five reinsurance companies. A deal would only be completed if one of those companies wanted to buy the risk at a mutually agreeable price. The risk exchange created a forum where a risk could be presented simultaneously to scores of potential buyers, thus providing a greater likelihood of getting the best possible deal. For this reason, CATEX was sometimes referred to as the electronic Lloyd s. Although CATEX originated as a marketplace for catastrophic risk, other risks were also traded (e.g., aviation and aerospace, accident and health, marine, energy, politics, weather, credit, and auto liability). Since start-up, 60 percent of the postings had been for risk other than catastrophic. As of late 1999, more than 1,400 risks had been posted on the exchange, with more than 350 completed transactions totaling more than $1.7 billion of insured limit. CATEX had also been successful at achieving a large and growing subscriber base in more than 80 cities around the world. Through easy transacting, low costs, and access to global players and global risks, CATEX made the process of risk diversification both efficient and effortless. Because of these factors, the company expected the volume of transactions in the overall reinsurance market to

6 -6- increase. What once took a company several calls and meetings to find the appropriate counterparty and price could now be accomplished through the click of a mouse. Companies were more likely to post risks that previously might have been too time-consuming or expensive to sell. Such success on the Internet generally drew competitors quickly. CATEX, however, stood alone. Somewhat unknowingly, the company had insulated itself from the threat of entry by a new party. The founders had worked very hard in the beginning to understand the needs of the industry players and to provide a service that added value by affording a first-mover advantage through the use of a large and growing subscriber base that included many of the most influential players in the industry. Moreover, CATEX was registered in New York as a neutral intermediary, and the exchange s by-laws were structured in such a way that no sector of the insurance or reinsurance industry was unfairly affected or excluded, thus maintaining the integrity and impartiality of the exchange at all times. Furthermore, by obtaining the New York license, CATEX realized a great source of competitive advantage as it was the only license of that sort that had ever been issued. The license gave CATEX the power to act on behalf of its clients in a neutral capacity. In addition, the license also provided a natural enforcement of CATEX contracts. If a subscriber did not perform on a contract, that subscriber could be subject to the loss of its New York insurance license; as a New York insurance license was critical to any company s ability to do business in the United States, CATEX s license, in effect, gave it de facto authority to enforce contracts something that was critical to the success of any market. CATEX received venture capital from Science Applications International Corporation, and was also backed by E.W. Blanch Company and Sculley Brothers, LLC. The backing of E.W. Blanch was significant as it was a reinsurance broker.

7 -7- Exhibit 1 CATEX CATEX Subscriber Base Primary Insurers and self-insureds 30% Brokers 20% Reinsurers 50%