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

3 Study Points Risk financing through derivatives Risk financing through insurance Integrated loss financing arrangements

Risk Financing Through Derivatives

5 The Markets Barter markets Cash-and-carry markets Spot markets Futures/options markets

6 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.

7 Basics

8 Options Call vs. put option Option premium Strike price European vs. American option

9 Options (Figure 14.1)

10 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.

11 Swaps The exchange of one security for another Currency swaps Interest rate swaps

12 Managing Financial Risks Foreign exchange (FX) risk Weather risk Pages

Risk Financing Through Insurance

14 Court Awards (Insight 14.1) Economic (general) damages Non-economic (special) damages Punitive damages

15 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

16 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.

17 Directors and Officers Liability Insurance D&O liability coverage Corporate reimbursement coverage Entity coverage

18 Insurance for MNCs Admitted insurance Nonadmitted insurance Global master program

19 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.

20 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.

21 Global Master Program (Figure 14.2) Whole Account Coverage Umbrella Liability Coverage Excess/DIC/DIL Coverage (Master Policy) Corporate Office Primary Liability Coverage Corporate Office Primary Property Coverage Other Property & Liability Coverage Placed Locally Local Compulsory Coverage LOCAL INSURER

Integrated Loss Financing Arrangements

23 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.

24 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.

25 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!

26 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!

Discussion Questions

28 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?

29 Discussion Question 2 Describe two important distinctions between forward and future contracts.

30 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?

31 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?