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W. Jean Kwon, Ph.D., CPCU
School of Risk Management, St. John’s University
101 Murray Street
New York, NY 10007, USA
Phone: +1 (212) 277-5196
E-mail: Kwonw@stjohns.edu
Risk Management and Insurance: Perspectives in a Global Economy
14. External Loss Financing Arrangements
There are two sections discussing alternative risk transfers.
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and Course Information
Study Points
 Risk financing through derivatives
 Risk financing through insurance
 Integrated loss financing arrangements
3
Risk Financing Through Derivatives
4
The Markets
 Barter markets
 Cash-and-carry markets
 Spot markets
 Futures/options markets
5
Forwards and Futures
Forward Contract
Futures Contract
 Specifies the price and delivery
date of the underlying
 For the future purchase and sale
of goods or services
 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 are regulated, liquid and
traded on organized exchanges.
 They contain standard contract
terms and cannot be customized
to individual needs.
6
Basics
7
Options
 Call vs. put option
 Option premium
 Strike price
 European vs. American option
8
Options (Figure 14.1)
9
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 norisk 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.
10
Swaps
 The exchange of one security for another
 Currency swaps
 Interest rate swaps
11
Managing Financial Risks
 Foreign exchange (FX) risk
 Weather risk
Pages 355-358
12
Risk Financing Through Insurance:
Focusing on Liability Risk
Refer to Chapter 19 for Insurance
Principles and Fundamentals of
Insurance Contracts
13
Court Awards (Insight 14.1)
 Economic (general) damages
 Non-economic (special) damages
 Punitive damages
14
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
15
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.
16
Directors and Officers Liability Insurance
 D&O liability coverage
 Corporate reimbursement coverage
 Entity coverage
17
Insurance for MNCs
 Admitted insurance
 Nonadmitted insurance
 Global master program
18
Admitted Insurance
 Benefits from purchasing coverage locally
•
•
•
•
The policy will be serviced locally.
Premiums and claims will be paid in the local currency.
The local insurer and broker provide advice and RM services.
The insurance program is complying with local laws.
 Disadvantages
• Policies 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.
19
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.
20
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
21
Not in the book!
Integrated Loss Financing Arrangements
22
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.
23
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.
24
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
25
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
26
Other ART Techniques: Contingent Capital
Not in the book!
27
Fundamentals
 Contingent capital
• Simply, an option to issue a corporate security
 Contingent capital facility
•
•
•
•
Right to issue new debt, equity or structured security
During a specified period
At a predefined issue price
On the occurrence of a triggering event
• Unexpected & substantial loss by the right holder
• High correlation between the loss exposure and the price of the
security
28
Contingent Capital - Elements
 Underlying
• Debt, equity or hybrid security defined at the beginning of the option
period; that is, before the security is issued
• Tends to be deeply subordinated debt or preferred stock
 Tenor
• Limited duration; for example, right to issue five-year, fixed rate
subordinate debt at any time during the next three months
29
Contingent Capital - Elements

Intrinsic value (strike price)
•
Usually at-the-money at inception; that is,
• Price set prior to loss realization
• Value tied to the price of the underlying on the date of
contingent capital negotiation
•
Cost-of-capital difference between
[1] One under the arrangement and
[2] The other in the open market at the time of exercise
• No option exercise if [1] > [2]
30
Contingent Capital - Elements
 Exercisability – dual triggers
• The underlying with a greater-than-market value and an objectively
defined loss event
• First trigger usually American, thus giving the right holder to issue the
securities at any time during the tenor period
• Instead of loss, the second occasionally tied to a variable beyond the
firm’s influence, thus minimizing problems of moral hazard
• Linking the firm’s negative earnings shock to the average industry
earnings, for example
31
Contingent Capital - Elements
 Placement
• Commonly a private placement with a (lead) option writer
• Until exercise, the writer collects a periodic commitment
(premium) until the facility is exercised
• On exercise and in case of a put option, the writer gets a security
in return for the (cash) payment to the owner of the facility
 Compare it with an insurance contract!
32
Committed Capital Facility Example
Insurer
Purchase the option, pay the premium
until exercise
Issue
Securities
w/ Collateral
Put Option
Cash
Commitment
Fee/Premium
SPV
Prior to exercise, holds capital, say,
commercial papers
On exercise by the insurer, liquidate its
own securities to purchase, say,
preferred stock issued by the insurer
Investment
Investors
Coupon + Premium
Trust
33
Discussion Questions
34
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?
35
Discussion Question 2
 Describe two important distinctions between forward and
future contracts.
36
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?
37
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?
38