Fall 2008 Version
Professor Dan C. Jones
FINA 4355
Handout, Homework
Risk Management and Insurance: Perspectives in a Global Economy
14. External Loss Financing
Arrangements
Professor Dan C. Jones
FINA 4355
Handout, Homework
Study Points
Risk financing through derivatives
Risk financing through insurance
Integrated loss financing arrangements
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Risk Financing Through Derivatives
The Markets
Barter markets
Cash-and-carry markets
Spot markets
Futures/options markets
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Forwards and Futures
Forward contract
Specifies the price and delivery date of the underlying
Traders in the forward market must honor the contract, regardless of
the outcome. This gives rise to a potential problem of credit risk, as
forwards are not regulated.
Futures contract
For the future purchase and sale of goods or services
Futures are regulated, liquid and traded on organized exchanges.
They contain standard contract terms and cannot be customized to
individual needs.
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Basics
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Options
Call vs. put option
Option premium
Strike price
European vs. American option
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Options (Figure 14.1)
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Arbitrage
The possibility of making a riskless gain with no chance of
loss
An example of the January effect (page 353)
A true arbitrage always works with certainty; that is, a no-risk
money machine.
An efficient market does not allow arbitrage.
However, the presence of some persistent anomalies seems to
indicate a lack of efficiency and the possibility of arbitrage profits.
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Swaps
The exchange of one security for another
Currency swaps
Interest rate swaps
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Managing Financial Risks
Foreign exchange (FX) risk
Weather risk
Pages 355-358
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Risk Financing Through Insurance
Court Awards (Insight 14.1)
Economic (general) damages
Non-economic (special) damages
Punitive damages
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Liability Insurance for MNCs
General business liability
Also known as “public liability” in commonwealth countries
Liability to third parties
Employment practices liability
See next page
Liability to employees
Directors and officers (D&O) liability
Liability as decision makers of the organization
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Preventing Employment Practices Liability (Insight 14.3)
Establish hiring practices in compliance with local laws.
Distribute employee handbooks that clearly document the
entity’s employment policies and procedures.
Provide all employees with a formal, published policy dealing
with sexual harassment and discrimination.
Conduct scrupulous annual performance reviews with interim
reviews to correct unacceptable behaviors.
Strictly follow established policy for terminating employees.
Conduct and document exit interviews.
Promptly investigate all allegations of harassment or
discrimination.
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Directors and Officers Liability Insurance
D&O liability coverage
Corporate reimbursement coverage
Entity coverage
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Insurance for MNCs
Admitted insurance
Nonadmitted insurance
Global master program
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Admitted insurance
Benefits from purchasing coverage locally
The policy will be serviced locally.
Premiums and claims will be paid in the local currency.
Premiums paid locally usually are deductible as a business expense
for tax purposes.
The local insurer and broker can provide advice and risk management
services.
The insurance program is complying with local laws.
Disadvantages
A policy may be difficult to evaluate and manage by the MNC’s risk
manager.
Local policies may be more costly.
The MNC may loose negotiation power and the spread of risk
associated with centralized purchasing.
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Nonadmitted Insurance
Benefits
Centralized administrative control
Possible broader terms and conditions
Possible lower cost
The premium will be payable in the home country currency, as will
losses  potential drawback as well.
Disadvantages
Claims settlement can become more complicated without local
coverage and the assistance of local insurer representatives.
Local management may not understand the nonadmitted coverage.
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Global Master Program (Figure 14.2)
Whole Account Coverage
Umbrella Liability Coverage
Excess/DIC/DIL Coverage (Master Policy)
Corporate
Office
Primary
Property
Coverage
LOCAL INSURER
Other Property &
Liability
Coverage
Placed Locally
Local
Compulsory
Coverage
Corporate
Office
Primary
Liability
Coverage
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Integrated Loss Financing Arrangements
Multi-line/Multi-year Products
Coverage over multiple lines of insurance, where lines are
different classes of insurance
Coverage a single deductible and policy limit applicable to all
losses and over time
The more exposures included, the closer such a contract is
aligned to the ERM concept, as it takes a holistic approach to
loss payouts.
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Multi-trigger Products
Claims are paid only if, in addition to an insurance event
(“first trigger”) during the contract period, a non-insurance
event (“second trigger”) also occurs.
Given that the probability of experiencing both losses is
lower that the probability of any one of the two events, the
premium will be lower than otherwise.
Such a contract is probably more consistent with ERM
programs.
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Understanding Multi (Two) Triggers
Traditional insurance
Fire damage resulting in business income loss
If business income loss is the first trigger, there is a serious moral
hazard problem
New approach
First trigger being a traditionally covered peril
Second trigger being a financial loss exposure
Not in the Book!
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Triggers
Fixed trigger
Payout depending the “occurrence” of a covered event
Likely the first trigger
Variable trigger
As an index (e.g., loss exceeding $20 M or price falling below $35 per
barrel)
Likely the second trigger
Switching trigger
Varies based on some weighting scheme of the multiple risks
Not in the Book!
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Discussion Questions
Discussion Question 1
What are the common methods to control or finance loss
exposures? Why would a typical MNC consider control
methods before financing methods? What role does
insurance play in managing the exposures?
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Discussion Question 2
Describe two important distinctions between forward and
future contracts.
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Discussion Question 3
Describe the corporate liability environment in your country?
Are there new laws governing how corporations should
handle employment-related issues such as age and gender
discrimination or what is defined as “unlawful discharge from
employment” in your country? If so, what changes can you
identify that have been taken by corporations in response to
such new laws?
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Discussion Question 4
A multi-trigger policy contains a condition that the
traditionally insurable loss event (e.g., fire) must be the first
trigger, followed by, say, a financial loss?
What adverse effect would the insurance market experience in
offering policies with a financial loss as a first trigger?
Based on the second example in the multi-trigger coverage, explain
the reason why the insurance premium for this multi-trigger policy
would be much, if not significantly, lower than the premium for a
single-event coverage?
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