In the world of risk management, businesses and individuals are increasingly exploring Alternative Risk Transfer (ART) solutions as a means to safeguard against potential losses. While ART strategies, such as captives, insurance-linked securities and risk retention groups (pools), offer flexibility and potentially lower costs, they also come with a range of risks and complexities.

Definitions of Alternative Risk Transfer (ART)

The alternative risk transfer market has two primary segments: risk transfer through alternative products and risk transfer through alternative carriers. Transferring risk to alternative carriers entails finding organizations, such as captive insurers or pools, that are willing to take on some of the insurer’s risk for a fee. Transferring risk through alternative products entails the purchase of insurance policies or other financial products such as securities. The term "securities" refers to a multitude of different investments, such as stocks, bonds, investment contracts, notes, and derivatives. In contrast, conventional insurance policies, though sometimes more expensive, offer a clearer, more predictable path to coverage and generally pose fewer risks to the client. We explore the potential risks associated with ART solutions, focusing on: • Regulatory and legal risk • Lack of liquidity and flexibility • The complexities relating to accounting and reporting • The risk of inappropriate advice • Tax implications

Regulatory and legal risks

ART solutions can expose clients to regulatory and legal risks. Many ART structures, such as captives or insurance-linked securities, may operate in jurisdictions with less stringent regulatory oversight. While this can offer certain advantages in terms of flexibility and cost, it also means that clients are potentially more exposed to the risk of fraud, mismanagement, or legal challenges. In the event that a claim arises, clients may face difficulties in enforcing their coverage, particularly if the ART structure is based in a foreign jurisdiction with less robust legal protections. Moreover, regulatory changes in the home jurisdiction of the client could affect the operation or financial viability of the fund.

Lack of liquidity and flexibility

While ART solutions such as captives offer flexibility in terms of tailoring coverage, they also come with inherent liquidity risks. If a captive insurance company or insurance cell faces significant claims or financial difficulties, it may lack the liquidity to meet its obligations. This could leave clients exposed to uncovered risks, particularly if the captive is not adequately capitalized.

The complexity relating to accounting and reporting

The financial implications may involve liquidity considerations where clients may face liquidity challenges if they hold large amounts of capital in ART structures (e.g. aggregate funds). Clients need to understand the concept of paying for claims themselves from a fund similar to a savings account. In situations of a major claim, cash flow could be strained and / or the fund can be totally depleted. Depending on the ART structure, there can be legal exposure if claims are disputed or if risk transfer does not occur as expected. For instance, in case of large claims, if the client did not make sufficient provision to properly provide for funding and at claims stage, the full claim cannot be settled, stakeholders may get wind up in legal action.

The Risk of Inappropriate Advice

ART solutions are often highly complex, requiring businesses to have significant resources, expertise, and administrative capacity to manage the policies. Maintaining a captive or similar structure can involve complicated accounting and reporting procedures, as well as compliance with various regulations such as the FSCA, PA and SARS. This can be particularly burdensome for smaller businesses that do not have the resources to manage such complexities. For advisers, recommending such a solution without fully understanding the client's ability to manage the complexity of ART structures can lead to significant problems. If a client does not have the resources or knowledge to properly manage an ART solution, they may face operational inefficiencies, higher costs, and even regulatory violations.