The Art of Risk Management: Alternative Risk Transfer, Capital Structure, and the Convergence of Insurance and Capital Markets

Author: Crhistopher L. Culp

PREFACE

Capital and insurance markets are converging in both product offerings and
institutional participation. Consider some examples. At the product level,
asset assurance can be obtained through either (re-)insurance guarantees or
credit derivatives, and foreign exchange or commodity price hedging now can
be done with futures, forwards, options, and swaps or with a multiline insurance
contract. At the institutional level, investment banks like Goldman Sachs
and Lehman Brothers now have licensed reinsurance subsidiaries, and reinsurers
like Swiss Re now directly place the functional equivalent of new debt and
equity with their corporate customers.

The recent trend toward convergence in insurance and capital markets is
much more fundamental than just increasing product or institutional similarities.
The real convergence is between corporation finance and risk management. No
longer is it possible to consider seriously how a firm will manage its risk without
simultaneously considering how that firm raises capital. And conversely.
At the center of this convergence maelstrom is alternative risk transfer
(ART), or contracts, structures, and solutions provided by insurance and/or
reinsurance companies that enable firms either to finance or to transfer some
of the risks to which they are exposed in a nontraditional way, thereby functioning
as synthetic debt or equity (or a hybrid) in a firm’s capital structure. In
short, ART forms represent the foray of the (re-)insurance industry into the
corporation financing and capital formation processes.

Today providers of risk control products like derivatives also are integrally
involved in the capital formation process, although many participants
in this area may not realize this. To discuss risk management in a corporate finance
context is still considered odd by some. And yet, increasingly, to discuss
one without considering the other is quite likely to lead to serious inefficiencies
in either how a firm manages risk or how it raises funds—if not both.

A comprehensive approach to corporate finance must take into account
both risk finance and risk transfer alternatives, both capital and insurance
market solutions, and both risk management and classical treasury decisionmaking
processes. Companies like Michelin, United Grain Growers, and
British Aerospace that have adopted this comprehensive approach to corporate
finance have met with tremendous success and provide us with very useful
examples of the kinds of efficiencies that can all too easily be left on the
table when a more compartmentalized approach is adopted.

The objective of this book is to explore the theoretical foundations underlying
a comprehensive approach to corporation finance and the practical solutions
and structures available to corporate treasurers for turning this theory
into practice.