What is Alternative Risk Transfer (ART)?
Alternative Risk Transfer, or ART for short, is a fancy way of saying there are different ways to handle risk besides regular insurance. Risk is the chance that something terrible might happen. Insurance companies constantly deal with risk—their job—but sometimes, they want to share that risk with others.
Sharing risk between insurance and financial markets
That’s where ART comes in. It lets insurance companies shift some of their risks to finance and investing. Why would they want to do that? Well, insurance companies have to follow a lot of rules. And sometimes, they can’t hold onto too much risk. So, they use ART to pass it on to others who can handle it better.
On the flip side, financial markets deal with their kinds of risk, like the ups and downs of investments. It might be nice to balance that with some insurance-type dangers for them. ART gives them a way to do that, too. So it’s a two-way street.
Different types of ART
Now, ART isn’t just one single thing. It’s more like a toolbox with different tools for different jobs. Here are some of the main ones:
Captives
A captive is a mini-insurance company that a more prominent company sets up to insure itself. The company says, “I’ll handle my risks, thank you very much.” However, the captive still has to follow insurance rules. This can help the parent company save money and have more control.
Derivatives
Derivatives are financial products whose value comes from something else. In the ART world, that “something else” is often an insurance risk. So it’s like placing a bet on whether the wrong thing will happen or not. Derivatives can get pretty complex, but the basic idea is to trade risk around.
Insurance-linked securities
These are like regular bonds or stocks, but instead of being linked to a company or government, they’re linked to an insurance risk. Investors can put money into them, but they might lose some or all of that money if a bad thing happens (like a giant hurricane). In exchange for that risk, they usually get higher returns.
Contingent capital
This is money that companies set aside for a rainy day. But instead of just sitting in a bank account, they use ART to ensure it’s there when needed. For example, they might buy a special kind of insurance that only pays out if the company gets into financial trouble.
Enterprise risk management
This is a way for companies to look at all the risks they face, not just the ones they can insure. They try to understand how the risks fit together and how to handle them. ART can be a part of that bigger picture.
Why do companies use ART?
There are a few main reasons why companies might want to use ART:
To save money
Regular insurance can be expensive. However, companies can sometimes get the protection they need for less by using ART. This is especially true for big companies that can spread their risks around.
To get coverage for unusual risks
Some risks are too significant or too weird for regular insurance. Think of things like cyber attacks, terrorism, or pandemics. ART can help companies find ways to cover those risks when average insurance won’t.
To free up money
When companies buy regular insurance, they have to pay premiums, and that money is gone. With some kinds of ART, they can get the coverage they need without paying much upfront, freeing up cash for other things.
To have more control
With regular insurance, companies are at the insurance company’s mercy. They have to hope they’ll get paid if something terrible happens. With ART, they can sometimes have more say in how the risk is handled and payouts work.
Who uses ART?
ART isn’t for everyone. It tends to be used by more prominent companies with more complex risks. Here are some of the main groups that use it:
Big corporations
Think significant airlines, energy companies, tech giants, and the like. They have a lot to lose if something goes wrong, so they often turn to ART for extra protection.
Financial institutions
Banks, investment firms, and insurance companies are significant users of ART. They use it to cover their risks and make money by trading in risk.
Governments and non-profits
Even governments and non-profit organizations can use ART. They might use it to cover disaster relief costs or encourage private investment in social projects.
ART pros and cons
Like anything in life, ART has its good points and bad points. Here’s a quick rundown:
Pros
- Can save money compared to regular insurance
- It covers risks that regular insurance won’t
- It gives companies more control and flexibility
- Frees up cash for other uses
- Spreads risk around
Cons
- It can be complex and challenging to understand
- Higher risk than regular insurance if done wrong
- Depends on financial markets, which can be unpredictable
- Not as strictly regulated as regular insurance
- May have tax and accounting issues
