Aon's Charles Winter outlines the benefits of financing risks in a non-traditional way

There have been many definitions of alternative risk transfer (ART), some of which encompass mechanisms that are no longer viewed as really alternative, such as captive insurance companies or multi-year/multi-line covers.

However, one of the following three features should be present for a structure to be ART:

  • The placement of underwriting risk into markets other than the traditional (re)insurance market

  • Protection against underwriting risk through mechanisms other than traditional (re)insurance contracts

  • The inclusion of non-traditional risks in (re)insurance contracts.

    In some cases a combination of these features may be present.

    Alternative market
    The catastrophe bond is an example of where an alternative market accepts an insurance risk. Financial market investors buy a bond, the value of which (coupon, principal or both) is dependent on the performance of a portfolio of insurance risk, rather than the usual credit and interest rate risks. The bond sold to investors is usually transformed through a single purpose vehicle (or SPV) into a reinsurance contract to meet the regulatory requirements of an insurance company.

    A parametric trigger is a non-traditional contract. This responds not to the indemnity value of a loss as in a conventional insurance contract, but to the movement caused in a defined index, such as the magnitude of an earthquake on the Richter scale or to an industry loss ratio.

    The non-traditional insurance and reinsurance markets have written policies to cover risks that fall outside those traditionally available. For example, they can guarantee revenue from infrastructure projects (such as toll roads or rail systems).

    The range of ART products can be seen as part of a continuum of risk-financing structures with insurance products at one end and banking products at the other. ART represents the convergence of these previously divergent disciplines, sharing the mechanisms and functions of each.

    ART products are often used as enablers to financial transactions. Conventional risk transfer or protection against an adverse event may not be the driving motive. Important objectives include: regulatory arbitrage between, say, banking and insurance markets; and reduction of the cost of capital for a project by transferring some of the uncertainties of success, or ring-fencing the credit exposure.

    ARTs can improve the financial management of a business by altering the perception of risk and help with tax efficiency. An example is accelerating tax deductibility by redefining a provision or contingent liability as an insurance premium.

    New capacity
    ART transactions can also attract new capacity for the transfer of conventional risks or at least manage the retention of risk if the usual sources of capacity are exhausted or cannot respond.

    Risk is increasingly seen in a broader context than the mainstream products of the insurance market can encompass. Awareness of this situation has been driven by both a greater prominence of the corporate governance process in most jurisdictions, and the realisation that the financial director's view of risk is different from that of many insurance professionals.

    Recent surveys have suggested only 20% of risks identified by corporations can be addressed by insurance.

    Constraints on traditional capacity mean that there is very strong demand for alternative approaches in the wake of pricing shocks or lack of availability of cover.