Marc Romano explains how coverage solutions are evolving to meet the needs of major industries.
The concept and practice of risk management has developed strongly in major corporations over the last few years. Management faces constant pressure from shareholders for both exhaustive information about the business and the risks to which it is exposed, while the search for shareholder value compels management to increase its mastery of those risks.
The risks which can affect a business fall under two headings: fortuitous and entrepreneurial. Fortuitous risks may be transferred either to insurance or financial markets. Entrepreneurial risks are those which are intrinsically linked to the purpose of the business and remain with the shareholders. If all risks were transferred, then the shareholders could expect no better return from their investment that they would get from the risk free level of interest.
Under the traditional organisation of business, the risk manager dealt with fortuitous risk and was responsible either to the general management or to legal services; financial risks were the responsibility of the finance director. The constant search to improve results has brought these traditional boundaries under the spotlight. Today, in a few companies, there is no longer a distinction between these type of risk management and finance.
The following important trends accompany this sociological development of risk management:
* Risks have become larger and larger.
It is clear that consolidation among businesses and the inter-dependence of suppliers translates into significantly increased exposures, for both property and liability, which test the limits of insurance capacity.
The size and extent of their own risks persuades the largest companies that they themselves have sufficient spread to create a balanced insurance portfolio. A natural suspicion leads them to assume that their own technical results are better than others, so they resist the notion of mutualisation which is intrinsic to insurance. As a result, major industries tend to favour means which allow them exercise to their autonomy.
* Dynamic risk management.
An aversion to risk leads major industries to look for means to smooth the financial impact of all risks, particularly those which are uninsurable.
These trends manifest themselves in concrete form by:
* A change in the nature of the capacity sought (cover for non-traditional risks).
* A wider range of products, including pure financial instruments
* A blurring of the distinction between entrepreneurial and fortuitous risk which throws into relief the concept of the shareholder as the ultimate bearer of risk.
The market response
Together these trends have found expression in the emergence of risk management products or solutions of a new type, generally called "alternative". They combine certain techniques which are proper to insurance (mutualisation) with financial techniques and dynamic risk management found in the financial markets.
Under the heading of alternative risk finance, Axa Global Risks with its partner Paribas, has created a dedicated structure capable of covering the whole panorama of this new market to maximise our services to our clients.
The logic behind these solutions is one of complementing existing products, not trying to substitute for them. Their capacity to deal with problems such as a correlation between a financial risk and a fortuitous risk (for example, to indemnify a gas pipeline company against the increased cost of gas which it would have to pay on the open market if the pipeline was damaged) does not challenge the importance of covering traditional property risks or the cost of raw materials. The idea is to provide a complementary service which is capable to putting a value on the absence (or existence) of a correlation between property damage and the market price of the raw materials concerned.
There would be little added value in looking for substitutes for instruments which have been proven over many years. On the contrary, the interest is in adding to them.
The principle characteristic of these new instruments is that they are not really products. There are concepts, families of solutions, but not products on a shelf. In effect, each combination of risks to be covered is unique and each business, by its history, structure and strategy, has a specific risk management approach.
The alternative solutions such as we have developed for our clients have to be individually tailored with the aim of maximising their effect while integrating most effectively within their existing risk management programme.
However, even if there are no standard products, it is possible to identify three families of solutions:
* Management of retentions.
* Integration of financial and insurance risks.
* Search for new capacity through direct access to financial markets.
The company which decides to keep a risk on its own balance sheet naturally uses its provisions as a risk management tool and amortises the effect of possible losses. Although this has as its principle virtue that it involves no one outside the firm, as a means it does sometimes lack flexibility. The provisions are affected according to the given risks and are not fungible. Their fiscal treatment is not homogenous.
The idea of retention management is to offer greater flexibility to clients while permitting them to smooth the impact of foreseeable risks which are uninsured, purely within the context of their existing insurance programme.
As a hypothetical example, one can imagine a business that places a sophisticated multi-line programme. The constraints linked to one or another branch can produce "holes" in the cover (too high a deductible, a difference in limits or conditions between two lines, risks not covered) which expose the organisation's self-insured retention. It is, therefore, possible to effect a cover of this type which fills the gaps and preserves the predictability of the results of the business.
Integration of financial and insurance risk
Here the ambition is to allow businesses to take into account correlations between their insurance programmes and the financial risks to which their operations naturally expose them.
These products find their place in the development of multi-line programmes which rest on a fairly simple idea: that it is better to buy a single cover for three risks than three separate policies. To put it somewhat lightly, the idea is to extend the well known concept of homeowner's multi-risk insurance to the insurance of major industries. We call our product Triple M, which stands for multi-risks, multi-nationals, multi-years.
The integration of financial risks within the programme can be more or less sophisticated. One of the most sophisticated forms is that of "double trigger" coverage.
To illustrate how it works, you can imagine a company whose turnover is closely correlated with the price of a raw material (oil) and its management wants to adjust its appetite for risk to changes in the economic environment. In other words, the more its results flourish thanks to a higher oil price, the higher the deductible the company is willing to carry. Inversely, the company wants to reduce its exposure when the price of oil falls below a certain level.
Our approach has been to develop a product which makes the deductibles and/or policy limits a function of economic variables, such as the price of oil.
The search for new capacity
It sometimes happens that industry is faced with an insurance market which cannot provide the cover that it needs (insufficient capacity, inadequate length of cover and so on). The idea, therefore, is to transfer that risk directly to the financial markets.
This is a product which has been developing over the last four to five years as a means of helping insurance companies find new capacity (in particular for natural catastrophes in North America). These structures have reached a level of maturity that now makes them suitable to meet the needs of major industries.
Depending on the manner in which it is done, this solution can meet two objectives: to insure an asset and to finance it, as in the following example of the construction of a factory in an earthquake zone.
A motor manufacturer wished to build a new factory on a site which is in a seismically active zone. When deciding whether to back the project, the investors included in their initial requirements a risk premium linked to the potential earthquake occurrence, but this additional return was not based on an in-depth study which had been carried out to determine the probability of a loss of this type.
In parallel, the operator of the project would have had to buy insurance against the earthquake risk. Such cover is annual and has to cover all or part (depending on availability of a market) of the investment cost.
Thus, it appears implicitly that the motor manufacturer would have to pay twice for one cover - once as part of the total remuneration to the investors, once to the insurers.
A different solution was found. After an analysis of the potential for earthquake loss (and so its cost), it was possible to get the investors to accept this risk for a price, with the stipulation that the return would be adjusted if there was a catastrophic earthquake. In this way, the manufacturer gained an overall savings in the cost of his protection by taking advantage of a scheme which was tailored to the duration and financial level of his needs.
These solutions are so called not just to describe their effects but to make them seem ordinary, because they respond to a real need by businesses and their shareholders. They are not a panacea but a means of allowing us to respond better to the expectations of our clients without ever forgetting traditional solutions.
Putting them into effect pre-supposes a considerable transparency on the part of suppliers as well as clients and the involvement of many parts of their business, risk management, finance, legal and operations all need to collaborate to complement traditional insurance cover.
Marc Romano is senior vice president alternative/financial risks for AXA Global Risks. He is also ceo of AXA Paribas Alternative Risk Finance, Paris. Tel: 33 (0) 156 92 93 23. Fax: 33 (0) 156 92 84 40.