Historically, risk was financed and transferred through guaranteed cost insurance. But within the last 40 or 50 years, the use of alternative risk transfer (ART) emerged as an option for businesses looking for different means of transferring as well as financing risk. Alternative risk transfer is a technique that includes both insurance and retention to manage risk, and, though varying in complexity, can benefit businesses of different sizes. Below are some common, but effective ART techniques that are available for businesses to implement. Each business should examine their respective capabilities to determine which technique is best suited to address their organization’s risk goals.
Self-insurance or retention, one of the most rudimentary ART techniques, allows a company or organization to create a system of recording its losses and paying for them. Although informal and involving more risk retention than transfer, self-insurance allows an organization to maintain a cash flow benefit since it pays with its own cash flow or liquid assets. This may provide companies the opportunity to save the money they would otherwise spend on premium. Organizations tend to offset some of the risk they assume by purchasing an excess coverage policy for losses that are sporadic but severe. Retention can also generate greater efficiency within companies that experience high-frequency losses by financing losses rather than filing a claim with an insurer. Companies that opt to self-insure not only control the claims process, but are also not subject to policy conditions and exclusions, which provides a great deal of flexibility.
Another popular technique of transferring and financing risk is a captive, a subsidiary that is created to insure the exposures of its parent company. Captives can be owned by a group or a single parent. Group captives work as formalized pools in which several organizations or businesses work together to not only share exposures, but also financial costs. Single parent captives operate more as a formal retention plan and only cover exposures for the parent company and its affiliates. Captives can also mitigate exposures through reinsurance or other insurers. Aside from diversifying or financing its risk, captives appeal to businesses and organizations for several reasons: First, captives are an alternative for companies that may not be able to insure their exposures in traditional markets because of their losses or the high-risk nature of their business. Second, like retention, captives are not subject to policy conditions and exposures, which allows a wider coverage of exposures. Third, captives can be domiciled around the world, allowing businesses to use jurisdictions that have no or minimal taxes and offer more favorable regulations. However, the capital requirements and start up costs for a captive can be quite high, which could be a deterrent for some businesses. For example, Florida requires single-parent captives to maintain a capital requirement of $250,000, while in other jurisdictions, the requirements can be much higher and reach well over $1 million. If organizations lack the capital to start a captive, they can meet such requirements through a line of credit. Depending on where the captive is domiciled, the line of credit may or may not be sufficient to meet the capital requirement.
Retrospective Rating Plans
Retrospective rating plans or “retro plans” were developed by the National Council on Compensation Insurance (NCCI) for workers compensation and the Insurance Service Office (ISO) for other coverages. Retrospective rating plans combine risk retention with an insurance program, and differ from guaranteed cost insurance because the premium is adjusted to reflect an organization’s losses. The benefit of a retro plan is that instead of using industry loss experience ratings, it uses an organization’s own losses from its policy period to set pricing. At the beginning of the policy period, a premium deposit is paid to the insurer and at the end of the policy period, depending on losses that occurred during the policy period, the premium is adjusted higher or lower. The adjusted premium is subject to a minimum and maximum limit, which is set in the policy. This provides an incentive for businesses to implement risk management strategies to ensure that losses are as mitigated as much as possible. Companies that maintain their losses low could save more on premium compared to guaranteed cost insurance.
Reinsurance, usually described as insurance for insurers, is risk transfer from one insurer to a reinsurer. An insurer could either transfer some or all of its exposures covered in the insurer’s policy, be it a single line of business, policy, or a number of policies. The insurer and reinsurer enter into a reinsurance agreement, which sets the terms for covered losses. In most cases, the insurer does not transfer all liability to the reinsurer; the insurer tends to retain a certain percentage of its insurance amount or dollar amount of loss. Reinsurance benefits both the insurer and insured, providing insurers an added layer of protection, especially for catastrophes or “Acts of God,” providing surplus relief to insurers, and increasing the line capacity of liability or property coverage.
A cat bond or catastrophe bond is an insurance-linked security that transfers risk to investors. Cat bonds were created as a response to the destructiveness of Hurricane Andrew in 1992 and the need to diversify the availability of capital. Reinsurers and large corporations can both purchase cat bonds to serve as a gap between traditional excess insurance and reinsurance. Cat bonds can be used for any insurable catastrophic event such as tornadoes, hurricanes, earthquakes, fires, or any adverse environmental event, and coverage can be based on a single event or cumulative losses over a set period of time. Losses can be measured by a specific metric, such as the category of a hurricane, actual loss, or an industry loss index. Cat bonds are meant to provide protection against infrequent, but severe events to ensure that the issuer and investor do not lose money.