The research and development stage for alternative risk transfer (ART) products is over. We will see continuous improvement in the techniques and tools that we use, but the risk manager of the modern corporation is now presented with a full and complete spectrum of risk management tools from which to pick and choose. Today and into the future, the risk manager's art is to be able to distribute each of his company's risks to that place where it is most efficiently held. He will be able to match the right risk to the right tool, and to the right risk management partner. And he will be adding significant value to his firm in the process.

ART has evolved significantly over the last ten years. It was born as a way for companies to smooth over imperfections in the insurance markets - for instance, instead of transferring risk at high cost and low efficiency to the insurance markets, they could transfer them to their own captive insurers, or they could share in the spoils of risk transfer through a well constructed finite risk reinsurance program. Then, as the marketplace developed, products and their complexity proliferated and ART was criticized as being “ART for ART's sake”: complex just to be complex. We are through that now. The marketplace understands when complexity is needed and when simplicity may be the key.

What matters now is efficiency. The risk manager's job is to have breadth of knowledge about the risk landscape that his company faces, the risk management tools that are available, how they work and what they are for, and how they could be applied to the organization's unique situation. Moreover, with this new set of tools, risk managers have to broaden their view of the risks that they are managing. They can no longer afford to be “property/casualty specialists”, for instance. They have to understand that the use of any particular risk management tool on any particular risk will have an impact across the entire risk landscape of the organization. This means that risk management strategies must - by necessity - take into account the risks across the organization, and individual risk management actions must be taken within this organization-wide framework.

The tools of the trade

Far from being limited strictly to traditional insurance, risk managers now have cheap and efficient access to a broad and varied set of risk management tools. These include:

  • Captives. A captive is an insurance or reinsurance vehicle that belongs to a company or group of companies, and is not active in the insurance industry itself. It mainly insures the risks of its parent company. On the one hand it is a formalized self-insurance vehicle for high frequency risks that can be carried by the company itself in an efficient way. On the other, it is used as a financing instrument for very specific low frequency, high-severity risks, for which no cover is available in the traditional insurance market.

  • Multi-line, multi-year products (MMPs). An MMP bundles several risks together so the payment to the buyer reflects the joint losses from these risks. The benefits of MMPs for policyholders include: efficiency gains, both in the diversification of risks within the insured portfolio, and in administration; the stabilization of risk costs, because MMP insurance programs are renegotiated on a multi-year basis, not annually and flexibility, because MMPs are usually tailored specifically to client needs.

  • Multi-trigger products (MTPs). Many clients are comfortable with retaining a particular risk, but would be nervous if that risk were to occur in conjunction with another event. For instance, an airline company can live with the volatility of the price of airline fuel. However, the risk manager calculates that, if the company were to experience a fire in a maintenance hangar and lost more than two planes at the same time as it experienced a spike in the rise of airline fuel, it would be facing a serious cash flow crisis. The risk manager could construct an MTP that pays out only when both events happened simultaneously - this way the risk manager has managed to smooth the peaks and valleys in the firm's earnings volatility, adding financial value to the company. In an MTP, the payments due to losses on one risk are only made to the buyer if triggered by an event on some other risk. The possible combinations of triggers provide an endless variety of MTPs. The corporation is able to customize an MTP to suit its own needs. MTPs by their very construction are multi-line products and therefore share many of the features of MMPs listed above.

  • Finite solutions. Finite risk reinsurance is based on the same instruments as traditional reinsurance. However, the essential characteristics of finite products, in particular the assumption of limited risk by the reinsurer, the multiyear period of the contracts, the sharing of the result with the client, and the explicit inclusion of future investment income in the stipulation of the price, offer additional possibilities that are encountering growing interest among corporations. Among other things, finite products can stabilize reinsurance costs and the availability for capacity; smooth fluctuations in results; expand underwriting capacity; provide (partial) protection against as yet unreported claims and optimize the balance sheet. From a macroeconomic perspective, they help to attenuate cyclical trends in the insurance market; provide reinsurance capacity even for hard-to-insure risks promote the establishment of long-term relationships between corporations and reinsurers and facilitate corporations' access to risk capital.

  • Contingent capital. These instruments are relatively new phenomena, based on a tried and true technique. In essence, a contingent capital instrument is an option to raise capital, subject to certain conditions. In its simplest form, it is a bank line of credit that a firm can draw on for most of its business needs, as specified by agreement with the bank. Contingent capital instruments help corporations manage their retained risks; provide off-balance sheet capital to cover those risks; and are usually structured as an option to issue a security.

  • Securitization. A risk represents a potential cash flow, either into or out of the company. In recent years, the capital markets have developed sophisticated ways for these cash flows to be transferred to counterparties who are able to hold the risk more economically than the originating firm. An insurance securitization can transfer a risk - usually to capital markets investors - by packaging up the cash flows in the form of bonds. Securitization has strong potential for providing risk managers with efficient risk transfer for uninsurable or difficult to manage business risks. At the same time they give capital markets investors an asset that is not correlated with the rest of their portfolio, bringing them diversification benefits.

  • Derivatives. The capital markets have been providing efficient risk management tools for financial risks for many years. Recently, however, financial market risk management techniques have been extended to increasingly difficult to manage risks, such as weather risk, or business risk.

    Table one describes the relative characteristics of each of these tools.

    The key to managing risk and capital efficiently is to have a strong understanding of the tools available to do so, and the way in which each one will impact the balance sheet. For suppliers of risk management solutions, there are three steps involved:

    1. Suppliers must understand the capital management and volatility issues facing the client.

    2. They must understand the complete new risk management tool box, and

    3. They must be able to develop structured solutions, together with the client-using the most appropriate tools from the box.

    The following case studies illustrate the types of issues many businesses may face and the variety of solutions that are available to address them.

    Case study 1

    A European aircraft manufacturer leased 500 planes on 15 year leases to its customers. This left the company with significant risk on its book - because of technology and market development uncertainty, timing of cashflows could be volatile. Moreover, the company was uncertain of the residual value of the planes at the end of the leases. This had significant impact on the company's capital at risk, because investors and analysts were uncomfortable with this non-core risk on the company's books.

    The solution to the problem was to provide the company with a cash flow and residual value insurance protection. This guaranteed the company smoother results, it removed a substantial balance sheet and profit and loss threatening non-core risk, and raised investors' confidence to such an extent that the share price rose 10% on the day of the announcement. This piece of risk management bolstered the company's market capitalization by 900 million euro on the day the deal was announced.

    Case study 2

    A US bank was restricted by the amount of capital that it was required to maintain according to regulation. Although it had a large number of loans to high quality customers, it was required to hold much more capital than was economically justified by the credit risks that the customers represented.

    The solution was to use a credit derivative to transfer the credit risks to an insurer. The insurer operates within a different regulatory environment, and could hold the credit risk much more efficiently than the bank. The effect was to provide the bank with “regulatory arbitrage”. While the bank faced unreasonably high capital needs according to its own regulatory regime, the insurer allowed it to free up capital which it could then reinvest to provide shareholders with a greater return.

    Case study 3

    A project developer wanted to invest the expected equity amount it thought it needed for a particular project. However the developer's customer was not convinced that the project's capital base would guarantee successful completion of the project.

    The solution was to find a supplier of contingent capital. Should costs overrun, the developer had guaranteed access to the capital needed to complete the project. The solution provided a comfortable resolution for both the developer and for his customer - the developer could undertake the project without being exposed to a heavier burden of debt than needed, while the customer was guaranteed that the project would be completed and contracts would be satisfied.

    Each of these case studies demonstrates that the risk manager's job is much broader than simply understanding the insurance buying process. The risk manager must understand his company's capital structure and the demands that are placed upon its capital by risk. He must understand how to identify risk, and how to relate that to its impact on the company's balance sheet. The next step is to develop an understanding of the tools that are available to him to impact these issues, and to learn when to use each of these. For a risk manager who only has the hammer of insurance, many problems look like a nail. Better to have a box with a few more tools in it.

    It is also important for risk managers to develop relationships with capital providers who understand the nature of risk and the risk management tools that are available to manage it. The key to a successful relationship in this modern world is for risk capital providers to understand that they are not out to sell products or do one off deals. Risk capital providers' ambition should be to use their global knowledge of the insurance industry, their financial engineering expertise and understanding of the nature of risk, their customer relationships and advisory abilities to enable deals that should be done to get done. The aim is to ensure that customers are able to achieve their goals.

    John G. Gantz, Jr. is a principal and head of global corporate marketing for Swiss Re New Markets, a Swiss Re Group division specializing in alternative risk transfer and risk financing for major corporations and insurers. He concurrently serves as a member of the board of directors of North American Specialty Insurance Company, a subsidiary of Swiss Re. The Swiss Re Group is a world leader in reinsurance and financial services.

    Prior to joining Swiss Re New Markets in April 1999, Mr Gantz served as executive vice president and member of the executive team of Swiss Re America, as well as founder and head of its alternative risk transfer division.

  • For more than 12 years before joining the Swiss Re Group in October 1996, Mr Gantz held various management positions with American International Group, Inc., including president of AIG Risk Management, Inc. From 1978 to 1984, he was with Wheelabrator-Frye, Inc., a Fortune 500 conglomerate. While associated with Wheelabrator, Mr Gantz also served as a team leader on the President's Private Sector Survey on Cost Control in the Federal Government, commonly known as the Grace Commission. He entered the insurance industry with the insurance broker, Bayly, Martin & Fay, Inc. of New York, now part of Aon Risk Services, where he worked from 1970 to 1978.