Denise Boutross McGlone is one of the few senior derivatives professionals with broad experience as both dealer and end-user. She started her derivatives career as a director in the treasury department at Sallie Mae in the early 1980s, where she worked on some of the earliest interest rate swaps. She then helped lead derivatives efforts at First Chicago Corp., Security Pacific and Dai-Ichi Kangyo Bank. From 1994–1997, she returned to Sallie Mae as CFO. She is currently a founding partner and principal at Aon Financial Products, where she is building a business in structured risk management products. She spoke with editor Joe Kolman in January.

Derivatives Strategy: What is a derivatives person like you doing in an insurance entity like this?

Denise Boutross McGlone: I asked myself that question a lot at first. Why would a capital markets person join an insurance broker to deliver financial or securities-type products?

If you look at the convergence of insurance and the capital markets, you’ll realize something important: the areas where the investment banks aren’t going to have a natural advantage are insurable risks and insurance-linked securities. Insurance companies have been analyzing and pricing event-type risk forever. When it comes to convincing capital markets investors and rating agencies about a new class of risk, therefore, the insurance companies will have a big advantage because they have the data availability to make the more compelling case. They also look at risk quite differently.

DS: Is that a big adjustment for you? You’ve spent your entire career looking at risk one way, and now you’re in an industry that looks at it in quite a different fashion.

DBM: Risk is risk—it’s really the same language, with a different dialect. Insurance companies take more of an actuarial approach, as opposed to the modeling approach we take in the financial community. But we see these techniques coming together. The truth of the matter is that if you can put the insurance industry’s actuarial approach together with our financial modeling approach and develop something that models a corporation’s entire spectrum of risk, you’re two steps ahead of the game.

DS: That’s the goal, but do you think it’s around the corner?

DBM: I think it’s getting closer. A few truly integrated deals have been done, and there are a number of other transactions that combine one or two financial risks with one or two insurable risks in an overall insurance policy. But the most critical change has been the mindset of the customer, both from the treasurer and insurance risk manager perspectives. They have begun to look at their collective risks on a more consistent basis across all sectors—the risks they retain, when coverage kicks in [the strike in derivatives lingo, the attachment point in insurance terminology], the linkage between their various risks and the acceptable level of earnings volatility. Over the first two weeks of January we’ve met with five different companies that wanted to talk about how integrated risk might work for them. Could they reduce volatility, reduce cost and reduce the need to transfer certain risks all at the same time? These are new questions for many companies.

We feel that the risk management question ultimately comes down to capital. Is a company efficiently using its capital and maximizing its risk-adjusted return on capital? You have to determine what level of risks to retain—whether event risks or capital market risks—which ones should be transferred and what’s the most cost-effective method of accomplishing that.

DS: What advantages do insurance companies have in this business?

DBM: There are two things that drive a company’s ability to make markets: distribution and risk management. In terms of distribution, insurance brokers have a vast array of clients with all sorts of risk management problems around the world. The power of distribution is a great advantage.

In terms of risk management, insurance entities have the ability to provide protection using the optimal market—be it the insurance or derivatives market—at any given point in time. We also have teams of people who are able to address the whole spectrum of risk, from operational to financial to business-type risks. Don’t forget, folks in the insurance industry were the first true risk managers.

DS: Can you give me an example of something that you’ve worked on recently?

DBM: Here’s a good one. The first week I was here, we got a call from somebody who wanted to hedge the price of chicken. I said, “Chicken? There’s no forward curve in chicken. How are you going to do that?” A couple weeks later, we got a call from another client who was a producer of chickens and wanted to sell the forward price of chicken. We didn’t end up doing the deal, but it was like I was back in the swaps market in 1982, when we were busy putting the two sides of a currency deal together, matching dollar for dollar, date for date, and making a real spread. At the other extreme, Aon has risk management relationships with major companies that stretch back to the 19th century. We are the exclusive broker for the management of their insurable risks and we may know their risk sensitivities as well as or better than the companies themselves.

DS: How can insurance companies hope to compete with the derivatives industry? Spreads are already pretty small on most standard products.

“We got a call from somebody who wanted to HEDGE the price of CHICKEN. I said, “Chicken? There’s no FORWARD CURVE in chicken.”

DBM: Our strategy is not to compete with the Street for plain-vanilla interest rate and currency swaps. The goal is to provide risk management services for a broad range of market risks, interest rates, currencies, commodities and equities. The power of the strategy emerges when you can provide advice and solutions that address both the insurable and financial risks on either a stand-alone or combined basis. For example, one of the things you might see is a dual-trigger policy in which your actual payout on the policy is a function of two things happening, such as a catastrophic event and a big movement in the Standard & Poor’s 500.

DS: What kind of need would trigger this?

DBM: We had a reinsurance company come to us that wanted to renew its property and casualty policy. It happened to mention, as a side comment, that it was worried about the value of its investment portfolio. We are working on a package in which the premium it pays on the insurance policy changes as a function of the movement in the value of its investment portfolio. In that situation, the best strategy is to link its insurance policy with a collar on its investment portfolio. One can be creative regarding the strike prices on the collar. For example, in this case the cost of the P&C insurance is $10 million and we set the strikes on the collar to effectively subsidize that premium.

Another innovation is a structure in which the retention level on the insurance level is variable and is a function of stock price. The theory here is that a strong stock price means high earnings and the ability to absorb the greater risk and lower cost associated with a higher retention level.

DS: And people thought financial innovation was a thing of the past.

DBM: Oh no, it’s just beginning. Witness the past few years and the growth of the insurance-linked securities market. Capital markets investors now underwrite event risk in the form of both contingent capital and risk-transfer securities.

DS: You’re now on the ground floor of your second financial revolution. How does it compare with the birth of the derivatives market in 1982?

DBM: There are a lot of similarities related to the origination and distribution channels and the need to upgrade the skill sets of relationship managers. The difference this time around is that relationship managers seem to recognize the need and are more willing to adapt.

DS: What changes do you see on the client side?

DBM: In the old days, you had a risk manager at a corporation who bought cover for his insurance products—the silo approach. He’d think, “I have property and casualty, I have liability, I have this and that.” The costs of insurance were dramatic, because all he did was renew his program every year. In many ways there was no rationalization of the capital spent to secure protection. Insurance was seen as a cost of doing business. Down the hall sat the treasurer and the CFO, who bought their own protection for their own set of risks and analyzed each dollar they spent to secure protection.

Now you see the insurance risk management function migrating to the treasurer. Instead of taking the bottom-up approach, which involves thinking about how much money should be put against a particular set of risks, we’re seeing a more top-down approach. Treasurers will ask, “How much earnings-per-share volatility can I withstand? Given our tolerance for earnings volatility and this profile of risk, what is the amount of money I want to put against this basket of risks to cover our earnings volatility?”

DS: If a company buys one of these combined risk packages from you, isn’t it going to be less likely to buy a vanilla product from the Street?

DBM: Not necessarily. One view is that the insurance and derivative markets are somewhat segmented by the types of risk they handle best. The derivatives markets, for example, are good at handling exposures that are near the money, while the insurance markets are better at handling the out-of-the-money exposures. I see situations in which we might include disaster insurance for foreign exchange or commodities within an overall insurance policy. That would still leave the near-the-money risks to be managed in a more traditional manner.

DS: So you’re going to focus on the fat tails.

DBM: Yes, but that’s just one element of our business strategy. On a standalone basis we’re also going to concentrate on the risks that straddle the insurance and derivative markets, such as credit and weather. We’ll work with customers to source out the most effective coverage and then package it as insurance or a derivative, depending on the customer’s preference. We’ll also look to compete on highly structured derivative solutions that combine a number of near-the-money capital market risks in the same package. Another solution we can offer, where appropriate, is an insurance-linked security through our affiliate, Aon Capital Markets.

Right now, we’re starting to see products out there that address all insurable risks and all financial risks, and in time we’ll also see products that address certain business-type risks as well.

DS: What kind of business risks are we talking about?

“The DERIVATIVE MARKETS are good at handling exposures that are NEAR THE MONEY, while the INSURANCE MARKETS are better at handling the OUT-OF-THE-MONEY exposures.”

DBM: Risks associated with patent expiration, brand name, corporate image and new product delivery. Right now, you can hedge your insurance risk and your financial risk, but you’ve still got business risks. In the future, the question might be, How much am I willing to spend to hedge my remaining risks and secure, in effect, a floor on my earnings growth?

DS: How do you take the other side? It would be hard to securitize those risks.

DBM: Well, David Bowie recently securitized the future sales on his recordings. That’s like insurance against brand identity, isn’t it?

DS: What’s driving this trend?

DBM: A lot of things. The global markets are getting extremely competitive. A CFO and treasurer have one goal in life—to deliver constantly increasing and stable earnings per share. They have to look at every dollar of capital they spend, and they don’t have the luxury of buying lots of insurance to protect risks that may never happen or to pay lots of money for low deductible levels.

Some people have begun to talk about EPS insurance, which would be the nth degree of risk management. We have a long way to go before we get there. At that point, when you can get insurance that protects all business risks and protects your earnings per share, you effectively become a utility. I don’t think that is what investors want in a lot of cases. Aren’t business managers paid to take selected risks? As I mentioned earlier, it all gets back to capital. You want to achieve the optimal balance between risk transfer and risk retention that maximizes your return on capital.

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