Traditionally, businesses and other organizations have handled risk by transferring it to an insurance company through the purchase of an insurance policy or, alternatively, by retaining the risk and allocating funds to meet expected losses through an arrangement known as “self-insurance,” in which firms retain rather than transfer risk. During the liability crisis of the 1980s, when businesses had trouble obtaining some types of commercial insurance coverage, new mechanisms for transferring risk developed, facilitated by passage of the Product Liability Risk Retention Act of 1981. These so-called alternative risk transfer (ART) arrangements blend risk transfer and risk retention mechanisms and, together with self-insurance, form the alternative market. Captives—a special type of insurance company set up by a parent company, trade association or group of companies to insure the risks of its owner or owner and risk-retention groups—in which entities in a common industry join together to provide members with liability insurance—were the first mechanisms to appear.
Other options, including risk retention pools and large deductible plans, a form of self-insurance, followed. ART products, such as catastrophe bonds, weather derivatives and micro insurance programs are also emerging as an alternative to traditional insurance and reinsurance products. Wholly owned captives are companies set up by large corporations to finance or administer their risk financing needs. If such a captive insures only the risks of its parent or subsidiaries it is called a “pure” captive. Captives may be established to provide insurance to more than one entity. An association or group of companies may band together to form a captive to provide insurance coverage. Professionals—doctors, lawyers, accountants—have formed many captives over the years. Captives may, in turn, use a variety of reinsurance mechanisms to provide the coverage. In particular, many offshore captives use a “fronting” insurer to provide the basic insurance policy. Fronting typically means that underwriting, claims and administrative functions are handled in the United States by an experienced commercial insurance company, since a captive generally will not want to get involved directly in running the insurance operation.