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The Actuary The magazine of the Institute & Faculty of Actuaries

Destroying value in an insurance company

Underwriting film productions has been an embarrassment for insurers. ‘They came to Hollywood, fell in love with the glitz, threw more than a billion dollars at it and got burned.’
You are a budding George Lucas with a wonderful idea for a film. You will create a screen-based musical themed on the rise of the best rock group ever Slade. Your lead actor will be Noddy Holder, who wants a paltry £1m for the privilege. Other actors, a special effects team, and the film studio rental will cost you another £2m. Easy. Go to your local friendly bank and ask them to lend you £3m. Or maybe not.

First go to some sales agents and tell them the genre of your film. They may offer you a ‘pre-sale’. This means they guarantee now to give you a fixed amount on delivery of your film. They may give you a small deposit now, if you are lucky. Chances are you still have no money in your pocket to start production.
Now you go to a bank and borrow money using the agreed pre-sale as collateral. The bank is worried you may not deliver the film on time and within budget. So they ask you to arrange a completion bond, where the bank will advance the funds for production (the strike price), provided an insurer will guarantee completion and delivery of the film within the strike price. The completion bond will provide extra funds to finish the film if it goes over budget, and will also repay the bank loan with interest and expenses if you don’t complete the film. This completion guarantee could cost you 610% of the film production costs.

Easy money
In the early 1990s it was that easy. It was possible for production loans to be fully collateralised by pre-sales. By the mid to late 1990s things had changed. More films were being made than ever before. Sales agents didn’t need to guarantee pre-sales to ensure a future supply of films and commission. They could wait for the finished product and have their pick. In addition, film-making costs, at least those of the major producers, were increasing faster than was box office income.
In this tougher environment, pre-sales and other current assets would often cover only around 75% of the required production loan. Although this was more risky for banks, they continued to lend the amounts required. As collateral they used future estimated rights which had not been pre-sold, based on sales agents’ estimates of box office and other income. Of course the bank had to place trust in the sales agent, and measured predicted sales in unsold territories against pre-sales achieved in other territories, to ensure predicted sales would significantly exceed the funding gap. Pre-sales pay off at delivery. Without pre-sales there will be a delay, say six months, between delivery and income generated. Therefore, in the case of gap finance, the bank allowed for future interest charges after the film delivery date, and predicted sales needed to cover this too. To cover the extra risk, the bank charged 510% of the gap, on top of standard interest charges.

Time-variable contingencies
By around 1996, low levels of pre-sales were leading to ever-increasing finance gaps. Banks shied away from the increased default risk. It was increasingly difficult to persuade investors to put equity behind studios and productions. Enter the insurance industry. An insurance product (initially called time-variable contingency) was created. This insurance would guarantee that, if film revenue fell short of the amount required to pay off the production loan within two to three years, the insurance company would pay off the difference.
In practice, banks used brokers to place the insurance, paying a broking fee. Insurers appointed risk managers to investigate the insured risk (including sales estimates), and to make recommendations on managing the risk. The risk managers received a fee based on the insurance premium.
These insurance policies cost around 615% of the sum insured. However, since the banks could rely on the insurance company to make good the loan if things went bad, rather than the sales agent to achieve the predicted sales, the bank charges for the gap finance reduced significantly from 510% of the gap to around 1%, plus interest.

To recap
– There are limited pre-sales.
– The bank agrees to finance a small gap.
– The market is flooded with independent films, many of which have limited distribution.
– Film production expenses are increasing.
– The funding gap increases.
– Equity is scarce.
– The banks are scared.
– The risk has increased significantly, but the overall cost to the studio has not increased in proportion.
Doesn’t it look just a little risky for the insurers? Although, as one commentator said: ‘Unlike banks, insurance companies have done an “actuarial” analysis of the industry.’ Phew.

The benefits of hindsight
Following large amounts of claims, these insurance policies have dissolved in a mass of litigation.
Some of the reasons include the following:
– When is a film deemed ‘delivered’? Historically, insurers behind completion bonds may have agreed to slippage in the initial delivery date, since otherwise they would definitely have to pay a full claim. Sales agents would also accept this later delivery, to give them a chance to earn their delivery fees. Gap film finance insurers would prefer to invalidate the insurance if the film is not delivered on time if this would avoid a claim.
– When is a warranty not a warranty? In one case there was a statement in a policy saying ‘ Productions will produce and make six made-for-TV films’, though there was no specific warranty in the policy to that effect. Only five films were made. The fronting insurer paid up and the reinsurer refused.
– Can an insurer refuse to pay if there has been misrepresentation or non-disclosure? In some gap film finance policies, there is a rather frighteningly named ‘truth statement clause’, which distances the insured (ie the lending bank) from misrepresentations of the agent, since the bank does not necessarily have perfect knowledge of the planned films and their potential. A typical disclosure/rights waiver provision may provide that ‘ZZ Insurance Ltd agrees not to seek to reject any claims etc, on the grounds of invalidity or unenforceability on non-disclosure or misrepresentation by any person’. The courts have ruled that this clause is so effective that, unless the insurer can prove fraud by the broker, it must pay.
Financial guarantees or not? On default of the financial notes, financial guarantees pay first and ask questions later (if at all). Some banks assumed they were getting failsafe financial guarantees, while insurers assumed they were insuring income flows from a given set of films and if the films were not produced, they shouldn’t have to pay.
As one industry figure commented: ‘The insurance companies were more than happy to take the premium income, but as soon as they had to pay substantial claims they reneged. They had plenty of advisers, but now because they are suffering losses they are trying to wriggle out of paying.’

Where are the lessons?
Huge losses, huge amounts of litigation for insurance companies. So, what went wrong and can we ensure we don’t do it again?
Maybe the pricing was ‘actuarially’ correct, and insurers had a run of bad luck. Maybe there is an element of learning from emerging experience, with the future profits resting with the insurers with the most tolerance for short-term losses.
Perhaps we did not look at the full picture. The entertainment industry is generally successful overall because a few blockbusters make all the money, covering losses for the many films that do not break even. In 2001 the top 4% grossing films accounted for 40% of US box office. Anyone pricing a new insurance product, which closely competes with other financial solutions, should consider this factor. Industry comment suggests studios were falling over themselves in the rush to protect their downside without giving away much of the upside (ie equity).
Instead of calculations based on the insurer’s view of risk, careful consideration of the studio’s viewpoint, comparing the total costs of equity and other forms of finance (with and without insurance) may have given clues on future claims. Similarly, an attempt to consider the Standard & Poor’s (S&P) rating of a vehicle without insurance may be enlightening. After the emergence of problems, Hollywood Funding #5 and #6 were downgraded from AAA to CCC- when Lexington made its disputation of payment clear. However, Hollywood Funding #4, not yet in the same trouble, had its AAA rating lowered to BB.
Consider the point of view of the designer of the asset-backed security (ABS). An insurance wrap from a AAA insurer is one way to get a AAA rating from S&P. An alternative is to over-collateralise, ie put an extra film in the ABS, but borrow the same amount. There is a cost to the studio of effectively mortgaging a film to provide this extra security in the vehicle, and this can be compared to the cost of insurance.
Whether or not the pricing was wrong, from a risk-management standpoint further issues emerge. There were cases where;
– management did not realise 60% of the premium in their well-established standard contingency account was from insurance-backed film finance;
– management did not realise that fronting was occurring;
– insurance companies’ exposure to a series of losses was not properly controlled;
– risk managers may have had a significant financial interest in ensuring the insurance was placed
– there was in-built moral hazard, since insurers underwrote a large proportion of the production budget, enabling businesses to be launched with limited personal risk to the owners.
Would we do it again? Well you’re the actuary and you advise your organisation. You tell me

Some examples
Some insurance examples widely quoted are:
– An insurance of Law Debenture Trust (LDT) a corporate vehicle for a consortium of investors. LTD received security for financing from HIH. The policies covered any shortfall in revenue earned by films co-produced by 7.23 Productions and by Rojak Films Inc. This was a fronting arrangement, with HIH being reinsured by Axa Reassurance SA, New Hampshire, and Independent Insurance Company Limited.
– Six Hollywood funding deals these tend to be asset-backed securities, ie stand-alone companies (‘vehicles’), whose assets are one or more films to be produced, and their expected revenues. These vehicles are separated from the studio producing the films, and banks and other investors can invest in fixed-interest securities, that will, of course, default excepting insurance payouts if the films are duds.
– Hollywood Funding #2 was a 1996 project to provide around $70m funding for a US studio called Phoenix Pictures. Chase Manhattan funded this vehicle and asked brokers to place an insurance to protect against default. A well-known broker placed the insurance and the Phoenix slate was born. Films insured included The Mirror has Two Faces, and The People vs Larry Flint.