Expert Commentary

Adding Value with ART

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.

October 2002

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.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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