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Alternative Risk Transfer (ART), also known as structured insurance, provides unique ways to transfer the increasingly complex risks faced by corporations that cannot be handled by traditional insurance and has led to the growth in the use of the form of risk transfer. Alternative risk transfer combine elements of traditional insurance and capital market instruments to create highly sophisticated risk transfer strategies tailored for a corporate client’s specific needs and liability structure that traditional insurance cannot handle. For this reason, art is sometimes referred to as “insurance-based investment banking”. According to a September 2006 report by Conning Research & Consulting, traditional insurance covers roughly 70% of the commercial insurance market in the United states and the balance is provided by the alternative risk transfer [reference: “Alternative Markets: Structural and Functional Evolution”, Conning Research & Consulting, Inc., September 2006].

Insurance-Linked Notes [ILNs]

Insurance-linked Notes (ILNs) have been primarily used by life insurers and property and casualty insurers to bypass the conventional reinsurance market and synthetically reinsure against losses by tapping the capital markets.

Basically, an insurance-linked note [ILN] is a means for securitizing insurance risk. ILNs can be classified as single-peril and multi-peril bonds. The former ILNs are typically referred to as “catastrophe-linked bonds” or simply “CAT bonds“. Typically cat bonds are issued through a special-purpose entity.

CAT bonds are designed to protect insurance companies from events like massive hurricanes and earthquakes, which happen rarely but cause enormous damage. The bonds pay interest and return principal the way other debt securities do-as long as a catastrophe that causes losses above an agreed-upon limit doesn’t whack the issuer. For example, a San Antonio-based insurer floated a CAT bond issue with the loss threshold being $1 billion. As long as a hurricane didn’t hit their client for more, investors would enjoy their junk bond like yields of about 11%, and get their principal back. However, in the event of the losses exceeding $1 billion, the bondholders would lose their principal as well as the interest.

While cat bonds have primarily been used for perils such as earthquakes and hurricanes, corporations are using them in other ways. For example, the risk to the lessor in a leasing transaction is that the residual value of the leased equipment is below its expected value when the lease was negotiated.

Cat bonds are extremely high risk and high return, with not only insurance companies but also big corporate hedging catastrophe risk by issuing CAT bonds. CAT bonds have come as a reprieve for companies working in high-risk areas like Oriental Land, and the owner of the Tokyo Disneyland. Faced with the prospect of insuring a potential fatality (Tokyo is an earthquake prone area) insurance companies, in trying to manage their risk and returns, prescribe massive premiums on such insurance policies. Reinsurers balk at the idea of reinsuring such high-risk insurance policies. However, with the presence of cat bonds, companies are resting easy.

Captives

A parent company, trade association, or a group of companies within an industry can set up a captive insurance company. These entities can be used for financing the retention risk as well as risk transfer.

In order to benefit from a captive, a company needs good information to evaluate the risks that are being incurred by the captive and have sufficient financial resources for funding an annual premium that is large enough to justify the costs of setting up and maintaining a captive. In a mutual insurance company the owners of the company are the policyholders. A group of companies can create a mutual insurance company to insure against specific types of risk common to them. Basically, a mutual insurance company is a form of self-insurance.

Finite Insurance

Finite insurance is an insurance policy that sharply limits the amount of the loss that the insurer can realize. The controversy associated with this type of insurance is whether it truly transfers risk from a corporation seeking protection to the insurer. The reason is that typically for this type of policy the corporation seeking protection makes a large premium to the insurer, the amount being sufficient to cover the insurer’s expected losses. The premium is then held by an insurer in an interest-bearing account. If at the end of the policy’s term the actual losses are less than the premium, the insurer pays the difference to the corporation. However, if the losses exceed the premium, the corporation makes an additional premium payment to the insurer for the difference.

Public and regulatory awareness of the problem with finite insurance resulted from the SEC enforcement action against Brightpoint Inc. and American International Group (AIG). The SEC charged AIG with accounting fraud because of the insurer’s role in devising and selling an “insurance” product that Brightpoint Inc. used to report false and misleading financial statements that concealed $11.9 million in losses that Brightpoint sustained in 1998. Without admitting or denying the SEC’s allegations, AIG and Brightpoint agreed to pay a civil penalty of $10 million and $450,000, respectively. There were further SEC investigations of other issuers of finite insurance, as well as then–New York attorney General Eliot Spitzer’s investigation of a $500 million finite insurance deal between AIG and General RE.

These actions have made financial-decision-makers reluctant to use finite insurance, particularly because there is the risk that such insurance might result in an earnings restatement. According to experts, however, the major concern with finite coverage is not that it may allow earnings manipulation but that it fails to transfer risk.

Experts in alternative transfer risk have argued that there are legitimate uses for finite insurance:

• Culp, for example, states that finite insurance “leads to a higher quality of earnings than if the firm doesn’t reserve for a major loss or just tries to set money aside internally”, further noting that companies can use finite insurance to shield them from allegations that they are setting up “cookie jar” reserves to inflate future results.
• A second advantage pointed out by some experts in art is that the coverage provided by finite insurance can assist companies that are reluctant to purchase traditional insurance to fix the cost of risk exposures that are difficult to quantify over a span of years.
• Finally, it is argued that finite insurance is particularly useful in “covering severe risks that are outside the core functions of a company”.

Multiline Insurance

Multiline insurance offers a tool for better integrated risk management by offering one large aggregate limit across several lines of business such as liability, property, and business interruption. The insurer makes a payment if the combined losses on all lines reach a specified amount. The programs usually operate on a multiyear basis. The corporation deals with only one insurer rather than several insurers covering different lines. Moreover, the corporation only has to renew the program every three to five years, thereby reducing the time the chief risk officer must devote to negotiating insurance contracts each year. The flexibility of creating multiline insurance allows an insurer to work with a corporation to obtain tailor-made coverage based on the corporation’s needs.

Contingent Insurance

Contingent insurance, more popularly referred to as “contingent cover”, is an option granted by an insurance company giving a corporation the right to enter into an insurance contract at some future date. All of the terms of the insurance contract that can be entered into, including the premium that must be paid if the option is exercised, are specified at the time the contingent cover policy is purchased by the corporation. Contingent cover includes premium protection options, contingent cover embedded in existing programs, and contingent insurance-linked notes.