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Chapter 2 Different types of reinsurance 2/9

Although the most popular method for an insurer of transferring risk to an outside party continues to be
ART has no strict
by way of conventional reinsurance, alternative risk transfer (ART) has become increasingly important as definition
another way to transfer risk. ART has no strict definition, although it is often said to be ‘a non-traditional
way of dealing with a risk transfer problem’. There is some argument as to its nature and whether it Chapter
should be included as a form of reinsurance at all. One opinion is that ART is a risk transfer to the capital
markets. The use of capital markets in the risk transfer process is an area under continuous 2
development. It attracts interest from banks and other financial institutions, such as hedge funds, that
can see they have the balance sheet capacity to trade risk which almost exactly counters other risk
offered to them in the course of their core business. The widest definition of ART includes any cover
containing an element of financial risk and this is the definition we will use here so that all factors that
may impact on reinsurance are considered.
Be aware
Any insurance-linked security that allows investors in capital markets to take a more direct role in providing
insurance and reinsurance protection, and brings about a convergence of insurance and capital markets, can be
considered as an ART instrument.

ART is a set of risk-financing techniques. Traditional techniques were once limited in their application to
traditional single class insurance risks, such as property. The alternative techniques combine with the
traditional to offer a powerful ‘tool-kit’ for meeting more broad risk-financing needs, including the
financial management of risks that have not traditionally been insured.
An ART solution is likely to contain several risk-financing techniques. ART solutions are hugely varied
and often developed uniquely to solve a specific problem. They enable companies to select the most
appropriate risk finance and acquire contingent capital at an economic cost.

Be aware
Contingent capital is debt that transfers into equity when there is a crisis or certain triggers are met, such as the
occurrence of a natural disaster. It is represented by funds that become available under a pre-negotiated agreement if
a specified contingency occurs. Contingent capital is useful when a company would otherwise find it difficult to raise
capital. Reference copy for CII Face to Face Training

Insurance-linked securities provide a mechanism within the financial system to transfer insurance risk to
capital markets and supply protection to investment portfolios. The financial system benefits from the
presence of insurance-linked securities, as well as other forms of ART. As a result of securitisations,
derivatives and swap structures insurers are better positioned to spread their risks across the broad
spectrum of the capital markets as opposed to relying on reinsurance or capital reserves so allowing for
efficient use of capital and adding liquidity to the financial system. This ultimately benefits individuals
and institutions seeking insurance protection. Capital market participants benefit from a diversity of
risks and returns that are not dependent on the factors that usually affect them.
Consider this…
In common with conventional reinsurance, an ART product requires an event to take place that triggers a payment by
the investor to the insurer. This could be:
• a single trigger, such as an earthquake achieving a pre-agreed measure on the Richter Scale;
• a dual trigger, such as windstorm in the Gulf of Mexico bringing about a fluctuation in oil prices outside of
predetermined parameters; or
• other convoluted combinations of events leading to multi-triggers, and so on. See section C1G.

C1 Development and features of ART

Capital markets and the insurance industry have long held a mutually beneficial relationship where
insurers provide risk protection to individuals and companies while capital markets provide the
insurance industries with a wealth of options to earn investment profits and manage reserve funds.
In turn, insurers have been among the largest purchasers of fixed-income securities from capital
markets. This has provided capital markets with substantial liquidity, enhanced trading efficiencies and
lowering borrowing costs for both government and corporate debt issues.
In recent years, the relationship between capital markets and the insurance industries has evolved to
the transferring of risk through securitisation, otherwise known as ART.