Fall 2008 VersionFall 2008 Version

Professor Dan C. Jones

FINA 4355

Handout, Homework

Risk Management and Insurance: Perspectives in a Global EconomyRisk Management and Insurance: Perspectives in a Global Economy

14. External Loss Financing 14. External Loss Financing ArrangementsArrangements

Professor Dan C. Jones

FINA 4355

Handout, Homework

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Study PointsStudy Points

Risk financing through derivatives

Risk financing through insurance

Integrated loss financing arrangements

Risk Financing Through Derivatives

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The MarketsThe Markets

Barter markets

Cash-and-carry markets

Spot markets

Futures/options markets

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Forwards and FuturesForwards and Futures

Forward contractSpecifies 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 contractFor 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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BasicsBasics

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OptionsOptions

Call vs. put option

Option premium

Strike price

European vs. American option

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Options Options (Figure 14.1)(Figure 14.1)

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ArbitrageArbitrage

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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SwapsSwaps

The exchange of one security for another

Currency swaps

Interest rate swaps

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Managing Financial RisksManaging Financial Risks

Foreign exchange (FX) risk

Weather risk

Pages 355-358

Risk Financing Through Insurance

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Court Awards Court Awards (Insight 14.1)(Insight 14.1)

Economic (general) damages

Non-economic (special) damages

Punitive damages

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Liability Insurance for MNCsLiability Insurance for MNCs

General business liabilityAlso known as “public liability” in commonwealth countries

Liability to third parties

Employment practices liabilitySee next page

Liability to employees

Directors and officers (D&O) liabilityLiability as decision makers of the organization

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Preventing Employment Practices Liability Preventing Employment Practices Liability (Insight 14.3)(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 InsuranceDirectors and Officers Liability Insurance

D&O liability coverage

Corporate reimbursement coverage

Entity coverage

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Insurance for MNCsInsurance for MNCs

Admitted insurance

Nonadmitted insurance

Global master program

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Admitted insuranceAdmitted insurance

Benefits from purchasing coverage locallyThe 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.

DisadvantagesA 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 InsuranceNonadmitted Insurance

BenefitsCentralized 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.

DisadvantagesClaims 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 Global Master Program (Figure 14.2)(Figure 14.2)

Whole Account Coverage

Umbrella Liability Coverage

Excess/DIC/DIL Coverage (Master Policy)

CorporateOffice

PrimaryLiability

Coverage

CorporateOffice

PrimaryPropertyCoverage Other Property &

LiabilityCoverage

Placed Locally

LocalCompulsoryCoverage

LOCAL INSURER

Integrated Loss Financing Arrangements

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Multi-line/Multi-year ProductsMulti-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 ProductsMulti-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) TriggersUnderstanding Multi (Two) Triggers

Traditional insuranceFire damage resulting in business income loss

If business income loss is the first trigger, there is a serious moral hazard problem

New approachFirst trigger being a traditionally covered peril

Second trigger being a financial loss exposure

Not in the Book!

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TriggersTriggers

Fixed triggerPayout depending the “occurrence” of a covered event

Likely the first trigger

Variable triggerAs an index (e.g., loss exceeding $20 M or price falling below $35 per barrel)

Likely the second trigger

Switching triggerVaries based on some weighting scheme of the multiple risks

Not in the Book!

Discussion Questions

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Discussion Question 1Discussion 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 2Discussion Question 2

Describe two important distinctions between forward and future contracts.

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Discussion Question 3Discussion 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 4Discussion 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?