Today there is an awareness that the classification between different types of risk is arbitrary. Solution providers need to respond say Roger Däster and Niall Tuohy.
In today's changing business environment, multinational corporations are increasingly exposed to an enormous number of risks from every angle: operational, financial, entrepreneurial. The spectrum is very broad. Historically, corporate management's attention has focused on insurable or event risks, those risks for which some measure of protection was available in the insurance or financial markets.
Different risk categories were managed by separate units within a company. The risk manager looked to the insurance markets to provide protection against operational risks such as property damage/business interruption, public and products liability, employers' liability, marine, D&O, motor fleet, construction/EAR, etc. The treasurer was responsible for managing the financial risks such as foreign exchange, interest rates or commodity risks. Some risks, either because of a lack of market capacity or the moral hazard they represented, were difficult or virtually impossible to insure, such as political risks, adverse publicity, product tampering, development risks, environmental clean up costs etc.
Other risks were not considered to be insurable or hedgeable at all. These were the pure business or entrepreneurial risks and could encompass:
* Regulatory environment.
* Health and safety.
* Patent infringements.
* Consumer boycotts.
* Demand/supply cyclicality.
* Failed or delayed product launches.
* Mergers and acquisitions.
This list is by no means exhaustive.
Risk is risk
Now we are witnessing a change in approach. There is an awareness that the classification between different types of risks is only arbitrary. Classifications such as "insurable", "uninsurable" or "difficult to insure" are giving way to a realisation that a risk is a risk and should be managed as part of a portfolio.
Risk managers and chief financial officers are moving towards a more integrated approach to risk management where all risks to which the corporation is exposed are managed as a portfolio. Their over-riding concern is to protect the business as a whole; they are looking for solutions which protect the balance sheet and create value for their shareholders. They are adopting integrated solutions where traditional insurance products are combined with alternative risk transfer instruments to implement tailor-made risk management strategies.
What do we mean by "alternative" and what are these alternative risk transfer (ART) instruments? Very simply, in the context of this article, the word "alternative" describes the risk carrier. With ART instruments, the risk carrier or financier is something other than the traditional insurance markets. The range of alternative instruments is varied; some old, some new, and the range and types of instruments will grow in response to clients' demands for more efficient solutions. Some of the currently available instruments are summarised below.
Captives have been around for a long time and they are still the most popular type of external risk funding mechanism, despite soft market conditions, tightening tax laws and intensified legislation pertaining to controlled foreign corporations. There is a large diversity of captive structures, including rent-a-captive and captive account models.
The risk capacity of a captive is provided by the capital investment and/or accumulated profits. One of the major advantages of the captive solution is that it can provide capacity for uninsurable risks which cannot be placed in the traditional markets.
Captives will continue to grow in number and in terms of premiums written. Historically, they have been used as the deductible funding instrument for traditional insurance risks. In the future, we will see the captive being utilised as an integrated financial risk management vehicle.
A relatively recent development has been the introduction of finite risk covers embedded or blended in a traditional insurance programme. Originally, finite covers were used solely between direct insurers and the reinsurance markets or by the reinsurers of captives. These solutions, which offer a combination of risk transfer and risk funding, are increasingly overflowing into the direct insurance market, and some innovative carriers are blending this concept into their direct programmes. They have evolved over the past few years in response to tax and accounting regulations which require a significant degree of risk transfer so as to qualify as valid insurance contracts. The risk capacity is provided by a combination of the premiums (and related investment income) and the finite capacity of the insurer.
Investment-backed insurance schemes are a new generation of finite solutions. A tailor-made insurance policy covering specific risks a client wishes to insure is backed-up by an investment in a special purpose company. The capacity available is a function of the size, term and other conditions relating to the capital contribution and the annual premium flows. Significant aggregate capacity is available at inception and grows over time. This solution offers custom-made protection and can include virtually any risk which threatens the client's business.
When it comes to catastrophe risks, the largest companies can be faced with tremendous difficulties in arranging sufficient capacity. They may not be able to obtain any coverage at all. The funding solutions already mentioned may not be feasible because of the high severity nature of the exposure. Standby loan arrangements might not allow drawdown just when the facility is needed most. Also, drawing down the loan immediately increases the aggregate liabilities on the face of the balance sheet, thereby resulting in a negative impact on capital and solvency ratios.
A solution which can overcome these difficulties is the so-called catastrophe equity put. A large, highly rated financial institution sells to the client a put option which becomes effective following certain specified events. The put entitles the holder to sell equity instruments, usually in the form of non-voting preference shares or subordinated notes, to the financial institution under certain conditions and, thus, provides capital after a catastrophic loss. The loss must be absorbed by the company and is charged directly to the income statement. However, by exercising the put option, the company can restore its shareholder equity and financial position.
A further recent development is the securitisation of insurance risk which is essentially a re-packaging of insurance risks into capital market transactions. Catastrophe bonds provide varying returns to investors based on insurance events rather than financial ones. Assets linked to insurance risks allow investors to improve the risk/return ratio on their portfolios, as there is no correlation between insurance events and financial market fluctuations.
Securitised risk products have mainly been designed for the insurance and reinsurance industries to date, but there may be potential for their use by the multinational industrial/services sectors in the future. Insurance futures and options may also prove to be attractive risk management tools. These products are based on catastrophe loss indices such as the PCS Cat Insurance Options, which are linked to various indices published by Property Claims Services in the US.
Companies are changing the way they view risk. Gone are the arbitrary classifications of "insurable", "financial", "uninsurable" etc. Sophisticated finance directors, treasurers and risk managers are managing their risk profiles as one portfolio. They are adopting solutions that protect their businesses as a whole. The insurance and financial markets are converging; so also are the previously separate risk management and financial management disciplines in the corporate domain. This new integrated approach is allowing companies to increase their options significantly, to take a wider view of pure business or entrepreneurial risks and to act with enhanced assurance and flexibility.
It is clear that a change in approach by clients requires changes in approach by the solution providers. They require new and enhanced skills and expertise which, generally speaking, will encompass banking and insurance know-how in order to provide the comprehensive customised solutions demanded by their clients. At the moment, there are only a handful of players who have the dedicated teams of experts who can incorporate capital markets, corporate finance and insurance skills in their solution structuring.
Roger Däster and Niall Tuohy are in the alternative risk financing section of Winterthur International. Mr Däster's contact details are Tel: +41 52 261 52 38. Fax: +41 52 261 70 90. E-mail: Roger.Daester@Winterthur.com. Mr Tuohy is available on Tel: +353 1 475 2200. Fax: +353 1 475 2260.