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The Actuary The magazine of the Institute & Faculty of Actuaries

If it sells, it’s ART

Frank Lloyd might have known a thing or two about making movies, but he probably knew nothing about transferring risk. Or did he? With the above statement did he hit the nail on the head? What is ART? What lies behind the initials? Is ART merely the latest sexy concept in the insurance firmament? Or does it represent fundamental change in risk management?

What is ART?
ART stands for alternative risk transfer. Beyond that there is considerable uncertainty regarding the definition of ART. People use the term ‘ART’ a little as Humpty Dumpty uses the word ‘glory’ in Alice in Wonderland, to mean whatever they want it to mean.
The simplest definition of ART is any risk transfer mechanism that is not purely traditional insurance or reinsurance. This could include:
n Finite insurance/
reinsurance Typically these are multi-year and/or multi-line contracts. These contracts appeal to purchasers because they tend to provide cover at a lower price than do the equivalent mono-line/single year contracts (as there is diversification over more years and/or uncorrelated product lines), and also allow smoothing of results. They also offer purchasers greater flexibility in managing their risks.
– Transfers of insurance risk to the banking and capital markets These markets will take on risks they consider to be uncorrelated with those they routinely accept, and therefore provide an additional source of capacity.
– Quasi-transfers of insurance risk Under this category come:
– contingent funding arrangements, whereby an organisation can obtain funding, on pre-agreed terms, if and when a particular event occurs. This is attractive to the buyer because only a commitment fee need be paid before the event, and the pre-agreed terms are almost certainly more favourable than those likely to be available after the event.
– insurance derivatives, such as catastrophe and weather options.
– swaps, whereby organisations with matching, but uncorrelated, risks can simply swap parcels of them, thus providing each other with greater risk diversification. For instance, a reinsurer with Japanese earthquake exposure might swap some of this with another reinsurer exposed to Florida hurricanes.
Swaps can be also arranged between non-insurance operations. For example, energy companies dislike warm winter weather as consumers will use less of their product. On the other hand, household insurers dislike cold winter weather as it leads to frozen pipes and insurance claims. Such organisations can swap their risks, although, unlike the reinsurers above, which can perform their swaps directly, the energy company and insurer would have to conduct their deal via a transformer insurer.
– Transfers of risks the traditional market would regard as uninsurable, such as some operational risks.
Some people include self-insurance, or the use of captives, within their definition of ART, as such risk management techniques are not traditional insurance. Some also include more traditional-sounding covers, such as adverse loss development covers, if the covers are complex and their placement involves considerable amounts of modelling.

The growth of ART
Demand for ART solutions tends to be fuelled by the scarcity of conventional cover, or through spiralling reinsurance premiums. An example of this occurred in 1992 when, with the insurance market depressed and the reinsurance market severely underpricing catastrophe risks, Hurricane Andrew (seen opposite) blew in as the biggest single insurance event in history. Premiums promptly rocketed and the market capacity for catastrophe risk decreased sharply. Organisations with exposures to such perils sought cover in new markets, even in non-insurance solutions. This sparked the development of catastrophe bonds and catastrophe derivatives (the Chicago Board of Trade started trading catastrophe options in 1995, other exchanges following in later years).
The supply of ART products has also been growing. Those outside the insurance market see ART as a means of diversification. Traditional reinsurance providers have viewed ART as protection for their bottom line against the ravages of a soft market. By developing more imaginative solutions to meet the risk transfer needs of clients, they hoped also to develop more lucrative ones.
So the ART market grew slowly but steadily. This was meant to change following 11 September 2001. In the aftermath of the terrorist attacks it was widely expected that both insurance and reinsurance rates would soar, at the same time as market capacity was slashed, with the cost of claims eating into many (re)insurers’ capital, and several going out of business. All this, coupled with demand from companies for insurance coverage, which was expected to rocket. With the surfeit of demand over capacity, and with few other options, the excess would go to the ART market. The ART market would also pick up business the traditional markets had overpriced. Hence there would be a step change in the growth of ART business.
That was the theory it just wasn’t the practice. Sure, premium rates rose. But those increases, and the subsequent fat profit margins, attracted new capital. Millions were injected into the major underwriting centres. Far from being slashed, overall market capacity remained pretty much as it was before 11 September 2001 (although underwriters lost any enthusiasm that they might have once had for particular lines, such as terrorism cover).
Insurers themselves have appeared less keen to promote ART solutions. As noted earlier, ART provided an opportunity to make good profits at a time when conventional business was being sold on thin margins. Part of these profits was justified by the work involved in bringing about a deal and the risks inherent within the complex structures. With conventional business now generating good margins, many insurers are throwing their resources entirely behind this easier to write and less risky business, leaving the ART market to its own devices.
So the need and the supply are not nearly as great as expected. Demand is also much lower than forecast, mostly owing to the ‘Enron’ effect. Although Enron was not the only recent company failure highlighting the perils of balance sheet manipulation, involving various ART-style transactions, it is the highest-profile. There is now a marked aversion among chief financial officers to become embroiled in anything not immediately transparent. While most ART solutions involve genuine risk transfer, and are not designed to distort the accounts, many do have complex structures that are not immediately obvious. It is now hard to sell any but the simplest and clearest ART structure.

One predictable consequence of the Enron situation and other recent failures is the call for regulators to clamp down on ART deals. This puts regulators in a difficult position. Generally they welcome ART solutions, as they increase market capacity and protection good for both consumers and market confidence.
On the other hand, regulators are also aware that the complexity of some ART arrangements poses a danger for unsophisticated purchasers. The lack of transparency in some ART contracts can frustrate the intentions of regulators, by causing the purchasers’ solvency positions to be mis-stated, their profitability distorted, and the information available to consumers rendered misleading.
Regulation of the ART market is tricky. It is hard to regulate something that cannot easily be defined. Also, ART currently crosses over between regulatory environments (banking, insurance, etc). In Europe and in other parts of the world, there is gradual convergence of the various regulatory regimes under a financial services umbrella. That will remove this problem (as well as the opportunity for regulatory arbitrage between the industries and countries), but it will take time to be completed.
Last year the Financial Services Authority published a consultation paper outlining how it would like to regulate ART-style products in the UK. It neatly sidestepped the issue of definitions by re-emphasising its existing principles and by declaring that no additional rules should be necessary to cater specifically for ART business. However, it made it clear that it is the responsibility of directors to understand fully any ART contracts their organisation buys, in particular the extent and security of risk transfer involved, and that the accounting for such contracts should allow realistically for the risk being transferred. Thus, the accounting for deals that are purely cosmetic should not allow for any risk transfer, rendering such deals redundant.

The future for the ART market?
We have still not seen the big surge in ART activity widely predicted for some years. Neither have we seen many truly hybrid solutions most still remain defiantly insurance solutions or capital markets solutions. So is ART a damp squib that will fizzle out like most short-lived fads?
I believe the answer is no. Despite all the problems discussed there continues to be activity with finite deals, non-catastrophe securitisation deals, contingent funding, weather derivatives, catastrophe swaps, and more. The global need for risk transfer mechanisms, within the discipline of risk management, is still growing and looks likely to outstrip the capacity of the traditional insurance and reinsurance markets. The excess demand will have to find other outlets. Moreover, some of the emerging issues feeding the growth in demand pension funding, longevity, the availability of professional indemnity cover, cover for flood-prone buildings appear to lend themselves to ART solutions.
How quickly will the ART market grow? To some extent that depends on the same external factors that have influenced development to date. But it is also in the hands of the practitioners. In particular it is important they develop simpler, more transparent structures, within which it will be easy to demonstrate the delivery of real benefit to the purchaser. It is also important that the market avoids being implicated in more financial scandals. ART needs ARTists, not impostors.