State of the "ART"—New Trends in Financing Risk
March 2000
In this article, Brent Clark presents an overview
of the alternative risk transfer (ART) field and explains how it involves developing
new approaches for financing traditional insurance risks and finding new ways
to use insurance concepts to address nontraditional risks.
by Brent
Clark
Strategic Risk Solutions
Recent years have seen the development of the acronym "ART" to refer to a
broad range of new concepts in the field of business insurance. The ART field
comprises two areas; developing new approaches for financing traditional insurance
risks, and finding new ways to use insurance concepts to address nontraditional
risks. More generally, ART represents the efforts of insurance (and reinsurance)
companies to expand the scope of what is essentially a mature industry.
This article presents an overview of the ART field, while future articles
will focus on individual areas in more detail.
The "Old New" Stuff
"ART" refers to alternative risk transfer, but this is not a completely descriptive
term. The alternative part originally came from efforts to create alternatives
to traditional guaranteed cost insurance for traditional insurance risks, like
workers compensation or property insurance. These alternatives included things
like retrospective rating, captive insurance companies, large deductibles, finite
risk insurance, and so on. Over time, some of these approaches, which were originally
considered as "alternative," are now considered to be mainstream approaches
used by established insurers.
One leading industry consultant says that approximately one-third of the
business insurance industry's volume has been diverted to alternative approaches,
with an accompanying observation that this is an increasing trend. The best
way to appreciate what is happening is to understand that over the last 2 decades,
large corporations have come to believe that it is more efficient to retain
(self-insure) risk, rather than buying insurance.
Corporations increasingly are seeking to retain more risk, especially the
predictable levels of loss costs. In fact, most of the alternatives mentioned
above are designed to allow a corporation to effectively retain risk, but in
a way that involves services provided by an insurance organization.
The trend toward increasing risk retention is very troublesome for the insurance
industry. Historically, insurance companies have most preferred to insure the
more predictable levels (layers) of risk. Insuring the "primary layer" of risk
generates a large volume of premium, which is used to support the cost structure
of a large traditional insurance company. As this primary layer volume is drawn
off into various alternative approaches, insurers experience financial pressure
to support what is often a relatively high fixed-cost base in the face of declining
premium volume.
Insurers' efforts to cope with this loss of volume have resulted in two significant
trends. The first is the effort to entice some of this lost volume back by developing
new products; hence the ART market, which is the subject of this column. The
second and more problematic trend is the underpricing of risk as insurers compete
among themselves for available premium dollars.
The insurance industry is overcrowded with companies that need to support
their cost and capital bases, which leads to underpricing to win or retain accounts.
The tricky thing about insurance (especially liability insurance) is that an
insurer can underprice the product today, but it may take several years before
the actual losses emerge. This leads to the phenomena of the "insurance cycle,"
with rates declining for several years, and then reversing to increases as insurers
finally are forced to recognize the accumulated losses.
But the real problem is not so much the competition among insurers, but the
fact that insurers are fundamentally trying to compete with the bigger trend
toward more self-insurance. Corporations have the ability to fairly accurately
predict their expected loss costs, and the easiest way to get them to buy insurance
is to charge them a premium that is less than their expected loss costs. But
since insurers must, in the long run, charge a premium that covers both loss
costs and operating costs, it is almost always cheaper for the corporation to
retain the risk rather than insuring it. Thus, insurance companies face a situation
in which their customers only want to buy if they are willing to sell their
product at less than cost!
There are a couple of things that corporations are interested in, however,
that represent opportunities for insurers. These are the things that have largely
driven the development of the ART field. One of the most important is managing
expense volatility. Expense volatility means an unplanned increase in operating
costs, which translates into lower profits or exceeded budgets.
One of the main benefits of insurance is that it can be used to smooth expense
volatility, at least with respect to certain types of contingent events. Insurance
permits a company to recognize, for financial accounting purposes, a planned
expense in exchange for not having to recognize an unplanned expense should
the insured event occur. Academics will debate whether a corporation should
spend money to reduce expense volatility (which leads to earnings volatility),
but the reality is that most corporate managers, and in fact most shareholders,
don't like earnings volatility.
Another key benefit of insurance is that premiums are tax deductible, while
contributions to a self-insurance fund, generally speaking, are not deductible.
Costs relating to self-insured losses are deductible only as they are actually
paid. Many companies prefer to fund for the cost of accidents that happen during
the year, and prefer the pre-funded amounts to be tax deductible if possible.
In many ways, insurance can be seen as a way to pre-fund accident costs on a
tax-deductible basis, although the tax rules have become strict as to what constitutes
bona fide insurance. (More on that in future articles.)
In summary then, many ART products are designed to deliver the tax and accounting
benefits of insurance, along with at least some of the economic benefits of
self-insurance.
The "New New" Stuff
Lately, ART refers more to alternative risks, things like financial market
or commodity risk, or unique operating/business risks faced by a particular
corporation. These are not risks that insurers have traditionally attempted
to insure. Insurers are now actively, however, entertaining proposals to insure
such risks. While some of these new risks cause some to ask if insurers are
engaging in "foolish boldness" in an effort to generate new sources of revenue,
there are some interesting ideas and concepts at work.
One of the most intriguing ideas is that insurance should be viewed as a
special form of equity financing for corporations. Some now refer to insurance
as "contingent equity." This relates to the concept that a firm's equity is
its principle source of funding to deal with the risks of the business. The
risks of the business range from the basic business risks of choosing areas
of activity, developing a strategy, and dealing with competitors, to risks of
unplanned events outside of management's control, including the costs of accidents.
From a corporate finance point of view, if a business did not face risk (uncertainty),
it could be financed with virtually 100 percent debt (provided the profits could
cover the interest expense). The return on equity would be nearly infinite.
The fact is, though, that business is risky. While modern shareholders do
seek to maximize the return on equity, lenders demand that the firm posses a
certain amount of equity so that it will be the stockholders, and not the lenders,
who bear the uncertainty of the risks of the business. A rule of thumb in corporate
finance has been that a ratio of 50 percent debt and 50 percent equity in a
firm's capital structure represents an acceptable balance.
It can be seen that insurance is in fact a substitute for equity. Consider
a small firm with $1 million in equity that wants to purchase a factory worth
$10 million, and is seeking to borrow money from a bank to finance the purchase.
If there were no such thing as property insurance, the bank would want to know
how the firm would repay the loan if the factory burned down. It would probably
only make the loan if the firm had enough equity to repay the loan if the fire
occurred, in this case at least $10 million of equity.
But since insurance is available, the firm can pay a relatively modest premium,
and thereby address the bank's concern. And since the firm does not have to
repay the insurer if there is a loss, the insurance recovery performs in a way
that is similar to equity financing (as opposed to debt financing).
Therefore, insurance can be viewed in a real sense as contingent equity;
i.e., equity financing that becomes available if certain defined contingencies
occur. By purchasing insurance, the firm can operate with less true equity financing,
permitting the firm to realize a higher return on equity for any given level
of sales and profits.
When viewed in this context, the "value added" of insurance is redefined
from merely being the way companies finance accident risk to an important financial
tool that can be used to leverage the firm's equity capital. The trick is to
find other kinds of risk that are important to the firm and which can be competently
underwritten by the insurer. Here the problem becomes more difficult for two
reasons.
The first problem is that the outcomes of many business risks lie too heavily
within the control of a firm's management. Thus, if an insurer tried to insure
against the risk of too much overtime, the firm would have an incentive to actually
use more overtime, and force the insurer to pay for it.
The second problem is knowledge and understanding of the risk. If the insurer
does not understand the risk better than the insured, the insurer will very
likely lose money.
For example, an oil exploration company might like to buy insurance against
the risk that none of its exploration programs produce oil. The question is
whether an insurer will be better able to assess that risk than the geologists
and other professionals that work for the oil company. In essence, that is the
risk that the management of that oil company is hired to manage. A related problem
is that if insurance was purchased, the oil company might be less cautious in
taking on risky projects, knowing insurance is available if the project fails.
Even so, the view that insurance can be more broadly viewed as contingent
equity invites a search for new risks that can be competently underwritten by
an insurer while providing a meaningful benefit to a company. The search for
these new risks is a mainstay of the current ART field.
There are a couple of other key new ideas in the ART field that will be introduced
in future installments. Suffice it to say that the ART represents a fertile
field for new ideas in managing risk for corporations and represents the best
chance for new growth opportunities in the mature business of insurance.
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