The art of ART … new ways of protecting the future

Interestingly, insurtech isn’t always about insurance. It can also be about new ways of transferring risk. In our last article for 2021, we take a look at some alternatives to traditional insurance.

You do not need to be an industry insider to know that insurance demand continues to outstrip supply. In particular, premiums for D&O, PI and cyber insurance continue to skyrocket with no clear resolution in sight. This has been due to a multitude of factors. However, the prolonged tightening of insurance capacity in the Australian and global markets has led to policyholders considering alternative ways of transferring risk through non-insurance products. Once the domain for large multinationals, alternative risk transfer ( ART) is becoming more popular among medium sized corporates and for a wider range of risks. What is the art of ART and how can insurers continue to stay relevant?

What is ART?

ART refers to the ability for companies to transfer risk without using traditional insurance. There are many types of ART, utilising creative and innovative structures to create bespoke solutions. These include:

  • insurance linked securities (eg. cat bonds)
  • sidecars;
  • swaps and derivatives;
  • index‑based solutions (eg. parametric products);
  • captive solutions;
  • virtual captives; and
  • group schemes such as discretionary mutual funds.

This article will focus on some of the alternatives that companies are considering in the current hard market.

Insurance linked securities ( ILS)

ILS are securities used to transfer major risks to ART capital markets. Insurers and reinsurers commonly issue them. The value of an ILS is linked to insurance related risks such as natural disasters, rather than traditional asset classes in the corporate sphere, providing diversification benefits for the investor. The most common type of ILS is a cat bond, protecting against catastrophe event losses. Others include longevity bonds issued by life insurers. Investors can also trade some ILS products on the secondary market.

ILS are useful for companies seeking protection because they provide access to alternative capital, a benefit in the current hard insurance market. Large superannuation/pension funds and asset managers may invest in ILS. These investors may receive interest payments in addition to a return. However, if the ‘insured event’ occurs, all or part of the principal is used to pay losses.

Similar to index-based solutions (discussed below), ILS generally identify an index determines whether an ILS trigger event has occurred. The index could potentially include losses not anticipated or the loss might not be correlated with the index. Accordingly, it is important that the trigger event is identified with precision. The terms of the ILS will also dictate whether the proceeds are ultimately paid if a trigger event occurs.

Index‑based solutions

One way to reduce the protection gap resulting from the hard market is with parametric or index‑based products. There are two elements to an index based product. These are 1) the index and 2) the payout. Both are pre-agreed and documented in the contract.

While companies commonly deploy index based solutions for natural catastrophe risks such as cyclones and earthquakes, the applications are increasing. Bespoke solutions enable parametric insurance for a wide range of risks including cyber risk,[1] connectivity risks (due to internet downtime)[2] and flight delay.[3] The simplicity of a ‘if triggered then pay’ approach has also led to parametric insurance being deployed on public blockchains.[4]

Parametric v Insurance

The main difference between parametric products and traditional insurance policies is that there is no indemnity assessment. This simplifies the loss adjusting process, and provides transparency as to the amount payable in the event of a claim. This provides certainty not only for the policyholder, but also the institutions participating in the risk.

However, while parametric insurance sounds promising, there are some things to look out for. The trigger event is based on data. It is important that this data is independent and reliable. If the insured person has the ability to influence the data this could lead to an unacceptable moral hazard. Furthermore, issues may arise where the source of data is no longer available. There may then be a dispute as to an acceptable alternative, a question which might be hotly contested if a claim is potentially on foot.

A significant downside of parametric products is basis risk. This is the potential for a disconnect between the parametric trigger and the actual loss sustained by the person who purchased the product. This mismatch between the potential loss suffered by the insured and payment under the parametric product is a weakness that does not apply to the same extent in a traditional insurance policy, where insurers generally pay claims on an indemnity basis after calculating the loss.

The cause of basis risk is the simplicity of the ‘if triggered then pay’ approach under a parametric product. But this could also be one of the inherent advantages of parametric products. Due to its simplicity, parametric products may not be insurance. Accordingly, there is the potential of an increased capital pool because participation is not limited to regulated insurers. This may be a significant advantage in times when capacity in the insurance market is limited.

A captive audience

Another type of ART is the use of an insurance captive. Historically, insurance captives were utilised by large multinationals to create tax effective insurance arrangements. However, the hard market has led to increased exploration of captives not just for tax benefits, but also to better manage and transfer risk within a group.

There are a number of different types of captives. These include:

  • a captive company that insures the liability of its parents;
  • a group captive that insures the risk exposures of the corporate group;
  • captives ‘for rent’ including protected cell or segregated account captives; and
  • virtual captives offered by insurers.

Why captives?

There are a number of reasons why companies prefer captives over traditional insurance arrangements, particularly for companies that are finding it difficult to place their risks in the insurance market due to capacity issues in the market. Captives can be domiciled anywhere in the world, enabling access to other reinsurance markets. Cover can also be tailored enabling better control over the company’s risk management strategy. The captive may be able to obtain better terms in the global reinsurance market.

A company can establish a captive in its jurisdiction of choice, hire one or seek a ‘virtual captive’ which seeks to emulate a captive by working with an insurer on a multi-year basis.

Establishing captives

Captives are regulated insurance companies and so ongoing compliance and prudential requirements apply. These costs and requirements need to be considered. However, the ability to better manage risk within an organisational group and access global reinsurance markets may make this an attractive option for companies despite the ongoing costs.

The compliance requirements are reduced where a third party manages the captive or where a company seeks to rent a captive such as a protected cell.

Protected cell companies/segregated account companies

Protected cell companies ( PCCs), also known in some jurisdictions as segregated account companies, are a legal structure permitted in certain jurisdictions. A PCC can be established and rented by a company seeking a captive solution. The assets and liabilities of each cell are legally segregated from other cells, providing a layer of protection. PCCs may offer a more efficient solution compared to establishing a captive, as the manager of the PCC takes care of the regulatory requirements. Some jurisdictions where PCCs are permissible include Guernsey, Delaware, Bermuda and the Cayman Islands.

Virtual captives

A low cost entry option is a virtual captive which is a low cost entry option for companies exploring ART. Under this option, a premium is paid to the primary insurer which insures the risk. However, part of the risk is ceded to a PCC managed by the primary insurer. Alternatively, the ‘cession’ may be emulated in a multi-year insurance agreement with the insurer with annual reviews of the cumulative loss ratio.

Potential issues

In the context of the hard market, however, captives may also face difficulties in placing reinsurance. Despite access to global reinsurance markets, it may still be difficult to obtain reinsurance for on hard to place risks negating some of the perceived benefit of setting up the captive. Furthermore, in the case of a captive domiciled in a jurisdiction other than Australia, the company will need to consider the risks associated with the involvement of a foreign jurisdiction. Access and ownership of any funds need to be carefully considered.

Mutual funds

The hard market has encouraged some companies to consider discretionary mutual funds ( DMFs). Under this structure, participants pool money together to form an indemnity pool. The funds in the pool are used to pay claims and obtain reinsurance should claims exceed the amount in the pool. This structure works best if the people who are participating in the pool have a similar risk appetite as the members may participate in claim decisions and management of funds in the pool.

Unlike a traditional insurance policy, members of a DMF do not have a contractual entitlement to payment in the event of a claim. The member may submit a request for payment and the board of the DMF will decide whether to pay. Accordingly, DMFs may not be suitable in some circumstances. For example, an individual, director or officer may not want to have their liability protected by a discretionary mutual fund where there is no guarantee of payment if they need it.

So what might the future hold for risk transfer?

Creativity is the limit for ART structures. This article has analysed just a few ways to manage and transfer risk. As demonstrated, there are advantages and disadvantages to each ART structure. A company will have to assess its risk and consider which approach may be suitable having consideration to the insurance market at the time and whether a traditional insurance policy may be preferable to these more exotic approaches.

Tim Chan is an insurance & insurtech lawyer at global law firm Norton Rose Fulbright and Founder of The InsurTech Lawyer blog. He regularly advises insurers and startups on emerging legal issues affecting the industry. Follow Tim on Twitter: @timinsydney

[1] See https://www.artemis.bm/news/parametric-cyber-business-interruption-cover-launched-at-lloyds/

[2] See Riskwolf for example: https://www.riskwolf.com/

[3] See Blink for example https://blinkparametric.com/

[4] See Etherisc for example: https://blog.etherisc.com/what-is-parametric-insurance-and-why-on-a-blockchain-ee5322b018db?gi=892aa3c2bfa9

Originally published at https://theinsurtechlawyer.com on December 20, 2021.

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Photographer 📷, booklover 📔, tech geek 👨‍💻, insurance nerd ☂️ and #aussie #insurtech lawyer

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Tim Chan

Tim Chan

Photographer 📷, booklover 📔, tech geek 👨‍💻, insurance nerd ☂️ and #aussie #insurtech lawyer

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