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2/10 M97/February 2018 Reinsurance

Imbalance in the insurance and reinsurance industries has given rise to new financial products created
Provide insurers with
better tools to within capital markets, providing insurers with better tools to manage risk and investors with new
manage risk investment opportunities. Traditionally, primary and secondary insurance markets have managed risk by
2 holding capital in reserve or by financing risk positions through reinsurance. However, capital held in
Chapter to free capital, combined with concerns over the reinsurance industry’s ability to provide future
reserve is unavailable to fund business expansion and new ventures, resulting in stagnation. The desire
coverage, has provided insurers with the incentive to look for risk management alternatives.
To begin with, insurance-linked securities were simple fixed income structures that allowed insurers to
manage catastrophic risks. Over time, they have become more complex and have evolved into a discrete
asset class with great appeal to a wide range of investors and provide insurers with a broader choice of
risk management tools. Insurance-linked securities include derivatives, catastrophe bonds, contingent
capital contracts, industry loss warranties, reinsurance sidecars and catastrophe futures, which further
converge capital and insurance markets. We will look at the features of these products later in this
chapter.
Cost and capacity limitations in the reinsurance market have created incentives for insurers to turn to
the capital markets by creating the opportunity to convert illiquid assets into liquid assets.
Insurance-linked securities serve to manage and hedge various insurance risks while increasing the
availability of capital by drawing on alternative sources of funding. Like most other markets, insurance-
linked securities have been adversely affected by the global financial credit crisis but have proved to be
more resilient as issuances continue to grow despite there being some weaknesses in certain individual
sectors.
There are two segments which make up the ART market:

ART market

Risk transfer Reference copy for CII Face to Face Training
through alternative Alternative
carriers products

The market for alternative carriers consists of self-insurance, captives and other loosely-defined risk
retention groups.
Refer to chapter 1, The use of captives increases dramatically when insurance markets harden. Many multinational
section B6 for
captives corporations already ‘parent’ a captive. Captive insurance companies represent an alternative form of
risk financing.
The captive must be adequately capitalised so that it holds sufficient funds to meet all foreseeable
losses within the capacity allocated to risk by its parent. The decision to proceed with the formation of a
captive will need to consider the cost and availability of that capital as well as those costs associated
with set-up, management and maintenance. Costs will be highest where the decision is taken to locate
‘offshore’, although there will likely be tax advantages to mitigate such costs.
It may be several years before the accounting of the captive’s insurance transactions allows the release
of profits to its ‘parent’ and so the establishment of the captive must be seen as a long-term investment.
Further capital will be needed if losses prove to be worse than anticipated and any future decision that is
taken to close the captive could involve running-off of claims over a prolonged period before closure.
Additionally, the captive must satisfy financial regulatory standards aside from local financial and
corporate governance regulations. Essentially, when market conditions soften, the reasons which were
so persuasive in validating the formation of the captive may have been overtaken. We will consider
captives in more detail in chapter 9, section C.

Question 2.3
From what you learned in chapter 1, what does the term ‘captive’ imply?

The key differential between ART and the traditional insurance marketplace is that insurance and
ART is intended to
supplement reinsurance markets provide catastrophic risk coverage whereas the capital markets provide additional
reinsurance financial capacity for insurance coverage through self insurance. However, ART is intended to represent
an integrated approach to supplement reinsurance needs rather than to be a replacement.