Overview of Risk Management and Alternative Risk Transfer

Abstract

Active risk management is increasingly important for companies interested in maximizing enterprise value. Creating a framework by which to properly evaluate financial and operating risks, which may be of a pure or speculative nature, demands proper focus on expected losses, probability of ruin, risk aversion, and expected utility, as well as techniques of loss control, loss financing, and risk reduction. Key drivers of the disciplined risk management process include analysis of costs and benefits, establishment of pre- and postloss management goals, and definition of a risk philosophy. While insurance and derivative mechanisms, based on risk pooling, risk transfer, diversification, and hedging, are by now well established and comprise the core of active risk management, innovative solutions from the alternative risk transfer market, including finite risk policies, multirisk products, insurance-linked securities, contingent capital structures, insurance derivatives, captives, Bermuda transformers, and enterprise risk management programs, have proven useful in giving companies additional tools by which to manage their exposures. Keywords: alternative risk transfer; operating risk; financial risk; pure risk; speculative risk; enterprise value; risk management process; loss control; loss financing; risk reduction; cost-benefit analysis; preloss management; postloss management; risk philosophy; risk transfer; indemnity contract; valued contract; diversification; risk pooling; hedging; basis risk; moral hazard; adverse selection; finite risk policies; multirisk products; insurance-linked securities; contingent capital structures; insurance derivatives; captives; Bermuda transformers; enterprise risk management programs