Captive Insurance And Hedge Funds Offset Risk

Andrew M. Amalfitano

Andrew M. Amalfitano 31-JULY 2010 Page 1 of 7

"How Captive Insurance and Hedge Funds Can Help Offset Financial Risk Exposures"

Andy Amalfitano

MSBC Seminar #4 - Risk Management Norwich University

July 31, 2010



Thesis In the last two years, many economists were proven wrong as the economy hit the

worst recession and downturn since the Great Depression of the early 20th century.

Today, missing predictions continues. One of many examples is offered by Soto (2010).

"In April we said GSCI Total Return Y/Y could appreciate by more than 20%

and at the same time we warned Crude Oil Valuation model just reached

again its overvalued territory. One month later, we can say we were

wrong.... It looks like Crude Oil Valuation will reverse completely... and there

might still be room for more decline ahead..." [1]

Risk managers try to predict and find easy ways to improve their financial advantage,

often listening to economic pundits. Those days are gone. "Global supply-demand

imbalances in raw materials, and resulting price volatility, will likely continue to impact

the profitability and competitive position of many U.S. companies." [2]

This paper describes why a company should consider using various techniques within

the financial markets to offset financial exposures.

Why

All businesses face exposures to predictable and unpredictable financial threats which

can undermine goal achievement. The worst of these risks will be the unpredictable

threats that present the greatest degree of uncertainty. Financial market-specific risks

come in many forms:

Interest rate changes

Foreign currency exchange rate fluctuation

Goods and services tax and import/export tariff law changes

Geopolitical upheaval in areas where business is conducted

Stock market volatility affecting investments and portfolios

and more



Depending on the size of the business, some or all of these market levers may impact a

business' viability. [3] What's more unnerving is the volatility and unpredictability of

these risks. Economists have attempted to manage and predict the future with tools

such as the CBOE-VIX [4], a widely used market analyzer. Academic researchers have

attempted to create models to improve predictability. Both set of experts seem to agree

that more data and understanding represents goodness, however, no specific model or

approach to offsetting financial risk can be a guarantee. [5]

Verni (2005) offers four pieces of advice in managing risks:

"Be skeptical

Assume Murphy's Laws are in force. If anything simply cannot go wrong, it will

anyway

If everything seems to be going well, you have obviously overlooked something

Every solution breeds new problems" [6]

Gathering intelligence on financial risks and understanding what the information means

to your business can be a key step in managing these risks. Scholes (2005) describes

questions that a company can use to determine the 'how' of understanding asset

management which he finds to be a key part of the strategy.[7] In addition, three key

asset management criteria that demand understanding are:

1. "Capital Allocation: How do we allocate capital to the risks we are taking, to each

strategy individually or to a portfolio?

2. Optimization: Risk management is not risk minimization - it is risk optimization -

but what is the right tradeoff between risk and return?

3. Stress Management: How do we handle it, and do we know how to do anything

about it?"[8]

It is incumbent upon financial risk managers to avoid poor financial investments and

make educated risks about trade-offs, alternatives, and options.



How

After decades of study and trial and error attempts to completely predict and

understand financial markets, no one single model has emerged that completely defines

how to manage risk 100% of the time or with 100% accuracy.

In a thesis offered by Rörden & Wille (2003) the authors concluded that "the only theory

which was considered to actually work in practice without any unrealistic assumptions

was diversification."[9] Examples of diversification include spreading investments across

different market types, investing some money in short-term and other money in long-

term instruments, and selecting assets or commodities that are significantly unrelated

by most measures.

A business needs to consider who they are as a company, what their tolerance for risk

is, and apply some flexibility to their approach in selecting financial risk strategies. What

is clear is that the lack of understanding of risks and/or the lack of a strategy will often

mean the difference between success and failure of a business.

Here are two of the many options available for consideration by businesses:

Captive Insurance

o A form of member-owned self insurance, usually in a group of similar

companies providing a form of alternative risk financing

o Offers reduced insurance costs, stabilized insurance budgets, direct access to

the reinsurance market, improved claims handling and data collection,

possible tax benefits, profit center creation, and a negotiation tool. [10]

According to Jay Krafsur of the Krafsur Law Group, captives offer members a significant

investment tool to manage insurance costs and reinvestment opportunities in the form

of reduced and re-investable loss funding. [11] Approximately 60% of premiums go into

loss funding which is mostly reimbursable over time. The other 40% is operating funds



which are not recoverable, however all of the premiums are investment funds which

provide a broad and rather securable asset which grows over time while simultaneously

providing member insurance coverage. Further, captives apply strict rules to

membership including letters of credit and other assurances of financial solvency of

their members. [12] This strategy provides an avenue that businesses can consider to

offset other financial risks that may be occurring within their industry or market space.

Hedge Funds

Usually reserved for the high net wealth individuals or firms[13], hedge funds can play an

important role in offsetting financial risks. A hedge fund is "an aggressively managed

portfolio of investments that uses advanced investment strategies such as

leveraged, long, short and derivative positions in both domestic and international

markets with the goal of generating high returns". [14]

Primarily, a hedge fund is a way for an individual or in some cases, a group of people to

invest significant sums of money using instruments that provide some security against

changes in market value. [15]

The concept of hedging can be applied as a strategy to financial risk management. The

old term 'don't put all your eggs in one basket' may still be wise advice to businesses

facing uncertain futures.

Conclusion

There is no one sure-fire answer to how to manage financial risk particularly in the

uncharted territory of today's economy. Economists and researchers disagree on the

best model or tool to use to forecast commodities, the stock market or other economic

changes. Therefore, market volatility continues to plague investment strategy success

for many businesses.

http://www.investopedia.com/terms/h/hedgefund.asp



Two possible strategies are investment in captive insurance and hedge funds. Both offer

unique ways to bring some level of security and risk avoidance to a business. These

strategies offer an opportunity for businesses to not place all their investments in the

same place and thus help ensure a more balanced financial risk situation.

Citations [1] Soto, Francis (2010). "Commodities Indicators: May 2010". Retrieved 7-30-10:

http://seekingalpha.com/article/204391-commodities-indicators-may-2010 [2] Dickson, Duanel; Manocchi, Jim, and Agarwal, Sanjay (2206). "Commodity Management: Profiting from

Volatility". Deloitte Consulting. Retrieved 7-30-10: http://aimediaserver4.com/chemweek/pdf/deloitte1.pdf

[3] Crabb, Peter R., (2003). "Financial Risk Management: The Big and the Small". Northwest Nazarene

University ID. Retrieved 7-30-10: http://sshuebner.org/documents/Crabb%2010-29.pdf [4] Chicago Board Options Exchange-CBOE (2009). "The CBOE Volatility Index-VIX". Retrieved 7-30-10:

http://www.cboe.com/micro/vix/vixwhite.pdf [5] Rörden, Sarah & Wille, Kristofer, Supervised by Sundström, Angelina, Examined by Liljefors, Ole.

"MEASURING AND HANDLING RISK - How different financial institutions face the same problem". Mälardalen University School of Sustainable Development of Society and Technology Bachelor Thesis in Business Administration, 15 ECTS, June 4th, 2010. Retrieved 7-30-10: http://sshuebner.org/documents/Crabb%2010-29.pdf

[6] Verni, Ralph, (2005), "Financial Risk Management in Practice: The Known, the Unknown and the

Unknowable". Roundtable 4: Insurance and Reinsurance." The Wharton School, Alfred P. Sloan Foundation, and Mercer Oliver Wyman Institute, 18

[7] Scholes, Myron, (2005), "Financial Risk Management in Practice: The Known, the Unknown and the

Unknowable". Roundtable 6: Asset Management." The Wharton School, Alfred P. Sloan Foundation, and Mercer Oliver Wyman Institute, 22-24

[8] Schoel, Ibid [9] Rörden, Sarah & Wille, Kristofer, Ibid [10] Theriault, Patrick, PA, CPCU, AIAF. "Captive Insurance Companies: What to Consider When

Establishing and Operating Captives". Wilmington Trust Captive Management Services. Retrieved 7-30-10: http://www.captive.com/service/WilmingtonTrust/images%20and%20pdf/captive101whitepaper.pdf

[11] Krafsur, Jay of Krafsur Law Group - Captive Insurance Consultants, Chicago IL. Interviewed by Andy

Amalfitano July 2010. [12] Krafsur, Ibid



[13] Investopedia, "Hedge Fund". Forbes Digital Company. Retrieved 7-30-10: http://www.investopedia.com/terms/h/hedgefund.asp

[14] Ibid [15] McNulty, Daniel, 2010."Offset Risk with Options, Futures, and Hedge Funds". Investopedia by Forbes

Digital Company. Retrieved 7-30-10: http://www.investopedia.com/articles/trading/09/offset-risk-options-futures-hedge-funds.asp

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Captive Insurance And Hedge Funds Offset Risk