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

The ART of Risk Management ''This book evidences links and trade-offs between some key drivers of corporate value creation: capital structure, strategic definition of core and noncore risks, risk management retention and transfer, with a valuation of externalization, to achieve an integrated allocation and management of firms capital. From math to legal, it takes us a definite step forward in modern finance.'' –Jacques Tierny, Deputy CFO, Michelin Group ''For someone like me who has observed the evolution of financial theory and practice over the past twenty years, Culps new book is a really extraordinary undertaking and accomplishment. On one level, it provides a comprehensive–and quite readable–account of the most important financing and risk management innovations in both insurance markets and capital markets. Even more remarkable is its success in fitting these innovative solutions and products into a single, unified theory of financial markets–one that integrates the once largely separate discipline of insurance and risk management with the current theory and practice of corporate finance.'' –Donald Chew, Editor of Journal of Applied Corporate Finance and a founding partner of Stern Stewart & Co. ''Chris Culp succeeds to cover this multifaceted and somehow fragmented ART market in a holistic way.'' –Thomas Bruendler, President, Allianz Risk Transfer (UK) Limited ''This is indeed a book about convergence. It is dealing with the latest developments in the insurance and capital markets which blur the boundaries between these two areas. Laying the scientific foundations of ART, it also brings together theory and practice of this innovative field in an unprecedented way. Moreover, Culp looks behind the driving forces of ART and relates them back to their common underlying aspiration, the quest for optimal capital structure.'' –Paul Woehrmann, PhD, Head of Center of Excellence ART and Member of Executive Management Continental Europe Corporate, Zurich Financial Services ''Culp divulges the true nature of convergence–as art and science, rooted in both traditional theories and forward-looking practices. He demonstrates undeniably that the marriage of the insurance and capital markets, once considered futuristic, is a pragmatic solution for corporations seeking to manage risk, generate capital, and create new value.'' –Tobey Russ, President & CEO, Chubb Financial Solutions The ART of Risk management......Page 5 contents......Page 7 ACKNOWLEDGMENTS......Page 11 PREFACE: COMPREHENSIVE APPROACH TO CORPORATION FINANCE......Page 13 PART I THE QUEST FOR OPTIMAL CAPITAL STRUCTURE......Page 19 CHAPTER 1 The Nature of Financial Capital......Page 21 Appendix 1-1: A Brief Introduction to Capital Theory......Page 37 Appendix 1-2: A Review of Basic Option Concepts......Page 44 CHAPTER 2 A Securities Perspective on Capital Structure......Page 54 CHAPTER 3 When Is Capital Structure Irrelevant?......Page 90 CHAPTER 4 Benefits and Costs of Debt and the “Trade-off Theory” of Optimal Capital Structure......Page 103 CHAPTER 5 Asymmetric Information, Adverse Selection, and the “Pecking Order Theory” of Optimal Capital Structure......Page 134 CHAPTER 6 Distinguishing between Capital Structure Theories......Page 145 CHAPTER 7 Risk and Signaling Capital......Page 151 CHAPTER 8 Regulatory Capital......Page 186 PART II CAPITAL STRUCTURE AND RISK MANAGEMENT......Page 201 CHAPTER 9 A Vocabulary of Risk......Page 203 CHAPTER 10 Risk Management as a Process......Page 217 CHAPTER 11 Risk Management and Capital Structure......Page 236 PART III CLASSICAL RISK TRANSFORMATION PRODUCTS......Page 261 CHAPTER 12 Commercial Banking Products......Page 263 CHAPTER 13 Derivatives......Page 281 CHAPTER 14 Asset Disposition and Securitized Products......Page 312 CHAPTER 15 Insurance......Page 329 CHAPTER 16 Reinsurance......Page 351 PART IV ALTERNATIVE RISK TRANSFER PRODUCTS......Page 367 CHAPTER 17 Alternative Risk Finance vs. Alternative Risk Transfer......Page 369 CHAPTER 18 Alternative Risk Finance: Self-Insurance, Captives, and Captivelike Structures......Page 380 CHAPTER 19 Alternative Risk Finance: Finite Risk Products and Solutions......Page 398 CHAPTER 20 Integrated Multiline and Multitrigger Alternative Risk Transfer Products......Page 419 CHAPTER 21 Committed Capital and Guarantees......Page 445 CHAPTER 22 Alternative Risk Securitizations and Securitized Products......Page 470 PART V PRACTICAL CONSIDERATIONS FOR WOULD-BE ARTISTS......Page 507 CHAPTER 23 USAA Prime: Choice Cats for Diversifying Investors......Page 509 CHAPTER 24 Emerging Role of Patent Law in Risk Finance......Page 521 CHAPTER 25 Weather Derivatives or Insurance? Considerations for Energy Companies......Page 538 CHAPTER 26 Convergence of Insurance and Investment Banking: Representations and Warranties Insurance and Other Insurance Products Designed to Facilitate Corporate Transactions......Page 550 BIBLIOGRAPHY......Page 563 INDEX......Page 577

As the capital and insurance markets continue to converge, the number of innovative alternative risk transfer (ART) products available to corporations, brokers, derivatives participants, and other financial professionals continues to grow. Understanding risk management in a corporate finance context and the ability to use ART to control risk and raise new capital has become a necessity in today's business world.

Risk expert Christopher Culp begins by laying down a solid foundation in corporate finance and the processes by which firms strive to find the elusive "optimal capital structure." Culp introduces competing theories on optimal capital structure and provides a summary of empirical evidence for and against these theories. Risk and signaling capital, as well as regulatory capital, round out the discussion of the quest for optimal capital structure.

To understand the motivations behind ART-many of which appear to be tied to the search by firms for optimal capital structure-Culp then probes the most interesting ART transactions to date by exploring their impact on the capital structure of many actual companies.

This comprehensive guide also provides a valuable overview of the risk control and capital structure functions provided by banking products, derivatives targeted at market and credit risk, asset divestitures and securitizations, and insurance and reinsurance. Also discussed are the many similarities between these traditional risk management products, especially (re-) insurance and options. Moving from traditional methods to today's most cutting-edge risk management and capital formation tools, The ART of Risk Management examines the emerging market for ART forms based on their type and function. You'll be introduced to the world of ART by looking at two distinct parts of that world: risk finance and risk transfer. You'll learn about major structures in each, including such risk financing methods as captives, protected cell companies, and finite risk products, and risk transfer methods, including multiline and multitrigger programs, "committed capital," and alternative risk securitization.

The final section of this invaluable resource presents some practical issues that ART product users will want to take into consideration. Guest contributors address catastrophic insurance products, weather risk transfer, patent law and ART financial innovation, and ART structures facilitating mergers and acquisitions.

As the capital and insurance markets continue to converge, the number of innovative alternative risk transfer (ART) products available to corporations, brokers, derivatives participants, and other financial professionals continues to grow. Understanding risk management in a corporate finance context and the ability to use ART to control risk and raise new capital has become a necessity in today's business world. Risk expert Christopher Culp begins by laying down a solid foundation in corporate finance and the processes by which firms strive to find the elusive "optimal capital structure." Culp introduces competing theories on optimal capital structure and provides a summary of empirical evidence for and against these theories. Risk and signaling capital, as well as regulatory capital, round out the discussion of the quest for optimal capital structure.To understand the motivations behind ART -- many of which appear to be tied to the search by firms for optimal capital structure -- Culp then probes the most interesting ART transactions to date by exploring their impact on the capital structure of many actual companies. This comprehensive guide also provides a valuable overview of the risk control and capital structure functions provided by banking products, derivatives targeted at market and credit risk, asset divestitures and securitizations, and insurance and reinsurance. Also discussed are the many similarities between these traditional risk management products, especially (re-) insurance and options. Moving from traditional methods to today's most cutting-edge risk management and capital formation tools, The ART of Risk Management examines the emerging market for ART forms based on their type and function. You'll be introduced to the world of ART by looking at two distinct parts of that world: risk finance and risk transfer. You'll learn about major structures in each, including such risk financing methods as captives, protected cell companies, and finite risk products, and risk transfer methods, including multiline and multitrigger programs, "committed capital," and alternative risk securitization.The final section of this invaluable resource presents some practical issues that ART product users will want to take into consideration. Guest contributors address catastrophic insurance products, weather risk transfer, patent law and ART financial innovation, and ART structures facilitating mergers and acquisitions. Learn about today's hottest new risk management tools One of the hottest areas of finance today, alternative risk transfer, or ART, refers to the use of various insurance products to manage market, credit, operational, legal, environmental, and other forms of risk. As the capital and insurance markets continue to converge, the number and complexity of new risk-defraying insurance products available to corporations, brokerages, money managers and other financial professionals will continue to grow. Expert Christopher L. Culp uses case studies of recent ART transactions used by risk managers to put the field into perspective for financial professionals and to acquaint them with the various types of risk control products now available. In addition he explores, in-depth, the links between ART, derivatives and bank-arranged risk financing, and he explains the key differences between classic insurance products and financial guarantees, risk financing, bundled layering, and other ART forms. This comprehensive guide provides a valuable overview of the risk control and capital structure functions provided by banking products, derivatives targeted at market and credit risk, asset diversitures and securitizations, and insurance and reinsurance. Also examines the emerging market for ART forms based on their type and function and learn about risk finance and risk transfer Many of the financial products offered by insurance and derivatives industry participants today are increasingly similar to one another.