Expert Commentary

State of the "ART"—New Trends in Financing Risk

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.

March 2000

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 these alternatives 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.

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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