Alternative Risk Transfer ART for Corporations

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Alternative Risk Transfer (ART) for Corporations

• Progressive tax rates induce firms to reduce risk
• Different tax treatment provides a tax benefit to
  insurers
• Tax treatment of depreciated property provides a
  tax benefit to property insurance
• Risk reduction increases the benefit of debt
  financing
• Government regulations requires business to
  purchase insurance and influences insurers
  choice
• Effect of accounting rules on risk management

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ART Key Features

• First Introduced in USA
• Mechanisms that made it easier to insure firms
  own risks, by means of captives, risk retention
  groups.
• Now includes finite insurance and reinsurance, as
  well as risk transfer by capital markets.

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Channels
--Captive Insurers
Solutions
Alternative
--Finite risk --Multi-year/multi-line products
(MMP) --Multi-trigger products (MTP) --Contingent
capital
Risk Carriers
--Insurance bonds --Insurance derivatives
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ART Key Features

• Alternative Distribution Channel
• Firms own captives
• Alternative solutions
• Finite productsemphasize on financing
• MMPcombine different classes of insurances
• MTPWhen insurance and non-insurance loss events
  occur simultaneously within a time frame
• Contingent CapitalFinancing of losses at
  conditions agreed upon in advance

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ART Key Features

• Alternative Risk Carriers
• Capital market investors directly involved in
  insurance risks
• Insurance-linked bonds and derivative instruments

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ART Advantages

• Improve Efficiency
• Participation in own loss development
• Eliminate credit risk
• Reduce Over-insurance
• Increase Capacities
• Financial markets are capacity providers
• Increase diversification effects
• Expand spectrum of insurable risks
• Diversification over portfolio and time

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Development of ART

• ART
• Closely linked to capacity bottlenecks and price
  cycles in the traditional insurance markets
• Often first developed in response to direct
  tactical considerations, but later become
  indispensable for long-term strategy.
• Driven by changes in client needs and prompted
  increasing convergence of banking, insurance and
  capital market solutions.

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Reasons for ART Development (I)

• Shifting risk landscapes
• Risks have been changing in past years
• Globalization of many markets
• Technology advances
• ..
• Figure 4 5 in handouts

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Reasons for ART Development (II)

• Increasing pressure from shareholders during past
  twenty years
• Influence from shareholders grew significantly
• Risk management has been changing to create more
  shareholder values

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Reasons for ART Development (II)

• Advantages to transfer risks
• Reduce the threat of financial distress and
  associated costs
• Safeguard future earnings
• Tax shield advantage
• A sign of good management
• Safeguard the management
• Other service provided by insurers

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Reasons for ART Development (II)

• Insurance roles in risk management
• Allow firms to have higher leverage
• Safeguard the financing of planned investments
• Free up capital that can be reinvested in
  projects earning higher returns

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Reasons for ART Development (II)

• Why risk should be insured or transferred?
• Allow firms to focus on their core skills
• Diversification of risk portfolios
• Lower premium and deductibles
• Lower volatility (Figure 6)

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Reasons for ART Development (III)

• Inefficiencies of traditional insurance solutions
• Structural inefficiencies
• Limited capacities
• Good risks subsidize bad risks (adverse
  selections)
• Incentives to reduce loss prevention measures
  (moral hazard)
• Credit risks for policyholders
• Basis risks

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Reasons for ART Development (IV)

• Developments on financial markets
• Convergence of insurance and financial markets
• New financial instruments have been created to
  hedge systematic and non-systematic risks

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Most Important Forms of ART

• Captives
• Finite risk
• Integrated multi-line/multi-year products (MMPs)
• Multi-trigger products (MTPs)
• Contingent Capital
• Securitization of risks
• Insurance derivatives

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Captives

• An insurance or reinsurance vehicle that belongs
  to a company or group of companies that is not
  active in the insurance industry itself
• Insures the risks of its parent company
• An instrument for self-financing risks
• Often conceived as reinsurance companies
• See Figure 9

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Captives

• Dominant form
• Single-parent captives
• Special Purpose Vehicles (SPV)
• Efficiency Gains
• Participate in ones own claims experience
• Tax and financial advantages?
• Strategic Benefits
• An instrument of holistic risk management

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Captives

• Grow consistently after introduction
• Premium volume at USD 21 billion
• 6 of global commercial insurance market
• Penetrated in US, UK, Sweden and Norway
• See Figure 10 and Table 2

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Finite Risk

• Based on the spreading of individual risks over
  time
• Key features
• Assumptions of limited risk by insurer
• Multi-year contract term
• Sharing of result with client
• Explicit inclusion of investment income

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Finite Risk

• Types (Past)
• Loss portfolio transfers (LPTs)
• Policyholders transfer outstanding claims
  reserves to the insurer
• Retrospective excess of loss covers (RXLs)
• Offer broader spectrum of cover than LPTs
• Often includes IBNR losses
• No transfer of outstanding claims reserves

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Finite Risk

• Types (Present)
• Financial Quota share reinsurance (FQR)
• Prospective excess of loss covers (PXLs)
• See Figure 13, 14

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Finite Risk

• Depends on tax regimes and regulatory conditions
• Global volume at USD 6 billions
• More than 2/3 generated in US
• Strong Demand for solutions that combine finite
  and traditional insurance elements

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Integrated multi-line/multi-year products (MMPs)

• Combine different categories of risk in one
  product
• Key features of MMPs (Figure 15)
• Bundling of different categories of risk over
  several years
• Allow substantial risk to be transferred
• Level of the liability limits and the inclusion
  of alien risks have been biggest challenges

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Integrated multi-line/multi-year products (MMPs)

• Benefits for policyholders
• Efficiency gains
• Stabilization of risk costs
• Administrative efficiency
• Flexibility

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Integrated multi-line/multi-year products (MMPs)

• Hurdles for slow growth
• High transaction costs
• Credit risks
• Limited offerings
• Traditional organization of risk management
• Lack of clarity on accounting and tax regulations

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Multi-trigger products (MTPs)

• Based on a holistic approach
• Key Features
• Two triggers for claims to be paid
• An insurance event
• A non-insurance event
• Possibilities are endless when linking the
  different triggers

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Multi-trigger products (MTPs)

• Key benefits
• Protection provided from disaster scenarios and
  price falls in equity or bond markets in the same
  financial year
• Price advantage
• Hurdles
• Same as MMPs

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Contingent Capital

• Key features
• Raising capital on terms agreed in advance or put
  options with an insurance event as an additional
  trigger
• A prerequisite for raising capital is the
  occurrence of an insurance loss

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Contingent Capital

• Benefits to policyholders
• Liquidity supply
• Efficient use of employed capital
• No impact on the balance sheet until the option
  is exercised

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Securitization of insurance risks

• Securitize catastrophe risk portfolios
• The insurance risks may not be limited in
  catastrophe risks
• Key Features
• Yield depending on a specified insurance event
• Forming special purpose vehicle with the
  capital raised
• E.g. Catastrophe bonds, See Figure 16

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Securitization of insurance risks

• Benefits
• Additional capacity without credit risks
• Efficiency advantages with independent triggers

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Insurance derivatives

• Use financial market instruments for controlling
  insurance risks
• Futures or options for natural catastrophe risks
• The extent of the effective insurance cover
  depends on the correlation of the index with the
  policyholders effective claims developments

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Insurance derivatives

• Benefits
• Additional capacity and low transaction costs due
  to securitizations to financial market
• Moral hazard problems are minimized
• Trading volume not really taken off yet
• Main purpose is to expand capacity at the
  reinsurance level

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Outlook

• ART solution is a complement to traditional
  solutions, not a replacement