Alternative Risk Transfer

ALTERNATIVE RISK TRANSFER

(May 2022)

Alternative Risk Transfer (ART) is, basically, any method used by an entity to shift some of its risk of loss to another entity, but without using traditional (standard, commercially available) insurance and/or reinsurance. The term is not precise, as it also goes by a variety of other names, including alternative markets, alternative risk financing, non-insurance (or non-traditional) financing and other terms. The term can also be applied to methods used to arrange adequate financing (even using an insurance vehicle) to handle a non-traditional (unconventional) loss exposure.

Related Article: Risk Management

Businesses have always, either deliberately or by default, used non-insurance methods to deal with risks. Certainly, the use of ART is always boosted when traditional insurance markets harden. However, using ART is not merely counter-cyclical to traditional insurance. Businesses routinely dedicate substantial dollars to addressing their operational risk and those sums do not flow freely and automatically between the two (traditional and non-traditional) markets.

The increasing use of ART is accompanied by businesses developing a greater awareness and appreciation of risk management and its more sophisticated version, Enterprise Risk Management (ERM). The latter has much more to do with moving away from viewing risks as involving merely a "loss vs. no loss" scenario. Rather, the growth of ART (and ERM) is a natural consequence of treating the possibility of loss as having broader financial consequences and opportunities particularly with regard to using capital more effectively.

ART Strategies

More businesses are re-evaluating their operational objectives and are taking steps to properly incorporate their risk management approach. Increasingly they are choosing a strategy that involves both traditional insurance and ART methods. Common ART strategies include:

ART methods continue to grow in use so previous, stand-alone strategies may be re-defined as belonging to ART, such as different trading or investing strategies (consider hedging).

Captive Insurers

A captive is a company formed by a particular business (or by multiple organizations) in order to provide insurance coverage for that owner’s/business' assets. Captives began decades ago for companies in classifications that found few or no access to sufficient coverage in the traditional insurance marketplace.

Related Article: Capital Markets

Self Insurance

This category remains a popular misnomer that is also referred to as self-funding. Insurance is a mechanism that requires a pooling method of funds (premiums) from, ideally, a large, diverse group. Therefore, "self" insurance is an inaccurate term. It is more appropriate to consider this method to be risk retention. Retention may often be unintentional or a default method. Naturally, any loss exposure that is not addressed by some strategy is, by default, retained by an entity. Self insurance is a more aggressive, deliberate retention philosophy.

Example: Puddin' & Pie Associated Bakers, Inc.'s Chief Risk Officer has, for several years, been very frustrated with the hassle of arranging for Work Comp coverage. She decides to hire a consultant to work on a self-insured Work Comp Plan.

It is a formal process of a firm deliberately choosing to fund certain exposures on its own. Such entities have to thoroughly evaluate their exposures, finances and other key issues in order to create a viable plan. Actions include devising a proper retention-level, studying laws (including accounting and tax implications) of their decision.

Loss-Sensitive Insurance Plan

Typical insurance cost consists of paying flat fees or rates (premiums), so the cost to businesses are guaranteed. Loss sensitive programs are the opposite approach where premiums are variable, depending on losses. There are several types of plans such as the following:

Deductible Plans
Retrospective Rating Plans
Dividend Plans
Retention Plans

Losses that occur during the policy period in which a loss sensitive plan operates determine the plan’s final premium. Such plans use upper limits and minimum premiums that frame costs and the cost is directly related to losses. Therefore, loss sensitive plans are incentive-based. Companies that want to create a successful plan have to really push safety measures, including loss controls.

Integrated Risk

This is a concept as much as it is a category of ART. Integrated risk refers to techniques that attempt to handle all of a firm's various exposures in a single bundle. The chief advantage of this concept is to improve a firm's efficiency in handling its risks and to reduce associated costs. Generally, the approach goes beyond risk management to include an operation’s employee benefits and financial issues.

Securitization

This refers to any method that allows an entity (typically an entity that is not an insurance company) to acquire control of cash flows that are related to an insurance risk.

Related Article: Convergence Products

Doing Nothing

It may appear odd to list this as an ART activity. However, under a holistic approach to examining the consequences revolving around risk, an entity that chooses not to pursue an opportunity has still made a de-facto decision that can substantially affect its risk universe. An entity that is truly sensitive to risk may need to evaluate what occurs if a given opportunity or exposure is not specifically addressed.

Related Article: The Cost Of Doing Nothing

Considerations for Using ART

A certain set of conditions should exist in order to make proper use of ART. The given loss environment should involve companies that face predictable losses. Volatile loss activity makes it difficult to assess the price-effectiveness of alternative methods. A company attempting ART must have a significant portfolio so, as is the case with predictability, there are cost differences that can be measured. A company that wants to use ART should have a high level of commitment to monitoring and making operational adjustments necessary to positively affect safety and losses. Finally, as ART routinely makes use of deliberately retaining certain risks, such retention must not make the entity vulnerable to a crippling loss that could damage its economic future.

Conclusion

ART is a dynamic, evolving area of different financial, non-traditional insurance and risk transfer strategies that are mixed together in order to respond to a much broader set of risks than could be met by traditional insurance (or reinsurance). Rather than depend solely on insurers, funding for various ART techniques may involve large (institutional) investors, commercial banks, credit markets and (interest rate) swap markets (essentially where entities [including governments] trade fixed rate for floating rate obligations).

ART promises to continue to develop new methods (as well as variations of current or past methods) to creatively deal with the world of risk. However, as the recent financial crises have illustrated, those methods are likely to face harder scrutiny to ascertain whether they are legitimate and viable ones.