Alternative Risk Transfer (ART) and Captive Insurance
(I) Shortcomings of Traditional Commercial Insurance
In today's world, the risk management landscape facing enterprises is constantly changing, from structural economic changes to changes in the legal and security environments, along with the emergence of various new types of risk, such as high technology, globalization, deregulation, and geopolitical shifts. The increase of various new risks continually challenges the limits of insurability; new risks are characterized by insufficient market information and a lack of historical loss experience data, and how to manage dynamic risks poses an even greater challenge to insurers. Excluding special risks, catastrophe risks, and trend-based fundamental risks from the scope of insurable risks can no longer meet the growing risk management needs of enterprises facing a constantly changing economic environment. The shortcomings of traditional insurance products are becoming increasingly apparent:
l Addressing various risks in an isolated, one-by-one manner
l Using good-quality risks to subsidize poor-quality risks
l Insurers' selectivity toward policyholders' credit risk
l The presence of moral hazard, which reduces the incentive to implement defensive measures
l Limited underwriting capacity
Traditional insurance tends to address various risks in an isolated, one-by-one manner, whereas increasingly complex risks and increasingly sophisticated risk management require an approach that considers all the risks a company faces in a comprehensive and integrated way. ART products were developed precisely to meet these needs and can reduce risk management costs.
The actuarial pricing principles of traditional commercial insurance are built on average-risk statistics: pooling similar risks, using the gains from "good risks" to offset the losses of "bad risks," and pursuing product pricing above the average loss. Given the information asymmetry between insurers and insureds, a good risk exposure may be unable to obtain a rate reflecting its true risk level and instead pays the higher market-average rate. As corporate risk managers and company financial officers have become increasingly sophisticated, they dissect and rigorously scrutinize every element of traditional insurance business; consequently, companies with better-quality risks are unwilling to subsidize the rates of poorer risks and turn instead to captive insurance and risk financing, which has put enormous pressure on the development of the traditional insurance industry.
Insurance companies also face credit risk crises: if an insurer's solvency is inadequate, it will be unable to bear its claims obligations. The heavy losses caused by catastrophes in the 1990s drove many insurance companies into bankruptcy, which suffices to show that this danger is real.
Having insurance coverage changes the behavior of the insured: once policyholders have purchased insurance, they may no longer actively avoid or control losses, because the insured's motivation to guard against or retain risk is weakened. This means insurers have to charge average rates to guard against moral hazard. If the captive approach is adopted, the policyholder has a direct incentive to take appropriate risk management measures to avoid losses or minimize them as much as possible.
In addition, the insurability of insurance is limited by insufficient underwriting experience with new risks, such as cyber risk, millennium risk, and terrorism risk. The commercial insurance market often becomes familiar with a new type of risk through alternative risk transfer (ART) products; subsequently, the coverage scope of traditional commercial insurance expands accordingly.
Enterprises face increasing liability risks of all kinds, with claim amounts growing ever higher. For example, between 1995 and 2000, even with overall inflation low, the average award in medical malpractice cases decided by U.S. courts doubled, reaching US$1 million; in 1998 there were only 17 verdicts as high as US$100 million or more, but by 2000 the number had risen to 27.
Major companies often find that, because the (re)insurance market clearly lacks underwriting capacity, the major risks that truly threaten their survival fall outside the scope of insurance coverage. Scenario simulations of certain catastrophe events project losses of tens or even hundreds of billions of U.S. dollars, clearly exceeding the underwriting capacity of commercial insurance; in many cases, the risks faced by large multinational corporations exceed what can be covered by commercial insurance products purchasable in the traditional insurance market. In such circumstances, risk securitization products supplement the underwriting capacity of commercial insurance by directly tapping the potential of the capital markets.
(II) The Development of Alternative Risk Transfer (ART)
It is precisely because of the defects of traditional insurance that alternative risk transfer mechanisms have developed. It is difficult to describe the alternative risk transfer mechanism with a single simple definition: it is an innovative risk management mechanism supported by a broad range of financial markets and financial instruments. As society's need for special risk management has grown, alternative risk transfer mechanisms have developed rapidly in recent years, and the concept has become broader.
Alternative risk transfer (ART) refers to risk management tools that serve the needs of enterprise-wide risk management by comprehensively employing (re)insurance techniques and the capital markets to conduct risk financing and risk transfer. It encompasses the various innovative products, instruments, and solutions that serve the management of enterprises' special risks. ART includes risk transfer and risk financing solutions tailored to clients, which can provide customers with comprehensive solutions such as multi-line and multi-year coverage. ART products place relatively greater emphasis on risk financing rather than risk transfer (such as finite risk solutions, committed capital, etc.).
Alternative risk transfer (ART) originated in the late 1960s and early 1970s as a special-risk solution mechanism gradually refined alongside the development of self-insurance, risk retention, and captive insurer techniques. At that time, many large enterprises began establishing captive insurers and developing risk retention techniques, and new risk transfer and risk financing techniques began to emerge. During the 1980s and 1990s, products that conduct risk financing through forecasts of loss timing and cash flows (involving no risk transfer) continued to develop, and a wide variety of finite risk programs appeared in large numbers, such as retrospective excess-of-loss covers, loss portfolio transfers, adverse development covers, and retrospective aggregate loss covers. From the mid-to-late 1990s to 2000, stimulated by multiple factors including property insurance market cycles, product innovation, and deregulation, a wide range of risk management tools and techniques - such as various risk management products, contingent capital instruments, securitization, and insurance derivatives - emerged in large numbers, driving the development of enterprise-wide risk management. Alternative risk transfer mechanisms are still in a stage of development, and their maturity and refinement still depend on the future integration of risk management techniques.
In recent years, the emergence of new risks - such as intellectual property, terrorism, composite financial indices, comprehensive liability/litigation, illiquidity, and cybercrime - has confronted enterprise risk management with unprecedented challenges, and enterprises urgently need to find solutions for uninsurable risks. ART can provide protection against a series of risks affecting the balance sheet, such as natural disasters, financial fluctuations, exchange and interest rate movements, operational changes, and environmental changes; both the range of risks involved and the breadth and depth of protection offered are far greater than those of traditional insurance.
In 2008, the issuance volume of catastrophe bonds and risk capital fell sharply from prior levels, but it continued to increase thereafter; as of 2013, issuance of risk capital, including catastrophe bonds, exceeded US$7 billion, and the cumulative outstanding amount had reached US$18 billion.
(III) Captive Insurance and Alternative Risk Transfer
Although the alternative risk transfer mechanism (ART) evolved out of captive insurance, captives and ART are still clearly distinct. First, a captive is the principal vehicle of alternative risk transfer mechanisms, but not the only one; commercial reinsurance companies and the capital markets are also important vehicles. Second, in addition to using ART to underwrite special risks, captive insurers also underwrite ordinary insurance like conventional commercial insurance companies. Third, alternative risk transfer mechanisms offer many solutions and are not the exclusive preserve of captive insurers; conventional commercial (re)insurance companies can likewise use alternative risk transfer tools to expand their own underwriting capacity.
Captive insurance is the core and key link between the traditional commercial insurance market and the alternative risk transfer market. The risks underwritten in the alternative risk transfer market are mainly special risks that commercial insurers do not cover; such risks include single risks of a special nature, emerging risks, or catastrophe risks with uncertain loss timing, all of which share the common characteristics of lacking historical actuarial data support and lacking a large pool of homogeneous risks for risk diversification. Captives underwrite such risks and provide risk financing, accumulating valuable actuarial data. After a period of time, some of these risks can be transformed into standard products underwritable by traditional commercial insurance. Captive insurance therefore plays a central supporting and driving role in insurance market innovation.
Common alternative risk transfer products provided through captives include:
(1) Multi-line/multi-year insurance products: policies that bundle multiple risks together in a single policy, provide coverage for the aggregate losses caused by different risk events, and have a policy term longer than one year (for example, providing both property damage and accident injury coverage in a single contract). Clients can consolidate risks within their own business portfolios, avoid purchasing excessive coverage, and greatly reduce the transaction costs of negotiating multiple policies.
(2) Multi-trigger products (MTP): two triggers are set in the contract - one an insurance event and the other a non-insurance event - stipulating that the insurer pays only when all triggering events have occurred. The second trigger is usually set as a financial risk beyond the insured's control, thereby avoiding moral hazard.
(3) Contingent capital products: these are products structured by combining insurance and the capital markets, and are instruments that enable an enterprise to raise capital after a pre-agreed adverse event occurs. Typically, the enterprise pays a fee to the insurer; when a specified adverse event occurs, the enterprise can, according to the commitment stipulated in the contract, obtain the capital it needs from the insurer in the form of senior debt, preferred shares, or subordinated shares. The providers of such capital do not bear the risk of the event itself; they merely provide financing for the loss after the event occurs, and they require a return.
(4) Catastrophe bonds: these promise bondholders that, unless a catastrophe - such as an earthquake - occurs, they will receive payment of principal and interest. Once a catastrophe does occur, the bond issuer's obligations are correspondingly reduced, and it need pay only part of the principal and interest.
(5) Index-based insurance products: the underlying of the transaction is set as an insurance-related index, such as the aggregate losses or aggregate loss ratio of a certain class of insurance, or it may be a natural phenomenon such as earthquake frequency or weather changes.
