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Alternative Risk Transfer
Integrated Risk Management through Insurance,
Reinsurance and the Capital Markets
by Erik Banks
John Wiley & Sons 2004
238 pages
Risk management is prudent and necessary for most companies.
Traditional insurance products are risk transfer mechanisms through which a
company or individual pays another individual, company or group to assume risks.
Insurance is only one risk management tool. Companies may retain, self-insure,
insure, expand or withdraw from certain risks.
Some risk decisions are strategic business decisions, such as entering or leaving a
particular business because of risks.
Generally rms should retain core risks and transfer, eliminate or cut non-core risks.
Captives are wholly or partly owned insurance rms offering exibility and economy.
Derivatives are nancial contracts whose value depends on the value of some
reference item or index. They have been used to protect rms against some risks
traditionally managed by insurance, such as earthquakes.
Capital markets provide opportunities to insure against risk, i.e. catastrophe bonds.
Insurance companies participate in the Alternative Risk Transfer (ART) market.
The ART markets good prospects are partly driven by enterprise risk management.
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Alternative Risk Transfer Copyright 2004 getAbstract 2 of 5
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What You Will Learn
In this Abstract, you will learn: 1) What are the basic essentials of risk management; and
2) How the alternate risk management (ART) market works.
Recommendation
In this excellent introduction to risk management, author Erik Banks offers a lucid,
clearly written and well-organized overview. He tells readers what risk management is,
why it is necessary, how it works and how companies can carry it out most prudently and
cost-effectively. He manages to convey the essential information about insurance and
reinsurance, the use of capital markets and derivatives, and the application of enterprise
risk management concisely. This is a remarkable achievement. Most books on insurance
bog down in jargon and details, while most books on derivatives are unnecessarily
complicated and dense. This one offered by the Wiley Finance Series is neither.
Although not exactly beach reading, its about as accessible as any book on this subject
could possibly be. getAbstract.com recommends it highly to executives and investors.
Abstract
Risk Management Survey
Risk management is a professional discipline with a long history and a well-developed
set of tested practices and procedures. Traditional approaches to risk management
include control, nancing and loss reduction via the derivatives and insurance market.
The alternative risk transfer (ART) market recently has offered a new set of solutions.
Understanding the relative advantages of traditional or ART markets requires reviewing
the nature of risk and the dimensions of risk management. Risk is uncertainty about
the future; corporations are most concerned about the uncertainty of nancial gains and
losses. Generally, peril and hazard are, synonyms for risk, but risk management denes
peril as a factor that will cause a risk, while a hazard is something that can create or
worsen a peril. Industry denitions of other terms include:
Operating risk The risk that arises from ordinary (non-nancial) operations.
Financial risk The risk that arises from nancial operations.
Pure risk A risk of loss with no possible upside.
Speculative risk A risk that offers not only possible loss but also possible gain.
Failure to manage risks actively means that rms simply take risks as they come.
Modern portfolio theory might argue that rms should accept some risks, but passively
accepting all risks is extremely imprudent. For example, some experts might suggest that
a gold mining company ought not to hedge gold price risk, since investors buy its stock
specically to gain exposure to the gold market. By hedging gold prices, the company
would reduce exposure to the gold market and frustrate its stockholders investment
strategy. Investors, experts could argue, can reduce their exposure to the gold market
by the strategic way they assemble their portfolios. Yet the argument that a gold mining
company should not hedge gold price risks does not suggest that it can neglect other
kinds of risk management. It should still reduce legal risk with liability insurance, re
risk with re insurance or risk of expropriation with political risk insurance. Investors
could not hedge these risks by portfolio management.
Risk management
is a dynamic and
well-established
discipline prac-
ticed by many
companies around
the world.
Theory and prac-
tice suggest that
the availability of
a compensatory
payment in the
event of loss
removes a rms
incentive to be-
have prudently.
Alternative Risk Transfer Copyright 2004 getAbstract 3 of 5
Companies handle such risks through the four-step process of risk management:
1. Identication Dene and describe a rms exposures to risk.
2. Quantication Calculate the potential nancial impact of risk.
3. Management Make and implement decisions about which risks to control, retain,
eliminate or increase. Sometimes a rm will seek more of a particular risk, such as
when a speculative risk presents a high probability of gain.
4. Monitoring Watch, measure and communicate data about risk status.
A rms board of directors must develop its philosophy of risk and provide management
with broad guidelines about the kinds of risk to take or reduce. For example, the
gold mining companys board may decide not to hedge gold price risk, but might
insure against legal liability or foreign exchange exposure. It weighs the advantages
and disadvantages of various risk control mechanisms according to standard risk
measurement techniques, which include:
Random variable A variable whose outcome is uncertain. It may be continuous or
discrete, that is, occurring only at specic times. Using samples, experts assemble a
distribution projection showing the probability of any possible event or outcome.
Expected value The product of an events probability of occurrence and outcome,
obtained by multiplying frequency by severity. For pure risks, the expected value is
synonymous with the expected loss.
Variance or standard deviation This measures the gap between an outcome and the
expected value. It is the likelihood of reality being better or worse than expected.
Risk transfer The practice of transferring risk from one party to another or to a
group of parties. The insurance market is a risk transfer market. Insurance is based
on the Law of Large Numbers, which says that one or two cases might display wide
divergences from expected values, but across many cases the outcomes will be near
the expected value. Central Limit Theorem says that as sample size grows, the prob-
ability distribution of the average outcome follows a normal curve.
Diversication The practice of combining numerous unrelated uncorrelated risks
in a portfolio to reduce the exposure to any particular risk.
Pooling This is the practical application of diversication in the insurance indus-
try. It depends on a careful analysis of correlations among risks. As the number of
uncorrelated risks in a pool increases, the standard deviation nears zero.
Hedging This risk management approach cannot be insured with traditional insur-
ance contracts. Hedging is a risk transfer mechanism, but its contracts can be more
complex and specialized than typical insurance contracts. Financial derivatives, such
as futures, forwards, swaps and options, are common hedging instruments.
Moral hazard Someone who has transferred a risk may cease to manage it pru-
dently. For example, a rm that buys re insurance no longer faces any exposure to
nancial loss in case of re, and may be less diligent about maintaining sprinkler
systems and keeping oily rags from piling up. In an extreme case of moral hazard,
the owner of a restaurant might start a re that burns down the restaurant in order to
collect fraudulently on the insurance policy.
Adverse selection This occurs when an insurer with inadequate information mis-
prices risks, offering policies for unreasonably low or high prices. In the former case,
the company will wind up with a portfolio of high risks. In the latter, the company
will lose customers. In both cases, the result is nancial losses.
Regardless of the
risk management
technique em-
ployed, the cost/
benet framework
(or some similar
objective metric
that can crystallize
inows and out-
ows) is an essen-
tial element in
decision-making
and the determina-
tion of enterprise
value.
Intermediaries
play a central role
in risk capacity,
in several ways:
bringing end-use
clients and inves-
tors together, sup-
plying capacity in
their role as inves-
tors, and acting as
end-users in their
role as corporate
risk managers.
The ART market
is a broad-based
sector that dees
precise classica-
tion.
Indeed, its scope
and coverage
vary considerably
among practitio-
ners, end users,
and regulators, so
that any denition
is based, to some
degree, on opin-
ion.
Alternative Risk Transfer Copyright 2004 getAbstract 4 of 5
The ART of Risk Management
Companies manage risk for many reasons. They may want to build or protect shareholder
value, insulate against market trends, manage credit risks or minimize taxes. The
Alternate Risk Transfer (ART) market began in the late 1960s and early 1970s, and has
its roots in the trend toward self-insurance, risk retention and reliance on captives. In the
1980s and 1990s, risk-nancing products became widely available. In the late 1990s, the
trend to enterprise risk management further propelled the ART market. The three kinds
of ART are:
ART products The tools, techniques and structures that aim at a dened risk man-
agement target, including insurance products, capital markets instruments, capital
structures and derivatives.
ART vehicles The channels employed, such as captives, special purpose vehicles,
capital markets subsidiaries, Bermuda transformers and so on.
Solutions Programs that use products and vehicles to manage risks, most notably,
enterprise risk management (ERM) programs.
Participants in the ART market include:
Insurers/reinsurers In addition to their normal business, these rms design,
market and use ART products and programs. Some support collateralized debt obli-
gations or provide credit risk products such as guarantees or credit wraps. Some have
established capital market units to provide nancial derivatives.
Banks Long-time participants in the derivatives market, banks recently expanded
into the insurance market with catastrophe bonds and weather derivatives. Some
rms established Bermuda transformers, Bermuda-based insurance companies that
often turn derivatives contracts into insurance contracts on behalf of the bank.
Corporate customers Corporations usually enter the market as users of ART prod-
ucts and techniques. Advanced corporate end users apply ERM approaches to review
their full set of risks as a portfolio.
Investors Investors provide the capital the ART market needs to function.
Agents and brokers These market intermediaries provide the distribution system
for ART products and services.
ART Products/Techniques
Traditionally, insurance is a risk transfer mechanism. Reinsurers insure the insurance
industry. They sell many types and permutations of insurance contracts, which include:
Captives Corporations establish and use these licensed insurance companies to
insure corporate risks. Firms save money by avoiding agency and broker commis-
sions and insurance company overhead costs. Captives give companies access to the
professional reinsurance market, allowing them to transfer risks at lower costs.
Securitization This is the practice of bundling cash ows, liabilities or assets into
pools or portfolios and issuing tradable shares or bonds secured by the cash ow
from those portfolios. Mortgage securitization is a fairly common example. Mort-
gage lenders sell mortgages to an entity that assembles them into a portfolio and
issues bonds. The payments derive from repayment of the portfolios mortgages.
Securitization techniques have also been applied to consumer credit, corporate debt
and such. By securitizing their debt portfolios, lenders reduce their exposures and
risks, obtain cash and expand their investment options.
A captive is a
closely held risk
channel that is
used to facilitate
a companys in-
surance/reinsur-
ance program and
retention/transfer
activities.
Despite certain
tax complexities
and ambiguities, it
is clear that cap-
tives, RACs, reten-
tion groups, and
similar structures
are part of the
mainstream of the
risk management
markets.
Multi-risk prod-
ucts are an in-
tegral element of
the risk manage-
ment sectors and
offer companies a
range of exible
alternatives.
Ultimately, how-
ever, contingent
capital products
must still be ac-
commodated
within a rational
cost/benet frame-
work, and they
must only be con-
sidered one part of
a nancial solution
rather than a com-
plete risk manage-
ment tool.
Alternative Risk Transfer Copyright 2004 getAbstract 5 of 5
Securities with insurance characteristics These include catastrophe bonds, weather
bonds and similar instruments. Traditionally rms reduced their risk of loss from
earthquakes or hurricanes by purchasing standard insurance contracts. Recently,
rms have found less costly coverage in the capital markets. Oriental Land, Co.,
the owner of Tokyo Disneyland, opted not to purchase earthquake insurance on the
theme park in 1983, because it was not available for the specic risks the company
wanted to mitigate. Insurance markets at the time offered coverage for property and
casualty risk, but not for the economic losses the rm might suffer in an earthquake.
In 1999, Goldman Sachs and Oriental Land came to market with a $200 million secu-
rities issue in two tranches. The rst tranche protected the company against business
interruptions due to an earthquake, and the second tranche offered reconstruction
money in the event of earthquake losses. The market has seen similar securities
linked to catastrophe risk, hurricanes, temperature extremes and other events.
Contingent capital structures These embrace contingent debt and contingent
equity. Contingent debt structures include contingent surplus notes, issued in the
context of special trusts, contingency loans arranged with banks in advance of a
possible loss, nancial guarantees, residual value guarantees and so on. Contingent
equity structures are variants of put options. A put option gives the buyer the right
but not the obligation to sell equity at a particular time or in case of a particular
dened triggering event. Loss equity puts and put-protected equity are the most
common contingent equity structures.
Insurance derivatives These include exchange-traded futures, options and options
on futures as well as over-the-counter forwards, options and swaps. The value of a
derivative depends on the value of some underlying commodity, currency or index.
A residential heating oil supply company might hedge its exposure to weather by
purchasing an exchange-traded temperature derivative whose value increases as the
temperature increases. When the temperature increases, the companys customers
will use less heating oil, but the increase in the value of its temperature derivative
would provide a hedge against lost sales. Derivatives have been or can be designed to
address almost every conceivable risk. Weather derivatives have provided protection
against rain or snow, drought, wind and so on.
The increasing popularity of enterprise risk management suggests a strong future for
ART. Companies that use ERM do not approach risks one-by-one, insuring against re
today, theft tomorrow, currency risk next week. Instead, a companys enterprise risk
manager analyzes all of the rms risks in a single portfolio of risks. This risk pooling
approach reduces the rms demand for discrete insurance products but may increase its
demand for specialized products and services to suit its unique risk prole.
About The Author
Erik Banks has held senior risk management positions at several global nancial
institutions and has written various books on risk management, emerging markets,
derivatives, merchant banking and electronic nance.
Performance
monitoring is an
essential element
of the ERM pro-
cess; integrated
management of
risks does not end
when a specic
program is created
the process
actually com-
mences.
The ART market
of the twenty-rst
century should
continue to adapt
to reect the new
requirements and
realities of the
global nancial
and economic sys-
tems.