As companies seek to reduce financial volatility, traditional insurance market solutions are increasingly supplemented by alternative forms of capital allocation which can present new opportunities.
According to Guy Carpenter, capital stood at $95 billion at the end of 2018, an increase of about 9% over a 12-month period and following 16% growth during 2017.
Looking ahead, capital owners — including private equity funds, sovereign wealth funds, hedge funds, and pension funds — have earmarked an estimated $1 trillion for investment in risk finance.
Nearly a third (31%) of respondents to our 2019 excellence survey said their organization uses or has used alternative risk transfer (ART) solutions, with another 8% saying they will do so within two years.
Capital owners are looking to diversify their investments. Capital seekers, meanwhile, want to tap additional capital pools to finance risk more efficiently, smooth volatility, and create opportunities for diversification.
By leveraging advances in risk modeling, ART solutions can be positioned at the forefront of innovation, providing coverage for risks that are traditionally difficult to quantify or insure — for example, the financial repercussions of a pandemic.
But without effective modeling, an organization may not recognize the benefits of alternative finance solutions for such a risk, while capital providers would be unlikely to express interest.
Many factors come into play when assessing a company’s readiness for an alternative risk transfer solution, including stakeholder knowledge, company size, and cost.
One-third of respondents said they need to learn more before making a decision regarding alternative risk transfer solutions.
Data-driven modeling is thus critical as companies need to compare traditional insurance against alternative risk transfer solutions to clearly understand the value each provides.
Among C-suite respondents, 53% said they need to learn more about alternative risk transfer solutions, while 30% of risk executives said the same. This should be seen as a call for risk professionals to educate both themselves and senior executives in order to add value to strategy conversations.
Alternative Risk Transfer Solutions in Use
Among focus group members there was general agreement that alternative risk transfer solutions hold promise. “It’s about getting more creative to keep costs down,” said the risk manager for a multinational hospitality company that was looking into parametric solutions to cover properties for wind perils.
When asked which solutions were in use, it was no surprise that captives were far and away the top response. Captives are often an integral part of an alternative risk transfer program, regularly used as a stepping stone toward other solutions.
Following captives, the most prevalent solutions were structured risk programs, risk retention groups, and integrated risk programs.
WHAT TYPES OF ALTERNATIVE RISK TRANSFER SOLUTIONS EXIST?
Structured risk programs: Tailored products that include a portion of self-insurance.
Risk retention groups: These entities, which are owned by their insureds, are based on the federal Risk Retention Act, which allows insurers to underwrite all types of liability risks aside from workers’ compensation.
Integrated risk programs: A combination of different coverages within a single multiyear policy or program, sharing at least one limit of liability.
Second loss cover: A type of reinsurance in which the reinsurer indemnifies the original insurer (ceding company) for losses above a specified limit.
Parametric solutions: Index-based solutions covering a predefined event with a predetermined payout mechanism that comes into play when the predefined event parameters are met or exceeded.
Catastrophe bonds: Commonly referred to as “cat bonds,” these derivative debt investment vehicles are designed to cover a specifically identified catastrophic loss event or a magnitude of loss associated with an event.
Dual trigger cover: These types of policies kick in when two types of predefined events take place.
Cost and Understanding Obstacles
In looking at obstacles to the use of alternative risk transfer solutions, we again found an opening for risk professionals to educate others in their organization. Nearly half of C-suite respondents said they don’t understand how the products work, compared to just 18% of risk professionals who said so.
At the same time, explaining alternative risk transfer solutions to others was the top obstacle cited by risk professionals.
Some focus group participants said they need more information to both understand and explain alternative risk transfer solutions. Having that would help others within the organization to “get more comfortable” with the concept, said the risk executive at a telecommunications company.
For risk departments, modeling and otherwise researching available risk finance solutions can complement concurrent investigations of existing and emerging risks.
For brokers and other risk advisors, this is an opportunity to not only educate risk executives about alternative risk transfer solutions and their benefits, but also to highlight the value of data and modeling tools.
Cost Remains a Hurdle
Cost was the main obstacle noted by excellence respondents. In understanding costs between alternative risk transfer and traditional solutions, it should be noted that the two offer different benefits. Alternative solutions are rarely, if ever, simply a replacement for traditional insurance.
Rather, they are used in targeted areas to address risks that may not be effectively covered through conventional means and to provide additional balance sheet protection that goes beyond that afforded by traditional insurance markets.
Comparing the financial costs between alternative risk transfer products and traditional ones fails to recognize the full value of alternative risk transfer solutions. While the cost of the product is important, decisions to use alternative risk transfer solutions are often driven by the protection afforded to the organization.
In Alternative Risk, Size Matters
Focus group participants agreed that company size plays a strong role in decisions around the suitability of alternative risk transfer solutions. “Smaller companies don’t have the ability to take on significant risk,” said the risk manager at a multinational networking products developer. “I don’t see smaller organizations stepping outside the box.”
It was somewhat surprising that nearly a quarter of the largest companies said they are simply not interested in alternative risk transfer solutions given that they are typically in a strong position to benefit. Larger companies are more likely to use alternative risk transfer solutions as they have stronger balance sheets and a greater ability to retain risk.
There is also a growing interest among them to hedge their risks by using large aggregate excess programs that provide more material limits above very large retentions.
Still, 41% of smaller organizations say they want more information about alternative risk transfer solutions. As alternative markets evolve, it’s possible their products will become more relevant to smaller companies.