1 L25: Alternative Risk Transfer Objective: understand why ART products are used and describe examples of specific types of ART products

2 Characteristics of ART Involve a high level of retention Span multiple years Include multiple sources of risk Cover sources of risk that are not normally covered by traditional insurance contracts Involve capital market institutions and securities

3 Types of ART ART allows a firm to retain most of its risk while obtaining benefits associated with insurance Types of ART: - Loss sensitive contracts - Finite risk contracts - Captives (Already discussed-Refer to the previous lecture) - Multiline insurance policies (Bundled policies, UGG) - Contingent debt and equity - Structured debt instruments Large firms are the primary users of ART

4 Loss Sensitive Contract Premiums ultimately paid by the insured depend on the losses that occur during the policy period Typically shift less risk to the insurer compared with traditional fixed premium (paid upfront) insurance contracts. Essentially a loan provided by the insurer to policyholders, losses paid by the insurer will be reimbursed by the policyholder. Require the policyholder to provide a letter of credit (LOC) from a major bank.

5 Examples of Loss Sensitive Contract Experience-rated Policies: To the extent that past losses are given considerable weight in the pricing of future policies Large Deductible Policies: Insurers temporarily finance the losses Retrospectively Rated Policies (Retro): - The policyholder makes additional payments if the retro premium > up-front premiums; receive the refund if the retro premium < up-front premiums - The retro premium depends on the magnitude of losses during the policy period

6 Retro Premium Loss Amt Paid By firm 0.5m 3m 0.5m3m Retro Premium= 100% of losses, with a min premium $0.5 m and a max premium $3 m

7 Why Large Deductible and Retro Policies? Tax Reason: Insurance premiums are tax deductible. Efficiency: Insurers can process claims in an efficient way Satisfy compulsory insurance requirements such as WC

8 Finite Risk Contracts/Financial Insurance Transfer relatively little risk to the insurer. Policy period 3-5 yr, typically. The insured firm pays premiums each year into a fund (subject to a fee) that accumulates interest and losses paid from the fund. Provide protection against the timing of the loss payments  Smooth the loss payments over time.( tax benefits & reduce the variability of reported earnings) Offer limited protection against unexpected loss payments.

9 An Example of Finite Risk Contract A 3-yr contract signed (1) premiums 4m each year; (2) credits interest at 6% annually on the year’s beginning balance; (3) insurer charges a fee at 10% of each premium;(4) has an aggregate limit of $20 m for 3 yrs. If paid losses in the three years equal 2m, 4m, and the end of each yr Question: What do cash flows look like with this finite risk contract?

10 An Example of Finite Risk Contract YR1 YR2YR3 At Beginning of Yr At End of Yr Balance from previous yr Premium Insurer’s Fee Beginning Balance Cash Flows in $000 Claims Payments Interest on Beginning balance Ending Balance What if claims are big?

11 An Example of Finite Risk Contract YR1 YR2YR3 At Beginning of Yr At End of Yr Balance from previous yr Premium Insurer’s Fee Beginning Balance Cash Flows in $000 Claims Payments Interest on Beginning balance Ending Balance

12 Multiline Insurance Policies Multiline- Integrated/Basket/Bundled Policies e.g. UGG Honeywell- One of the first companies to combine pure and price risk into one policy. This loss financing program provides an aggregate limit and lasts for 2.5 yrs. -Property -Liability -Directors and Officers’ Liability -Currency fluctuations

13 Contingent Financing Arrangements A firm arranges with a financial institution or investor to borrow money or issue new stock at prearranged terms, contingent on some event occurring. EX: Consider Hoyt Company is considering alternative ways of financing potential property losses over the coming year to its manufacturing facility that is valued at $5m. Hoyt is able to pay up to 1M from cash flow, and therefore is seeking ways of paying losses above 1M

14 Contingent Debt/Borrowing Hoyt obtains an option from Bank A to borrow p to if the losses>1M Note: interest rate 8% on the loan is arranged ex ante, Bank A will charge $20,000 up-front fee for granting Hoyt this option. When to exercise this option for Hoyt?

15 Contingent Equity Hoyt arranges to issue new stock/equity at a prearranged price if losses incur. Suppose Hoyt issue up to 100,000 shares at $40/share if losses>1M Note: investors who agree to buy the new equity bear some risk since $40/share is prearranged fixed price. (What if they pay more for the shares than they are worth?  Require an up-front fee) When to exercise this option for Hoyt?

16 Lines of Credit Most large businesses have an arrangement with a bank, called a LOC, whereby the bank agrees to lend $ to the firm over some future period if the firm decides to borrow. Borrowing is not triggered by a prespecified event Specifies the max amt that can be borrowed— require the firm keep a compensating balance with the bank (e.g. 5% of the max amt) Types: Committed LOC  r specified Noncommitted LOC  r NOT specified

17 Structured Debt Instruments Debt securities that link payments to some other variable. Firm can reduce risk of financial distress by having the interest payments contingent on some other variable that is highly correlated with the firm’s earnings. Examples: - Price or Index linked debt - Cat Bonds

18 Price or Index –Linked Debt Consider the Lan gold mining company that needs to raise capital to develop a new mine. Option1: issue new debt - Good: interest payments to debtholders are treated as a deductible expense for income taxes - Bad: Financial leverage goes up! Option2: issue new stock  dividends paid to equityholders are not treated tax deductible Option3: Issue debt with interest payments that are linked to the price of gold. If gold prices drop, than the promised interests drop.

19 Cat Bonds Firms issuing cat bonds promise the bondholders that they will repay the principal plus interest unless a catastrophe occurs. If a cat occurs, the issuer is not obligated to pay some of the promised interest and principal without defaulting on the debt.

20 Typical Cat Bond Structure

21 Cat Bond Trigger Types

22 Cumulative Return

23 Investor Based Dominated by Capital Mkts Investors

24 Investor Diversification