Reinsurance and other forms of risk transfer: financial reinsurance and alternative risk transfer (ART)
Treaty and facultative reinsurance are the traditional methods of transferring the risk of loss. But from the 1980s a number of financial products were developed, referred to variously as financial insurance or reinsurance, or sometimes finite reinsurance, limited risk reinsurance or structured reinsurance.
Originally there was no single generally accepted definition of what is meant by these terms and no clear dividing line between these and other kinds of insurance. More recently the term alternative risk transfer (ART) has come to be applied to a range of products that, like conventional reinsurance, provide capacity to the insurer or reinsurer and help even out fluctuations in an insurance company’s results over a number of years. ART products are also alternative in the sense that they often represent company-specific, tailored solutions. There is now a recognised definition:
where explicit maximum loss potential, expressed as maximum economic risk transferred arising from both a significant underwriting risk and timing risk transfer, exceeds the total contract premiums by a limited but significant amount, together with either explicit and material consideration of the time value of money, or contractual provisions to moderate the balance of economic experience of the parties over time to achieve the target risk transfer.
So the concept is that both underwriting risk and timing risk are involved, and that the loss potential so reflected exceeds the premiums to a significant extent (otherwise it would not be an insurance contract), but the exposure is nevertheless limited; and the contract has time value of money (financial) aspects as well as insurance. The definition also reflects the tailored nature of these contracts, aimed at a specific result. See GIM8190 on types of risk.
Thus ART covers a wide variety of products which combine aspects of the insurance, banking and capital markets. It can refer for example to:
- financial or finite insurance in which an insurance contract is underwritten by a third party reinsurer, the principal aim being to spread the insured’s own losses across a series of financial periods (the term finite refers to the risk and is sometimes criticised on the footing that it seems to imply wrongly that conventional insurance involves infinite risk)
- contracts in which a risk is transferred to a capital market maker
- bespoke over the counter (OTC) insurance transactions in which there is a one-off insurance contract which transfers risks which are unique in their structure or peril