Insure It All
A new wave of insurance products allows corporates to combine risks more efficiently and hedge exposures in ways they never thought possible.
By Lawrence Richter Quinn
When buying property or casualty insurance these days, most insurance risk managers know their new marching orders: Don’t spend too much time quibbling over known exposures and the wide array of means to manage those risks.
Worker’s comp, fire, other hazards? It’s a piece of cake. Self-insure up to a certain level or simply retain, in insurance parlance, a certain amount of risk—say, $50 million. Above that, buy all the traditional P/C policy coverage needed, at whatever price feels good. In today’s soft market, after all, those kinds of coverage are available almost everywhere. Insurance companies look at them as loss leaders, putting corporate insurance risk managers in the driver’s seat.
Set all that aside for a moment, and consider the nontraditional types of exposures that have not been well-covered until now—exposures for which it’s difficult or impossible to obtain affordable pricing. How about product-recall exposure? Patent or copyright infringement? Or weather-related exposures—the possibility, say, that beer sales will decrease 20 percent in the summer if the temperature rises above 80 degrees on only a third of summer days?
Losses in those areas have plenty of impact on earnings and, ultimately, shareholder value. Add the most vague of insurance types—business interruption exposures—to natural and man-made exposures, and then, as the coup de grace, capital markets or traditional treasury and purchasing management risks related to foreign exchange and commodities.
Next, take all of those risks—the old, boring stuff, and the things nobody quite understands—and think of them as baskets of risks. Then chose among a variety of new mechanisms for covering them. Consider “insuritizing” some or all of these risks—that is, combining some or all of them in a single insurance policy. To much ballyhoo, Honeywell did exactly that in 1997 in an insurance policy that combined worker’s comp and foreign exchange. Under its three-year policy, Honeywell agreed to absorb all foreign exchange and worker’s comp losses up to somewhere between $25 million and $30 million; after that, its insurance policy kicked in. The company’s overall insurance costs are supposed to decline 25 percent. A handful of other firms have reportedly structured similar policies, and still others are now examining the possibility.
Or, as an alternative, do away with those new insurance vehicles and buy earnings insurance coverage—insurance that will pay a company should it not meet agreed earnings-per-share or EBITA (earnings before interest, taxes, depreciation and amortization) projections. At the end of the day, after all, that’s what the management of traditional insurance, treasury and commodity exposures is all about: smoothing out volatility and giving Wall Street analysts and institutional investors confidence that management is performing consistently, profitably and on target—quarter after quarter.
|“We call some of these new insurance policies ‘derivatives in drag.’ FASB is saying, ‘You can’t take a derivative, dress it up as an insurance policy, and make it anything other than a derivative.’”
Marsh & McLennan
Sound messy? Absolutely. But these days all of these exposures, old and new, are on the radar screens of traditional insurance risk managers, treasurers, strategic planners, accountants and others at mid-sized as well as Fortune 500 companies. Within the next 18 months, several dozen U.S. and international corporations may have signed state-of-the-art insurance policies that promise to change forever the way people think about corporate risk.
And if most of the lingo that comes up in these discussions sounds eerily familiar—baskets of risk, uncorrelated risks, indices and triggers—it’s no coincidence. It is the same nomenclature used in discussions about derivatives over the last decade or so. Understand that, and the predictable accounting, tax and other hurdles that must be tackled before anyone signs anything become all too apparent.
“I’ve been working with corporate financial officers for years, and what they have always wanted from the insurance industry is earnings-per-share insurance,” says Jim Davis, chairman and CEO of Advanced Risk Management Services, the consulting division of global insurer Willis Corroon in Nashville, Tenn. “Historically, P/C insurers have defined the risks they underwrite as those with negative outcomes—workers’ comp or fire loss, for instance. But many corporate risks have positive upsides—think of the money that can be made from a foreign exchange hedge. If you broaden the horizon and look at all of these exposures together, you can start providing the earnings protection companies have always wanted.”
According to G. Alan Zimmerman, a principal at Morgan Stanley in New York, corporations are finally analyzing their collective risks in the same light, regardless of whether they are traditional insurance risks. “Who cares if you have a lawsuit that cost you $50 million or a currency loss of $50 million? It’s still costing the corporate entity money,” he notes. But finally, the insurance industry and corporate executives are beginning to see the linkages and are starting to look at their risk management alternatives in this light.
“Many companies are in the ‘we’re looking at this extensively’ stage,” adds Zimmerman. “That’s always the precursor to things happening. Do I think that these new types of insurance coverages are going to grow? Yes. If you look at it in terms of the stock market, there’s a clear value to having stable rather than volatile earnings, and it pays up. To the extent that the market penalizes volatility, companies have to look at these things. It’s tough to be a pioneer, but these deals will get done.”
A former senior executive at Hedge Financial Products Inc., owned by insurance giant CNA, agrees. “Earnings protection is ultimately what people want to achieve,” he says, “but writing an insurance policy for earnings per se remains quite difficult because so many things go into it that are neither hedgeable nor reservable. Nevertheless, one can write insurance policies for most components of earnings or the things that affect them—product recalls, foreign exchange, exposures to random events such as fire and so on.”
Taking the first steps
There’s plenty of evidence that corporates and insurers are moving quickly to bring these new types of insurance coverage into play—if not immediately, then certainly within the next year or two. Several major multinationals are already setting up interdepartmental and interdisciplinary committees to examine these new insurance products. “Most companies are interested in looking at these alternatives and will probably form study groups to determine if and how to approach this new marketplace,” notes Mitch Cole, a principal at Tillinghast-Towers Perrin in New York.
|“A company has literally hundreds of operational risks, including disruptions in the supply chain and loss of key customers. If these operational risks run through your earnings, they can be covered.”
One such firm is Hewlett Packard Co. in Palo Alto, Calif. “We started looking at the blending of traditional and non-traditional insurance products two or three years ago, trying to do something strategic or different,” says Roberta Martoza, a solutions manager. “We’re not going to be bleeding-edge, setting the trend, but we asked Swiss Re New Markets to talk with us about some of these alternatives, and recently Goldman Sachs has done the same.”
After “philosophical discussions” with Swiss Re, Hewlett Packard “formed a team to look at moving some of these items off balance sheet, and we’re walking through our financials and looking at some of the deals we have already put together,” says Martoza. “Those on the team include people from tax; accounting; the controller’s office; our insurance area; cash management, which represents treasury; and the treasurer when we need him. We’re keeping our eyes and ears open, and we’re cautiously optimistic that we can put something together.”
A variety of companies are also close to inaugurating insuritization programs, which wrap traditional insurance risks, treasury risks and commodity exposures together under a single insurance cover. “We’re working on one program that involves product recall, foreign exchange and other exposures,” says Scott Sanderson, senior vice president of global risk consulting at insurance broking giant Marsh & McLennan in Minneapolis. “If a negative foreign exchange movement and a product recall occur concurrently, the insurance would be triggered, but if foreign exchange moved into a gain position, the gain would be used to offset a recall event. The result is that the firm has substantially dampened the volatility of recall through other things happening in the company.”
Davis at Advanced Risk Management Services says he’s working on five or six such transactions. “We’re doing work now for a steel company that uses slag as a manufacturing component,” he says. “There’s no secondary market for it, but there is an externally verifiable index that tracks its price, so we’ve taken that index and suggested embedding it in an insurance contract.”
The former Hedge Financial executive offers an agricultural example. “Let’s say you have a company selling tractors in Illinois, and it wants to protect itself during periods of low soybean production in that area,” he says. “There are data showing 50 years of soybean yield in that state, so you can put together an insurance program that protects the company from losses resulting from low production, with a second trigger that revolves around soybean production as reported by the U.S. Department of Agriculture. That way the insurer is not paying out because of poor management at the company or other things specific to the company. In examples like this, you have an independent source of information driven by macroeconomic or weather events.”
Some companies are now talking about putting together their own catastrophe bonds aimed as much at covering business interruption expenses as the specific immediate damage to a company’s physical assets. Executives at two modeling firms expect to see the first corporate-specific cat bonds issued in the next several months—by a European corporation.
John Gorte, manager of the risk management department at Dow Chemical Co. in Midland, Mich., calls cat bonds “conceptually great” since the capital markets represent an alternative insurance market. “With the market as soft as it is, it’s not a competitive alternative,” he says, “but when it hardens up, we’re going to look at just about anything that can get us the coverage we need at the right price.”
Insurance executives and bankers say the most logical issuers of cat bonds are those in heavy industry—such as petroleum and chemical companies. “The profile of companies looking at this are those with a considerable exposure either to their assets or to business interruption itself,” says Dennis Kuzak, vice president of EQECAT Inc., a cat modeling firm in Oakland, Calif. “Examples would include companies that are part of the petroleum industry, which is asset-rich, or retailing [businesses] associated with resorts, travel and vacations, where disasters can change the cash-flow picture dramatically. The focus is on lost earnings or total revenues over a period of time after an event. It’s difficult to provide coverage in this area, because the traditional insurance industry doesn’t understand how to underwrite the risk or settle a claim when it’s made.”
Marsh & McLennan’s Sanderson says that, at least hypothetically, “it’s conceivable that the same company could have both an insuritization program and a cat bond in place, in which the insuritization would cover some capital markets risks and the securitized bond would cover insurance risks.” He adds that these options are at opposite ends of the spectrum and that “neither is right or wrong.”
In January, New York-based Reliance Insurance announced its introduction of “Enterprise Earnings Protection Insurance,” targeted at mid-sized corporations. Bernard Friemann, president of the financial risk management division of Reliance, explains that “EEPI brings many types of operational risk into an insurance contract. A company has literally hundreds of operational risks, including things such as disruptions in the supply chain and loss of key customers. If these operational risks run through your earnings at the EBIDA level, they will be covered under EEPI unless they are explicitly excluded.”
|“The profile of companies looking at cat bond issuance are those with a considerable exposure either to their assets or to business interruption itself.”
Friemann sees EEPI, which at this point has no takers, as a complement to insuritization. “Many people have been working on this concept for a long time,” he says. “It leaps down the insuritization path. They both involve financial basket of risks, but we pick up a big chunk of the operational risk. We think the target market for these will be those companies with somewhere between $50 million and $500 million in EBIDA.”
What do all of these new programs have in common? They enable companies to allocate capital more efficiently, says John Kelly, managing director in Citigroup’s insurance derivatives group. “Industrial companies are starting to look at this,” he continues. “For instance, if you have an insurance policy that puts a floor on performance of one sort or another, you can raise capital against that policy, against that floor. Then you can say, ‘Here’s the cost of capital with an insurance-based solution, vs. the cost of more traditional long-term debt or equity. If you can use insurance to address risks brought about by random events, financial markets and other events, and as a means to allocate capital more efficiently, then this should have a positive impact with ratings agencies, investors and others. This is what will drive interest in these programs from the industrials.”
A host of problems
No one expects the use of these new products to mushroom anytime soon. In part, the reason is that it currently takes 18 months or more to study the alternatives and structure individual transactions. Moreover, corporate-specific cat bonds covering business interruption aren’t likely to be commonplace as long as the cost of reinsurance remains so low. Last year, for example, Sears, Roebuck & Co. almost accessed the capital markets directly to cover its property exposures, but then decided against doing so. “We looked seriously at purchasing an option to provide a top layer for our property risk program,” says Pamela Rogers, assistant treasurer of risk management at Sears, Roebuck, “but we couldn’t ask shareholders to pay the premium required when the traditional insurance markets got us to the same place at a much lower cost.”
Earnings insurance, meanwhile, is coming under heavy criticism from a variety of insurance and banking executives. They are skeptical of the ability to structure something that would cover all of the earnings components, the ability to price it reasonably enough to entice corporate buyers, and the ability of insurance entities that end up with the earnings-related risks on their own books to hedge them. “How will you price it and control the phenomena that affect the claims costs?” wonders Joseph Buff, managing director of Joe Buff Inc., an insurance financial consulting and advisory firm in Brooklyn Heights, N.Y. “Suppose, for whatever reason, there’s a recession, or the board of a company makes a stupid management decision. The company may expand too quickly or implement a strategy that didn’t work out in retrospect. Look at how tricky it is for Wall Street analysts to project ahead a couple of quarters regarding a company’s earnings per share. Here, the biggest challenge may be getting a handle on how you handle the behavioral aspects of a corporation.”
Another concern is that the development of enterprise-wide risk programs will reignite the old corporate and shareholder debate about the wisdom of using derivatives or derivative-like products, even if they’re folded into some form of an insurance contract. “We’re not trying to provide another form of derivatives contract,” says the former Hedge Financial executive. “When we can say that there are no derivatives here, that it’s simply another approach to a firm’s insurance policy, that adds value.”
Predictably, however, the greatest difficulty companies face in pursuing these new insurance solutions are working through the accounting issues. In 1997, the Financial Accounting Standards Board issued Statement 133, which deals with accounting for derivative instruments and hedging activities. The statement makes clear that companies have to mark to market any derivatives transaction, regardless of its packaging. “We call some of these new insurance policies ‘derivatives in drag,’” says Marsh & McLennan’s Sanderson. “With its new statement, FASB is saying, ‘You can’t take a derivative, dress it up as an insurance policy, and make it anything other than a derivative.’”
Ideally, the derivatives components of an insuritization or enterprise contract will be bifurcated and marked to market—and therefore won’t discourage corporations from developing one of these contracts. In some cases, however, “you can’t easily separate the derivatives component and mark it to market, and if that’s the case, you’re supposed to mark to market the entire insurance contract,” notes Sanderson. “Let’s say you have an option on the euro combined with worker’s comp in an enterprise program. The contract says the insurer will pay the company when the losses on the two—the euro option and the worker’s comp policy—total $20 million. In cases like this, you can’t bifurcate the option, so you’re supposed to mark to market the worker’s comp program too. But what is the market value of that worker’s comp program? These are the kinds of things that need to be worked out.”
Financial Accounting Statement 133 is already affecting the types of policies that can be structured, says Robert Curtis, an account executive with insurance company XL America in Stamford, Conn. “Unfortunately, FASB responded extremely quickly to the Honeywell deal and other transactions, and, as a result, these are going to be much more difficult to structure in the future,” he says. “When you try to move these types of enterprise programs past the auditors and the boards of these companies, that’s where you’re going to start getting questions.”
It’s not clear whether FAS 133 will jeopardize earnings insurance policies as well. “We’d love to see one of these contracts,” says Bob Traficanti, a project manager for Statement 133 at FASB. “Our position currently is that it’s impossible to say whether they will be treated as derivatives. There is currently an exclusion in FAS 133 regarding sales volume. We are concerned that these may have embedded derivatives in them. The bottom line is that you have to look at these on a case-by-case basis.” Nonetheless, several insurance and banking executives say the new insurance contracts will survive Statement 133 in one way or another. “You can’t get discouraged too easily,” says one industry participant. “For years people were saying that earlier FASB initiatives would kill the derivatives markets as they developed, but it didn’t happen that way. The bottom line is that if these new insurance contracts make sense for corporate America and companies globally, they will get done.”
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