Adding Value with ART
October 2002
What is meant by alternative risk transfer?
Brent Clark provides his perspective and explains how ART can add value by providing
solutions for risk problems.
by Brent
Clark
Strategic Risk Solutions
I am often asked to give a definition of ART. I don’t think there is a simple
definition, but one way to address the question is by asking how ART can add
value.
The term “ART” literally means “alternative risk transfer.” But it has become
a term of convenience for efforts to expand the scope of what insurance companies
(and other types of financial institutions as well) can do to help their clients
manage risk. The idea is to move beyond just using insurance to cover accident
risk to providing solutions for risk problems that are more important strategically
or financially for the client.
ART is also used to refer to captives and certain other risk financing strategies
that really have more to do with self-insurance (risk retention) than with risk
transfer. So for me, ART refers to a range of risk financing strategies or customized
risk transfer solutions that lie outside the realm of traditional insurance.
But as most practitioners would admit, ART is a fuzzy term.
Risk Problems
Focusing on the issue of alternative risk transfer (as opposed to self-insurance
strategies), participants in the ART field mainly add value by being willing
to deal with risk problems for which there are no readily available insurance
or capital market solutions. These risk problems may have one or more of the
following characteristics.
Uniqueness. The risk problem will be relatively
unique to the client. Since many risk markets are designed to handle certain
predefined kinds of risk, any risk not fitting into one of these categories
will be difficult to transfer or trade.
Complexity. The risk problem may be based on
a set of facts and circumstances that require a deep understanding of the client’s
industry or other aspects of the client’s situation, often coupled with other
complex subject areas like accounting, tax, legal, etc.
Cyclicality. Certain problems relate to the
fact that revenues or expenses may fluctuate from accounting period to accounting
period. While it may be possible to have an academic view that such fluctuations
are in fact cyclical, in the “real world” it is common for people to become
uncertain about whether any given fluctuation represents a permanent downward
trend or simply the downward leg of a cycle. In extreme cases, overreaction
to the downward leg of a cycle can create a distress “run on the bank” situation
that may be inappropriate if the fluctuation is temporary.
Illiquidity. The presence of one or more of
the attributes listed above can create the problem of an “illiquid risk,” that
being a risk for which there is no active insurance or capital market that is
readily willing to take on that risk for a price.
ART Underwriting
ART underwriters can add value by providing a market for the transfer of
illiquid risk problems. The idea is to give a company with a difficult risk
issue a place to go when there is no readily available insurance market or capital
market solution. The ART company is one that should have the capability and
willingness to listen to a complicated story, and to perform research and analysis
as needed to gain an understanding of the risk problem.
The ART underwriter needs to be able to gain a rational basis for establishing
a price to accept a transfer of the risk. The underwriter must also determine
that the risk is fortuitous, and that the outcome does not lie within the control
of the insured. The underwriter must be able to determine that the insured is
not seeking to transfer the cost of a known problem (cost transfer versus risk
transfer).
To be successful, the ART underwriter must charge a premium that compensates
for the expected value of loss, plus a margin for risk, expenses, and profit.
Some might argue that if the cost paid by the insured exceeds the expected value
of the loss distribution, the underwriter is adding no value.
The counterargument is that the presence of such a risk may penalize the
company by causing a negative perception among analysts, shareholders, or rating
agencies. More fundamentally, protection against financial ruin from an unlikely
but possible event may be perceived as important to business owners or managers,
even if modern financial theory might argue otherwise. In many cases the ART
underwriter adds value by taking on risk when the perception of a risk problem
is greater than the reality of the risk (Note the opposite can be, and often
is, true: that the reality of a risk is greater than the perception of the risk.)
Contingent Capital
One good way to view the role of an ART underwriter is that of a specialized,
sophisticated investor who will consider stepping in to provide capital to absorb
risks that general investors (or insurers) don’t like. The capital provided
might be in the form of an insurance policy, or it might be in the form of a
swap or option, or some other financial instrument such as a specially structured
note or equity investment.
This concept has been described as contingent capital. The idea is to recognize
that insurance really functions as a source of stand-by capital that can be
called upon to replenish equity capital that gets depleted due to the occurrence
of some contingent event. Since the company may not want to carry the cost of
extra debt or equity capital to finance such contingencies, paying for “contingent
capital” can be viewed as an option. As discussed in earlier articles, it can
be argued that a company that does not want to face the risk of ruin should
hold equity capital in an amount sufficient to cover the cost of contingent
events. But if the probability of the occurrence of those events is low, then
carrying extra equity capital can be unnecessarily expensive. By providing contingent
capital, the ART underwriter adds value by charging a price that reflects the
contingent nature of the capital need. The value added is in being able to determining
a price for that contingent capital commitment. The cost of purchasing the contingent
capital commitment is less than the cost of carrying additional equity capital
of the same amount.
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not necessarily held by the author’s employer or IRMI. This article does not purport
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