The ART of Transferring Risk

From the University of Chicago: "alternative risk transfers" blur distinctions between insurance companies and banks.
David KatzAugust 21, 2003

Once upon a time, in the not-so-distant past, a finance chief could tell the difference between an insurance policy and a derivative contract.

It was really a no-brainer. An insurance policy was a signed agreement under which your company paid a premium. In exchange, the company got to transfer some of its risks — like fires or class-action lawsuits — to a property/casualty insurance company.

A derivative, on the other hand, was a security you bought from a banker or a dealer to hedge corporate financial risks or to bet on a good investment return.

Recently, however, distinctions between the commercial insurance industry and the capital markets have started to blur. Both camps are routinely lumped under the adroitly coined rubric of ART, short for “alternative risk transfer.” The only common element? Risks are covered in nontraditional ways.

Indeed, it’s hard to tell the players without a scorecard. Looking like investment bankers, some insurers and reinsurers now help clients issue securities — not necessarily to raise capital for a project, say, but to cover the client’s risks. Carriers are also venturing into what was once exclusively capital-markets terrain by serving up hedging features in some P/C products.

For their part, some bankers can easily be mistaken for insurance executives. Like insurers, they take part in deals involving captive insurance companies — perhaps the oldest part of the ART scene. Further, capital-markets mainstays like Lehman Brothers and Goldman Sachs have become players in the Bermuda reinsurance market.

Navigating such shifting — and often offshore — waters can be tough for CFOs with risks to cover and capital to protect. But if they’re equipped with a coherent way to shop the ART market, they can find ways to cut risk-transfer costs, says Christopher Culp, who teaches “Alternative Risk Transfer: The Convergence of Corporate Finance and Risk Management,” an executive education course at the University of Chicago’s Graduate School of Business.

What finance executives need is a methodical way to sort through the mounting numbers of alternative-risk offerings, according to Culp, an adjunct associate professor of finance at the school and a managing director of CP Risk Management LLC, a consulting firm. While selecting alternative risk coverage might involve dicier decisions than choosing a breakfast cereal in a supermarket, he suggests, similar principles apply.

In the latter case, the professor asks, “wouldn’t it be great if we had a more systematic way of knowing which box to go to?”

Between RAROC and a Hard Place

To be sure, the observation that corporate finance and risk management are melding is nothing new. Culp, however, says his course has become especially important right now.

University administrators apparently agree: They plan to offer a version of the class as part of Chicago’s regular MBA program. (Earlier this year, Culp and a Swiss Re executive taught a similar course open only to the reinsurer’s client companies and its own executives. Another such course will be held in the fall, and the school would do the same with other interested companies.)

There are two reasons Culp thinks convergence is an idea whose time has come. One is that the ART market is in the midst of a “revolution” in product offerings. That’s a big change in a small amount of time. Just a few years ago, the market consisted mainly of all-purpose, multiyear, multiline insurance policies and catastrophe-linked futures sold at the Chicago Board of Trade. Mainly because they were relatively pricey, the policies and the futures drew less-than-enthusiastic receptions from corporate buyers.

More recently, fueled by insurance-premium hikes that have made alternative products look cheap by comparison, the ART market has taken off. Among the most successful products, says Culp, are “multitrigger,” business-interruption policies that pay off for a disaster only if one or more other bad things occur. One example of an added trigger might be a 20 percent drop in net cash flows.

Another hot product: “Finite risk” insurance and reinsurance policies. Under such policies, buyers typically plunk down premiums big enough to cover most expected losses over a period of as long as ten years. Buyers often get rebates if losses are less than expected. It’s the insurer for whom the risk is “finite,” since the policyholder ponies up a hefty sum to help cover the risk.

Besides the burgeoning of the ART market, a shrinkage in the broader economy is bringing risk management and corporate finance closer together, says Culp. Senior managements are simply wary of making investments without having some idea of what the downside might be.

Using metrics like risk-adjusted return on capital (RAROC), executives are factoring operational risk into their calculations of the cost of capital projects, the professor adds. “Deploying capital in new areas is something companies demand a high risk-adjusted return for doing,” he explains. “Capital is scarce.”

In the course, Culp tries to show how deft ART-buying choices can help companies make more efficient use of such scarce capital. Normally, he notes, a corporation short on funds might issue stock or corporate bonds, for instance. But if the shortfall is triggered by a negative event like a drop in product demand, it might be hard to find willing investors or lenders.

In such cases, companies might more wisely have tapped the ART market beforehand and bought “contingent capital,” according to Culp. Offered by insurers and reinsurers, the product enables a company to pick up quick capital by selling securities to the insurer at a preset price if a specified bad event happens.

That could make raising capital a whole lot cheaper. “Instead of having to issue common stock, you get it from a contingent-capital insurer that knows you better than the investor community does — and thus gives you a better price,” he explains.

Hacking Through the Hype

To make such moves, however, finance executives need to know what the various ART products actually do. That’s a tricky task, since the products are often ill-named, says Culp.

Among his examples of flashy, though unhelpful, terms of ART: “earnings-per-share insurance” (a policy including a number of different kinds of coverage) and “adverse-development coverage” (insurance for that part of a loss that exceeds what the buyer has self-insured).

Indeed, Culp thinks that much of his task in teaching the course is to help executives sort through puffery. To be astute consumers, they need to be able to “look at what the product itself is,” he says, “rather than what somebody calls it in the marketing department.”

Alternative Risk Transfer: The Convergence of Corporate Finance and Risk Management” will be presented at University of Chicago’s Graduate School of Business on October 8-10, 2003, and on April 26-28, 2004.

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