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Survey Report

Insurance Marketplace Realities 2020 Spring update – Alternative risk transfer

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COVID 19 Coronavirus

May 7, 2020

ART solutions are benefiting from new technologies and increasingly robust analytics, which lay the foundation for many of these products.

Overview

Alternative Risk Transfer (ART) concepts have been the vanguard of innovation and progress in the insurance industry for decades. Captives, integrated risk, catastrophe bonds, insurance-linked securities and other products that are now widespread started as bespoke solutions for a targeted problem. While the ART market is a steady force throughout traditional market cycles, it is during hard market cycles, like the present, when ART concepts can deliver the most value and receive the most attention from risk managers — deservedly so.

Today turmoil continues to spread across many lines of insurance as insurers struggle to address high combined ratios, low interest rates and now the economic upheaval brought on by the COVID-19 pandemic. The ART marketplace offers insurance buyers alternative risk transfer/financing solutions, which in most cases are customized for each situation. When insurers withdraw coverage, ART solutions allow basic needs to be met, providing evidence of cover, capping per claim volatility or aggregate volatility, obtaining desired limits and deductibles. These alternatives can provide protection that might otherwise be unavailable for catastrophic risk (earthquake, hurricane, etc.) or other hard-to-insure risks (pandemic, weather, reputational risk, product recall) while mitigating the impact of a large loss to corporate financial statements.

Highlights from the ART gallery

Some ART solutions have been on the market for many years, while others are just emerging. All are benefiting from new technologies and increasingly robust analytics, which lay the foundation for many of these products. Here is a list of key ART solutions in order of interest/activity.

Parametric solutions

These programs offer risk transfer based on indexes, or numerical measures of perils, such as rainfall, that are both objective and highly correlated to loss. Growing out of the agricultural sector, parametric solutions address adverse weather (e.g., too much/too little rain, temperature extremes, snow fall) and natural catastrophes (e.g., hurricanes, earthquakes, hail, tidal surge). Composite indexes are used where multiple risks are addressed. New indexes (hail, flood) are emerging as the industry embraces new technologies or indeed an insured’s own data where it is robust and collected regularly (e.g., units of manufacturing production).

Who is it for?

  • Organizations exposed to uninsured natural catastrophes or large aggregations of risk within cat deductibles
  • Industries impacted by weather generally
  • Businesses with non-damage and potentially uninsurable business interruption risks, such as failures in their supply chain

Benefits

These programs can complement property policies, cap deductibles, address uninsured risks and provide additional limit. They avoid most of the headaches of claims adjustment and review — claims generally settle within days, avoiding long loss adjustment periods.

Challenges

Basis risk is a key challenge, arising from a lack of alignment between the index/structure selected and the ultimate loss. Improved technology is addressing basis risk, refining marketplace responses and pricing.

Pandemic and COVID-19

Parametric options to address the non-damage business interruption impact of pandemic are available (for new policies in 2020, COVID-19 will, of course, be excluded). Industries of particular interest to insurers include hospitality, leisure and mining, although these can be applied to many others.

Structured solutions

These multiyear programs incorporate structural financing elements to create attractive risk transfer financing approaches. Risk financing may take the form of pre- or post-loss funding, or in corridor retentions. Structured solutions allow the insured to participate in the payment of losses while accessing some risk transfer to mitigate the timing and aggregate severity of losses.

Who is it for?

  • Organizations with challenging risk classes (e.g., large auto fleets and property in high hazard industries)
  • Situations where the premium charged is getting close to the limit offered
  • Risks that the traditional market has excluded

Benefits

These solutions allow an insured to evidence cover while leveraging its risk tolerance to take a longer-term view of risk, while still transferring volatility to an insurer. In low-loss scenarios, an insured could achieve a more cost-effective outcome than if they had remained in the traditional market. In high-loss scenarios, they could secure risk transfer that would not have been otherwise available.

Challenges

Internal hurdles can take time to surmount, achieving buy-in from key stakeholders (CFO, treasurer), establishing a clear understanding of policy operation and determining levels of embedded risk transfer.

a schematic photo of a structured solution example
Example: Structured Solution

Other ART solutions

Portfolio solutions

These multiline and multiyear programs apply portfolio theory to the purchase of insurance to achieve certainty in rate and coverage while creating efficiencies in use of insurance market capacity and administration. With sophisticated modeling now available, these solutions are gaining attention as a way to optimize the value of an insurance portfolio through the best mix of limits of retentions.

Multiline/multiyear stop loss

Insureds may wish to leverage their risk tolerance to assume greater risk in a controlled way. By raising retentions, companies can reduce their dependence on the traditional markets while at the same time managing volatility. A stop loss program can cap volatility and create certainty in earnings. This allows the insured to assume a controlled amount of risk.

Catastrophe bonds

Most often used by insurers as an alternative to reinsurance, these products are also offered by capital markets interested in large, single corporate risks that can be robustly quantified. Businesses outside of the insurance industry typically access this market when seeking otherwise unavailable capacity.

State of the ART market

We see significant growth in interest in parametric solutions, where both capacity and demand are increasing. Interest is being driven by restrictions in the traditional market, while second generation parametric products provide more refined solutions. For insurers, robust independent data, vetted analytical models, new technology and greater client awareness are leading to favorable combined ratios. We see insurers continuing to allocate more capacity to parametric solutions.

Other sectors of the ART market, however, are challenged or indeed contracting. Portfolio programs (or integrated risk programs) are attracting less capacity, driven by carrier uncertainty, coverage limitations, increased deal committee conservatism and long processing times. These markets are moving toward structured programs where they can limit downside risk.

For those buyers who face limited traditional options and can absorb significant risk, a captive insurance company can be a strategic alternative used in conjunction with other ART solutions to provide efficient fronting, or to control volatility and protect capital and surplus.

To assess the applicability of ART solutions, risk managers should approach the renewal process with robust analytics and clear risk tolerance analysis. This will allow them to effectively determine the value of these products in minimizing total cost of risk scalation in this challenging insurance market.

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