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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 fi rms should retain core risks and transfer, eliminate or cut non-core risks.

• Captives are wholly or partly owned insurance fi rms offering fl exibility and economy.

• Derivatives are fi nancial contracts whose value depends on the value of some

reference item or index. They have been used to protect fi 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 market’s good prospects are partly driven by enterprise risk management.

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Leadership & Mgt.

Strategy

Sales & Marketing

Corporate Finance

Human Resources

Technology & Production

Small Business

Economics & Politics

Industries & Regions

Career Development

Personal Finance

Concepts & Trends

This summary is restricted to the personal use of Hugo A. Gonzales (hugoaguilar7@googlemail.com)

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, it’s 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, fi 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 fi nancial gains and

losses. Generally, peril and hazard are, synonyms for risk, but risk management defi nes

peril as a factor that will cause a risk, while a hazard is something that can create or

worsen a peril. Industry defi nitions of other terms include:

• Operating risk — The risk that arises from ordinary (non-fi nancial) operations.

• Financial risk — The risk that arises from fi 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 fi rms simply take risks as they come.

Modern portfolio theory might argue that fi 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

specifi cally 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, fi re

risk with fi 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 fi rm’s

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. Identifi cation — Defi ne and describe a fi rm’s exposures to risk.

2. Quantifi cation — Calculate the potential fi nancial impact of risk.

3. Management — Make and implement decisions about which risks to control, retain,

eliminate or increase. Sometimes a fi 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 fi rm’s 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 company’s 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 specifi c times. Using samples, experts assemble a

distribution projection showing the probability of any possible event or outcome.

• Expected value — The product of an event’s 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.

• Diversifi cation — 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 diversifi cation 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 fi rm that buys fi re insurance no longer faces any exposure to

fi nancial loss in case of fi 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 fi 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 fi nancial losses.

“Regardless of the

risk management

technique em-

ployed, the cost/

benefi t framework

(or some similar

objective metric

that can crystallize

infl ows and out-

fl 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 defi es

precise classifi ca-

tion.”

“Indeed, its scope

and coverage

vary considerably

among practitio-

ners, end users,

and regulators, so

that any defi nition

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-fi 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 defi ned 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 fi 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 fi nancial derivatives.

• Banks — Long-time participants in the derivatives market, banks recently expanded

into the insurance market with catastrophe bonds and weather derivatives. Some

fi 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 fl ows, liabilities or assets into

pools or portfolios and issuing tradable shares or bonds secured by the cash fl 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 portfolio’s 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 company’s 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 fl exible

alternatives.”

“Ultimately, how-

ever, contingent

capital products

must still be ac-

commodated

within a rational

cost/benefi t frame-

work, and they

must only be con-

sidered one part of

a fi 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 fi rms reduced their risk of loss from

earthquakes or hurricanes by purchasing standard insurance contracts. Recently,

fi 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 specifi c 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 fi 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 fi 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, fi 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

defi ned 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 company’s 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 fi re

today, theft tomorrow, currency risk next week. Instead, a company’s enterprise risk

manager analyzes all of the fi rm’s risks in a single portfolio of risks. This risk pooling

approach reduces the fi rm’s demand for discrete insurance products but may increase its

demand for specialized products and services to suit its unique risk profi le.

About The Author

Erik Banks has held senior risk management positions at several global fi nancial

institutions and has written various books on risk management, emerging markets,

derivatives, merchant banking and electronic fi nance.

“Performance

monitoring is an

essential element

of the ERM pro-

cess; integrated

management of

risks does not end

when a specifi c

program is created

— the process

actually com-

mences.”

“The ART market

of the twenty-fi rst

century should

continue to adapt

to refl ect the new

requirements and

realities of the

global fi nancial

and economic sys-

tems.”