Risk management is a well-established discipline with a long history. Most global companies have adopted risk management practices in their operations to ensure sustainability of their business. Traditional forms of risk management include loss control, loss financing and risk reductions with tools such as insurance and derivatives, used to hedge risks. Alternative risk transfer (ART) markets, however, offer new forms of risk protection that often rival their traditional counterparts. ART practices have not been as widely adopted as traditional risk management tools, although they should sometimes be considered either as a supplement or a substitute to traditional methods.
(Banks 2004, p.3) In the following subchapters traditional and alternative risk transfer methods are introduced, and their advantages and disadvantages discussed shortly.
3.1.1 Traditional risk transfer methods
For an insurer, traditional methods of risk transfer involve reinsurance and retrocession.
Typically, primary insurers buy reinsurance, and the reinsurers buy retrocession. In the case of reinsurance, the primary insurer that cedes the risk is called a cedent, and the reinsurance company taking on the risk is called a cessionaire. Commonly, a reinsurer will transfer the risk forward to other reinsurers, who are called retrocessionaires. This form of risk transfer is called a retrocession. (Weber 2011, p.55)
When it comes to reinsurance, the transfer of risk is based on a voluntary contractual agreement between the cedent and the cessionaire. As reinsurance is a very important method of transferring risk for primary insurers, the related products are under constant development and scrutiny. Reinsurance can be categorized into three forms based on reinsurance methodology, which are obligatory, facultative, and semi-obligatory reinsurance. (Weber 2011, p.55) Table 1 summarises these forms in terms of contractual relationship and possibilities for covering risk.
Form of reinsurance (contractual relationship)
Types of reinsurance
(possibilities for covering risk) Obligatory reinsurance
Agreement on the insurer ceding all risks fitting of the contractual description, as well as the reinsurer accepting all risks of the contractual description.
Facultative reinsurance
The insurer may choose to cede or not to cede a specific risk, while the reinsurer may choose to accept or decline the risk in question
Semi-obligatory reinsurance
Either the insurer or the reinsurer being obliged to cede or accept all risks fitting the description, while the other has the right to decide based on their own volition
Proportional reinsurance
Baseline: sum insured/probable max. loss
Premium calculation: proportional splitting of original premium
Main treaty types: quota share, surplus
Non-proportional reinsurance
Baseline: the loss
Premium calculation: not related to the original premium
Main treaty types: excess of loss, stop loss
Table 1: Different forms and types of reinsurance, adapted from Weber (2011, p.57)
Obligatory reinsurance (or treaty insurance) is based on a contract, where the primary insurer is obliged to cede a share of a risk they have insured to the reinsurer. As such, the reinsurer is also obliged to take the risk. As one may assume, such a contract is quite detailed, and includes the risk, region, time frame covered, amounts and additional terms and conditions. When the contract is agreed on, the insurer is sure that every risk fitting the criteria in the documentation will be reinsured. Once the documentation is done,
obligatory reinsurance offers benefits in efficiency and low-cost administration, as the insurer does not have to provide details on every risk being ceded. It is worth mentioning that the reinsurer thus blindly participates in the business, which may cause concerns in terms of risk management. Therefore, a trustworthy relationship between the parties is crucial, and is often used for insurance products of low severity of claims and high occurrence rate. (Weber 2011, pp. 56-57; Banks 2004, p. 81)
Facultative reinsurance differs from obligatory reinsurance in the sense that the primary insurer decides whether to cede a risk to the reinsurer on a case-by-case basis. As one may guess, this also means that the reinsurer can decide whether to accept, decline or negotiate the terms regarding the reinsurance contract. Therefore, each risk is analysed prior to being ceded and accepted on an individual basis and governed by a contract negotiated separately. This type of reinsurance can be considered more costly and time- consuming compared to obligatory reinsurance, but the risks insured also differ from those of the obligatory reinsurance practice. For facultative reinsurance, risks that vary widely and are of high severity are more typical, and therefore it is understood that more consideration should be taken before the decision to reinsure them. (Weber 2011, p. 58;
Banks 2004, p. 81)
Semi-obligatory reinsurance is much like obligatory reinsurance, except for the fact that one of the two parties is free to choose the risks it wants to cede or accept. It can either be a facultative-obligatory reinsurance, where the insurer decides on the risks they wish to cede, or an obligatory-facultative reinsurance, where the reinsurer may accept or decline the risk in question, although the latter form is very rare in practice as the cedent is left without a reliable reinsurance cover. Naturally, both forms require extreme long- term trust between the parties to be a viable choice. (Weber 2011, pp. 58-59)
3.1.2 Alternative risk transfer methods
Whilst traditional risk transfer methods have proved to be potent towards some risks, others require different solutions. Previously mentioned ART products haven’t been clearly defined and set in literature or industry, but a typical commonality between ART products is that the insurance-economical risk transfer happens in the global financial markets, instead of happening within the insurance or reinsurance sector. (Weber 2011,
p.65) Although the objective of the thesis is not to cover ART practices extensively, as insurance-linked securities fall within ART, introducing different forms of ART is necessary for creating a deeper understanding of these practices and differences between them. Weber summarizes different ART forms into seven categories (figure 3), which will be shortly introduced and discussed in this subchapter. Insurance-linked securities will however not be discussed since they are elaborated on further in the following chapters.
Figure 3: Alternative forms of risk transfer, adapted from Weber (2011, p.66)
Risk carriers can be divided into captives, insurance pools and self-insurance. A captive is an insurance or reinsurance carrier of the main company or a group of companies, and not part of the core business itself. Captives are typically set up in countries with favourable taxation laws to increase efficiency of the risk transfer, and a form of self- insurance. Similarly, an insurance pool is just a risk transfer arrangement between corporations, and by pooling the risk between multiple corporations the volatility and financial severity of the risk on a single company is greatly reduced. Finally, self-
Risk carriers
- Captives - Pools
- Risk detention groups
Finite Solutions
-Loss portfolio transfer - Adverse development - Spread loss
- Finite quota share groups
Multi-risk Products
-Multi-peril -Multi-trigger -Blended
Contingent Capital
- Agreements - Put options
Insurance-linked securities
- Value-in-force - Catastrophe risk - Funding
Derivatives
- Futures - Forwards - Options - Swaps
Side Cars Alternative Risk
Transfer
insurance, as one may assume, refers to a company insuring the risks of i.e., its employees itself. (Weber 2011, pp. 66-70)
Finite solutions are a combination of risk transfer and risk financing. In essence, the primary insurer works as a cedent, closing an agreement with the reinsurer that re- arranges the timing of losses. The reinsurer then uses the premium income from the cedent to purchase assets, the expected income of which are then used to calculate the price of the reinsurance. In this arrangement the reinsurer has access to continuous regular premiums, and the cedent has long-term coverage with stable terms. The cedent bears the ultimate risk out of the original underwriting, but a finite solution allows for smoothing of losses over time, allowing for more stable year-to-year earnings. (Weber 2011, p.71)
Multi-risk products are a risk-transfer solution that combine various exposures into a single contract in a cost-effective and efficient way. Multi-risk products can be divided into two broad classes: multiple peril products and multiple trigger products. The former provides coverage for related or unrelated perils of multiple classes, and the latter only if multiple events occur. Multi-risk products can be divided into further subclasses, but that is beyond the scope of this study. Typically associated with enterprise risk management, multi-risk products are used in the alternative risk transfer for corporations. As multi-risk products are often custom designed to fit the risk management strategy of a corporation, packaging the right types and sequencing of exposures is time-consuming, but often the cost-effectiveness and efficiency makes the effort worthwhile. (Weber 2011, pp. 73-76;
Banks 2004, pp. 103-112)
Side cars refer to special-purpose reinsurance vehicles (SPRVs), that are designed to remove the underwriting risk from insurers or reinsurers. In this arrangement, a newly founded holding company issues equity and debt. The proceeds from the securities are allocated to a trust, which pays the claims to the cedent in case of a loss event. Otherwise, the trust pays the SPRV the debt interest and profits. The SPRV then pays the holding company dividends from the income collected from the trust as well as the cedent. The holding company then pays dividends to share owners and interest on their bonds to the investors. (Weber 2011, pp. 87-88) A very similar arrangement is used in the structuring of CLOs and other securitizations, which will be further discussed in the next subchapter.
Derivatives, as their name may suggest, derive their value from other assets. Because of this, they can be used as tools for either speculation or hedging. As time has passed on, derivatives have gotten a reputation for creating excess risk as many investors have used them for speculation way above their means. However, derivatives are commonly used for risk management purposes and work much like insurance, in the sense that you pay a premium and if an event happens, you get a payment. (Bodie, Kane and Marcus 2014, pp.
678-692)
Contingent capital refers to contracts of predefined terms, where the organisation can raise cash by issuing debt or selling stock. Contingent capital can thus be divided into contingent debt or contingent equity, and it offers a method of financing low-frequency and high-severity losses more reliably, as these solutions have been pre-arranged. In essence, the organisation determines an amount and specification of capital as well as the event which triggers the debt issuance, to which the reinsurer agrees. Then, the organisation pays a specified fee either up-front or regularly based on the contract made.
A key detail to notice is that this arrangement raises funds from the capital markets when the trigger event occurs, combining insurance and capital markets. Although contingent capital has a lot of similarities with insurance, it is a balance sheet and cash flow arrangement. It should be acknowledged that unlike ILS, which combines elements of insurance and securities, contingent capital facilities are strictly funding facilities or security transactions that contain no insurance contracting. (Weber 2011, pp. 84-87;
Banks 2004, p. 135)