Residual Value Insurance, Today’s Reality

By Thomas A. Orofino & Paul D. Dean

It was the shipping industry that gave rise to the world’s most innovative, and for many years, the world’s largest insurance market, Lloyd’s. It all began at John Lloyd’s coffee house as it was there that ship captains would gather before and after voyages to talk shop, trade stories of ships and cargos lost at sea. The insurance business then was a personal one as it was there that gentlemen would gather together with ship captains to negotiate the insuring of a ship’s cargo against loss at sea or a vessel’s final safe passage to its destination. Great care was taken to outline risks insured, undertaken/underwritten, by these gentlemen who pledged their personal fortunes to insure the safe outcome of a ship’s voyage. It was in John Lloyd’s café in London where the phrase “underwrite” came into being. Once the insurance contract was drawn up, the risk to be insured was outlined, the individual or “name” as it is know today, would sign his name and commit his personal fortune under the recitations of the insured agreement; i.e., he would “underwrite” his name to the contract.

Today the decision criteria, motives and the cyclic activity of banks and insurance companies have many similarities with the volatility involved in operating ships and their cargo. The challenge in financing the shipping industry as well as underwriting the future value of vessels is our focus in this article. It is our attempt in this article to draw the similarities between banking and insurance so as to explain how residual insurance is underwritten and why it is underwritten in the manner in which it is. Given the long history between shipping and insurance it is ironic that it is the shipping industry that utilizes the insurance industry’s capital to assist in ship financing the least.

Banking extends credit first and collects premium/interest over time. Insurance collects premium/interest first and extends credit or pays a loss, over time. The business cycles are similar: today’s banking market is characterized by “tight” money lending practices; the insurance markets are characterized as “hard” markets. Both these cycles were preceded by “soft” markets: easy money in banking and lose underwriting in insurance. Enron, Andersen, WorldCom, Tyco, and other events put an end to the soft markets. Both the insurance and banking markets, as well as their shareholders, are paying the price for these practices. Banks are writing off loans with failing borrowers. Insurers are paying millions of dollars in claims on Directors and Officers Policies for corporate entities, Errors and Omissions Policies for professional practices entities such as accounting and law firms and Surety Bond claims to financial institutions. To maintain the stability of the financial markets the Fed (US Federal Reserve) keeps it’s “window open” and lowers interest rate to maintain market liquidity. The lack of regulatory intercession in the insurance markets has produced a deeper and more pronounced market cycle than in banking. What do we learn from these cycles and where do we go from here? Certain lessons are learned the hard way; we have actually seen the aggressive “underwriting” practices lead to the demise of some insurance companies. We do not welcome this demise as it withdraws capital from this market, not a healthy event for the insurance market.

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