Alexander Müller and Kai von Rappard analyse the contribution of these alternative types of cover for large businesses and their contribution to integrated risk management.

Risk management in industrial businesses is finding that not only does it have to provide for risks as efficiently as possible, but it also has to contend with a constant stream of new risks. Traditional approaches to risk are no longer the way to resolve this dilemma. We are witnessing a move away from looking at risks in isolation and, instead, combining them into integrated risk packages. This development is underpinned by the vision of combining insurance, financial and trading risks and ultimately leading to a reduction in both the size and volatility of risk expenditure. Multiline/multiyear and finite risk are approaches to mastering the new challenges.

The objective of integrated risk management is protection of the financial resources of the business as a whole - balance sheet protection - as opposed to conventional event coverage. On the one hand, banks and insurance companies are developing increasingly sophisticated instruments to protect themselves; on the other, their clients are moving away from the concept of dealing individually with different risk components.

As well as cover for traditional insurance risks they are looking for protection against all types of losses which might affect their assets, for example by jeopardising accounts receivable or currency and interest rate risks. Furthermore they need to be able to transfer, to professional risk carriers, at least some of their conventional trading risks such as the effects of changes in environmental protection requirements, the effects of inflation or fluctuations in raw material prices.

Today, there is a broad spectrum of covers available for traditional insurance risks. However, too little importance is attached to the mutual interdependency of different types of risk. Moreover, coverage of risks is normally based on a 12 month reporting period, meaning that one loss occurrence can sharply affect operating results and, in extreme cases, even jeopardise liquidity.

The risk manager strives to avoid such an outcome by purchasing individual programmes with high limits for all lines because he (or she) is not able to determine, with sufficient authority, correlations between different risks as regards the occurrence and size of losses. He hopes this will secure the best possible guarantee of being prepared for every catastrophic event. Moreover, he buys the relevant covers every year because he does not know the date when the “100 year event” will actually occur.

The new generation of industrial insurance programmes is ultimately based on the findings of Markowitz's Modern Portfolio Theory. In contrast to traditional insurance where there are individual cover limits for each class, in multiline/multiyear programmes the diversification effect is critical. In the same way as combining a number of different shares to achieve a balanced portfolio reduces the non-systematic risk and, hence, improves the performance of the entire investment, an integrated insurance programme stabilises the statistical loss probability of the combined risks. By introducing non-insurance risks into the picture, you will inevitably achieve higher cost efficiency. With finite risk, the financial effect of a loss occurrence can ultimately be spread over a number of financial years.

Multiline/multiyear covers
Multiline/multiyear policies are integrated insurance programmes that combine the main lines of casualty, property and business interruption plus EAR/CAR, marine, DP and machinery breakdown risks. In many cases all lines in the insurer's spectrum of cover are included. Cross-class event coverage is normally provided once at no additional cost and reinstated a second (or possibly a third) time on payment of an additional premium which has been agreed in advance. Monoline excess covers can be added over and above the multiline capacity, for example for catastrophe risks or very high exposures in particular lines.In some cases this additional capacity is placed on an individual basis because, for the time being at least, it can be obtained at a reasonable price and because there are no further benefits to be gained from diversification in these risk sectors.

It is essential to the structure of an integrated insurance programme that optimum deductibles are set. Hence, a strategic decision must be taken with regard to “acceptable” tolerances for the main business indicators such as operating results, cash flow or the value of the business. In principle, the policyholder should retain for his own account those losses that can be budgeted for with sufficient accuracy and purchase cover where it is advantageous to do so.In all cases, two different types of deductible need to be set. First, an event deductible must be specified under the lower level of cover. This serves, on the one hand, to avoid any danger of eroding the aggregate deductible and, on the other, to create a genuine incentive to exercise effective risk control. However, optimum control of risk expenditure can only be achieved by setting an aggregate period deductible. Secondly then, this basket aggregate limits expenditure over the period of the contract and permits a more aggressive approach when determining the event deductible, which in turn reduces premium costs.

A difficult question arising when a multiline programme is designed is that of creating a uniform, broad-based trigger. This should ideally be co-ordinated across all lines, but leaving specific triggers for individual lines. There is also the question of how to clarify the temporal allocation of combined loss occurrences with regard to deductibles and limits. These are set on a fixed basis during contract negotiations, whereas the circumstances of the business may vary enormously and this may well be reflected in changes in the value of fixed assets or substantial deviations from budgets. If the basis for fixing the deductible changes, the deductible itself should be changed.

It is the aim of a double trigger to adjust deductibles dynamically in line with the performance of the business. In essence, this means that the conditions should be adjusted according to certain critical factors such as sales figures, number of units, spot prices in the crude oil markets or, for the tourist industry, the number of rainy days. The double trigger can thus be of value to the client if he can negotiate separate deductibles for the “double” event at a small additional premium (again on the basis of minor correlations).

It would seem that only a few contracts incorporating double triggers have been concluded to date. We suspect that clients tend to have a rather conservative attitude towards innovations like this, and there are probably only a few insurers who are in a position to implement these products in line with underlying regulatory and tax considerations. However, it is safe to assume that this type of programme will gain general acceptance sooner or later as part of an integrated approach to risks.

Time periods
Multiline/multiyear insurance programmes are normally concluded for a period of three to five years. This leads to less volatility in premium costs due to reduced dependence on cyclical market fluctuations and lower administration costs, as there are no more annual renewal negotiations. Particularly noteworthy are the different types of cancellation provisions under multiyear contracts. Back-up covers can be used to avoid the problems which arise when the multiyear cover is exhausted and the contract lapses before its natural expiry date.

It seems that there is currently total capacity of around $1 billion to $1.5 billion available in the world market. The cake is shared between a small number of protagonists who can offer multiline capacity of up to $200 million each per event.

Finite risk
One new form of cover gradually gaining acceptance in Europe is the finite risk programme. This permits the policyholder to effect a limited - both as to time and quantity - transfer of risks which are traditionally difficult to insure, such as wide ranging compulsory environmental covers, extended products guarantees or recall costs.

In addition to the conventional insurance risk, the timing risk is also ceded under finite risk contracts, that is, the insurer bears the risk of early loss payments and waives part of his interest yield as a result. Moreover, the insurer also assumes a credit risk in providing interim finance; the creditworthiness of the insured will be critical here.

Ultimately the policyholder bears a substantial share of its own losses. However, the financial impact is spread over several financial years. In industrial insurance business, the principle of mutuality inherent in insurance thinking is being replaced by an increasingly individual approach to clients. In the same way as bad risks subsidise good risks in personal lines or small and medium sized industrial business, under finite contracts those years where there are few losses now subsidise those where there are many.

Finite risk is also suitable where there are fundamental changes in the business, such as when two companies merge, since critical liabilities in the annual balance sheets are eliminated and the process of assessing them is thereby made easier.

Finite risk covers may be coupled with conventional risks to form blended covers, thereby combining the two elements of risk transfer and balance sheet protection. Let us take as an example an industrial company that retains products guarantee losses of up to $100,000 per event for its own account. After careful evaluation, we can work on the assumption that an aggregate annual loss of $2 million is deemed possible whereas the likelihood of an aggregate loss of $4 million is extremely remote. The following parameters could then be fixed for an insurance contract with a five year term:
• Annual aggregate: $4 million.
• Aggregate over 5-year period: $15 million.
• Premium: $2 million.
• Option to cancel after three years.
• Profit commission: 90% of “experience account” after three years, 95% after four years, and 99% after five years.

Both the cancellation clause and the policyholder's profit commission are vital elements of the finite insurance contract. It is important to determine what constitutes the “experience account”, as this will be used to pay the profit commission to the policyholder when the contract expires or is cancelled prematurely.With finite risk contracts, the question of how best to manage the accumulated funds arises. It is possible that the policyholder determines the investment programme himself as part of his business strategy. Alternatively, he can take advantage of the technical expertise of recently formed “general finance initiatives” by subcontracting the management of the funds to a professional asset manager.

It is up to the asset manager to find the right mix of long term investments with relatively high returns and short term investments with lower interest rate risks and higher liquidity. The asset manager's aim is to balance the timing of expected receipts from the invested funds against expected withdrawals for loss occurrences in the best way possible so that the whole portfolio is “immunised” against interest rate risks.

Conclusions and outlook
Sometimes it is argued that under the prevailing market conditions of generally low insurance premiums, alternative forms of cover in the form of multiline/multiyear, finite risk or even captive arrangements are not worth pursuing. It is evident that the optimum deductible does, indeed, become lower as premium levels fall, but this does not mean the policyholder has to completely forego the idea of self-financing instruments.

To this must be added the fact that, given the current state of the market, those offering such instruments might be more prepared to consider unusual client requirements. As explained above, the client can use longer term multiline/multiyear policies to safeguard to some extent against cyclical price fluctuations. Why then should he not try to freeze his risk costs for three to five years on current terms and conditions?

The conclusion is, therefore, that the above argument is, at best, only true to a limited extent. What is more important is that the integral risk attachment point should follow a logic based on the protection of balance sheet indicators and creation of shareholder value. The goal of modern risk management is optimising risk costs and not only across all classes of insurance but - as far as possible - across all the business's risks.

Loss occurrences, whatever their nature, are of concern because they are charged to the profit and loss account and absorb the company's capital funds. When it comes to implementing appropriate safeguards, it is of only secondary interest whether such occurrences are due to a major fire or higher raw material prices. This wider definition of risk represents a new and interesting challenge for the risk manager. Also, in the long term, only those bancassurers who can provide clients with integrated, tailor-made risk solutions will survive.

Alexander Müller, is senior underwriter multiline with Winterthur International. Tel: +41 52 261 5782; fax: +41 52 261 7090; e-mail:

Kai von Rappard is risk financing consultant with Winterthur International. Tel: +41 52 261 5228; fax: +41 52 261 7090; e-mail: