GetAbstract is an Internet-based knowledge rating service and publisher of book Abstracts. Risk management is prudent and necessary for most companies, says Hugo A. Gonzales. Alternative Risk transfer (ART) market's good prospects are partly driven by enterprise risk management, he says.
GetAbstract is an Internet-based knowledge rating service and publisher of book Abstracts. Risk management is prudent and necessary for most companies, says Hugo A. Gonzales. Alternative Risk transfer (ART) market's good prospects are partly driven by enterprise risk management, he says.
GetAbstract is an Internet-based knowledge rating service and publisher of book Abstracts. Risk management is prudent and necessary for most companies, says Hugo A. Gonzales. Alternative Risk transfer (ART) market's good prospects are partly driven by enterprise risk management, he says.
GetAbstract is an Internet-based knowledge rating service and publisher of book Abstracts. Risk management is prudent and necessary for most companies, says Hugo A. Gonzales. Alternative Risk transfer (ART) market's good prospects are partly driven by enterprise risk management, he says.
Overall Applicability Innovation Style To purchase individual Abstracts, personal subscriptions or corporate solutions, visit our Web site at www.getAbstract.com or call us at our U.S. ofce (954-359-4070) or Switzerland ofce (+41-41-367-5151). getAbstract is an Internet-based knowledge rating service and publisher of book Abstracts. getAbstract maintains complete editorial responsibility for all parts of this Abstract. The respective copyrights of authors and publishers are acknowledged. All rights reserved. No part of this abstract may be reproduced or transmitted in any form or by any means, electronic, photocopying, or otherwise, without prior written permission of getAbstract Ltd (Switzerland). Alternative Risk Transfer Integrated Risk Management through Insurance, Reinsurance and the Capital Markets by Erik Banks John Wiley & Sons 2004 238 pages Risk management is prudent and necessary for most companies. Traditional insurance products are risk transfer mechanisms through which a company or individual pays another individual, company or group to assume risks. Insurance is only one risk management tool. Companies may retain, self-insure, insure, expand or withdraw from certain risks. Some risk decisions are strategic business decisions, such as entering or leaving a particular business because of risks. Generally rms should retain core risks and transfer, eliminate or cut non-core risks. Captives are wholly or partly owned insurance rms offering exibility and economy. Derivatives are nancial contracts whose value depends on the value of some reference item or index. They have been used to protect rms against some risks traditionally managed by insurance, such as earthquakes. Capital markets provide opportunities to insure against risk, i.e. catastrophe bonds. Insurance companies participate in the Alternative Risk Transfer (ART) market. The ART markets good prospects are partly driven by enterprise risk management. 8 8 8 8 Leadership & Mgt. Strategy Sales & Marketing Corporate Finance Human Resources Technology & Production Small Business Economics & Politics Industries & Regions Career Development Personal Finance Concepts & Trends This summary is restricted to the personal use of Hugo A. Gonzales (hugoaguilar7@googlemail.com) Alternative Risk Transfer Copyright 2004 getAbstract 2 of 5 Relevance What You Will Learn In this Abstract, you will learn: 1) What are the basic essentials of risk management; and 2) How the alternate risk management (ART) market works. Recommendation In this excellent introduction to risk management, author Erik Banks offers a lucid, clearly written and well-organized overview. He tells readers what risk management is, why it is necessary, how it works and how companies can carry it out most prudently and cost-effectively. He manages to convey the essential information about insurance and reinsurance, the use of capital markets and derivatives, and the application of enterprise risk management concisely. This is a remarkable achievement. Most books on insurance bog down in jargon and details, while most books on derivatives are unnecessarily complicated and dense. This one offered by the Wiley Finance Series is neither. Although not exactly beach reading, its about as accessible as any book on this subject could possibly be. getAbstract.com recommends it highly to executives and investors. Abstract Risk Management Survey Risk management is a professional discipline with a long history and a well-developed set of tested practices and procedures. Traditional approaches to risk management include control, nancing and loss reduction via the derivatives and insurance market. The alternative risk transfer (ART) market recently has offered a new set of solutions. Understanding the relative advantages of traditional or ART markets requires reviewing the nature of risk and the dimensions of risk management. Risk is uncertainty about the future; corporations are most concerned about the uncertainty of nancial gains and losses. Generally, peril and hazard are, synonyms for risk, but risk management denes peril as a factor that will cause a risk, while a hazard is something that can create or worsen a peril. Industry denitions of other terms include: Operating risk The risk that arises from ordinary (non-nancial) operations. Financial risk The risk that arises from nancial operations. Pure risk A risk of loss with no possible upside. Speculative risk A risk that offers not only possible loss but also possible gain. Failure to manage risks actively means that rms simply take risks as they come. Modern portfolio theory might argue that rms should accept some risks, but passively accepting all risks is extremely imprudent. For example, some experts might suggest that a gold mining company ought not to hedge gold price risk, since investors buy its stock specically to gain exposure to the gold market. By hedging gold prices, the company would reduce exposure to the gold market and frustrate its stockholders investment strategy. Investors, experts could argue, can reduce their exposure to the gold market by the strategic way they assemble their portfolios. Yet the argument that a gold mining company should not hedge gold price risks does not suggest that it can neglect other kinds of risk management. It should still reduce legal risk with liability insurance, re risk with re insurance or risk of expropriation with political risk insurance. Investors could not hedge these risks by portfolio management. Risk management is a dynamic and well-established discipline prac- ticed by many companies around the world. Theory and prac- tice suggest that the availability of a compensatory payment in the event of loss removes a rms incentive to be- have prudently. Alternative Risk Transfer Copyright 2004 getAbstract 3 of 5 Companies handle such risks through the four-step process of risk management: 1. Identication Dene and describe a rms exposures to risk. 2. Quantication Calculate the potential nancial impact of risk. 3. Management Make and implement decisions about which risks to control, retain, eliminate or increase. Sometimes a rm will seek more of a particular risk, such as when a speculative risk presents a high probability of gain. 4. Monitoring Watch, measure and communicate data about risk status. A rms board of directors must develop its philosophy of risk and provide management with broad guidelines about the kinds of risk to take or reduce. For example, the gold mining companys board may decide not to hedge gold price risk, but might insure against legal liability or foreign exchange exposure. It weighs the advantages and disadvantages of various risk control mechanisms according to standard risk measurement techniques, which include: Random variable A variable whose outcome is uncertain. It may be continuous or discrete, that is, occurring only at specic times. Using samples, experts assemble a distribution projection showing the probability of any possible event or outcome. Expected value The product of an events probability of occurrence and outcome, obtained by multiplying frequency by severity. For pure risks, the expected value is synonymous with the expected loss. Variance or standard deviation This measures the gap between an outcome and the expected value. It is the likelihood of reality being better or worse than expected. Risk transfer The practice of transferring risk from one party to another or to a group of parties. The insurance market is a risk transfer market. Insurance is based on the Law of Large Numbers, which says that one or two cases might display wide divergences from expected values, but across many cases the outcomes will be near the expected value. Central Limit Theorem says that as sample size grows, the prob- ability distribution of the average outcome follows a normal curve. Diversication The practice of combining numerous unrelated uncorrelated risks in a portfolio to reduce the exposure to any particular risk. Pooling This is the practical application of diversication in the insurance indus- try. It depends on a careful analysis of correlations among risks. As the number of uncorrelated risks in a pool increases, the standard deviation nears zero. Hedging This risk management approach cannot be insured with traditional insur- ance contracts. Hedging is a risk transfer mechanism, but its contracts can be more complex and specialized than typical insurance contracts. Financial derivatives, such as futures, forwards, swaps and options, are common hedging instruments. Moral hazard Someone who has transferred a risk may cease to manage it pru- dently. For example, a rm that buys re insurance no longer faces any exposure to nancial loss in case of re, and may be less diligent about maintaining sprinkler systems and keeping oily rags from piling up. In an extreme case of moral hazard, the owner of a restaurant might start a re that burns down the restaurant in order to collect fraudulently on the insurance policy. Adverse selection This occurs when an insurer with inadequate information mis- prices risks, offering policies for unreasonably low or high prices. In the former case, the company will wind up with a portfolio of high risks. In the latter, the company will lose customers. In both cases, the result is nancial losses. Regardless of the risk management technique em- ployed, the cost/ benet framework (or some similar objective metric that can crystallize inows and out- ows) is an essen- tial element in decision-making and the determina- tion of enterprise value. Intermediaries play a central role in risk capacity, in several ways: bringing end-use clients and inves- tors together, sup- plying capacity in their role as inves- tors, and acting as end-users in their role as corporate risk managers. The ART market is a broad-based sector that dees precise classica- tion. Indeed, its scope and coverage vary considerably among practitio- ners, end users, and regulators, so that any denition is based, to some degree, on opin- ion. Alternative Risk Transfer Copyright 2004 getAbstract 4 of 5 The ART of Risk Management Companies manage risk for many reasons. They may want to build or protect shareholder value, insulate against market trends, manage credit risks or minimize taxes. The Alternate Risk Transfer (ART) market began in the late 1960s and early 1970s, and has its roots in the trend toward self-insurance, risk retention and reliance on captives. In the 1980s and 1990s, risk-nancing products became widely available. In the late 1990s, the trend to enterprise risk management further propelled the ART market. The three kinds of ART are: ART products The tools, techniques and structures that aim at a dened risk man- agement target, including insurance products, capital markets instruments, capital structures and derivatives. ART vehicles The channels employed, such as captives, special purpose vehicles, capital markets subsidiaries, Bermuda transformers and so on. Solutions Programs that use products and vehicles to manage risks, most notably, enterprise risk management (ERM) programs. Participants in the ART market include: Insurers/reinsurers In addition to their normal business, these rms design, market and use ART products and programs. Some support collateralized debt obli- gations or provide credit risk products such as guarantees or credit wraps. Some have established capital market units to provide nancial derivatives. Banks Long-time participants in the derivatives market, banks recently expanded into the insurance market with catastrophe bonds and weather derivatives. Some rms established Bermuda transformers, Bermuda-based insurance companies that often turn derivatives contracts into insurance contracts on behalf of the bank. Corporate customers Corporations usually enter the market as users of ART prod- ucts and techniques. Advanced corporate end users apply ERM approaches to review their full set of risks as a portfolio. Investors Investors provide the capital the ART market needs to function. Agents and brokers These market intermediaries provide the distribution system for ART products and services. ART Products/Techniques Traditionally, insurance is a risk transfer mechanism. Reinsurers insure the insurance industry. They sell many types and permutations of insurance contracts, which include: Captives Corporations establish and use these licensed insurance companies to insure corporate risks. Firms save money by avoiding agency and broker commis- sions and insurance company overhead costs. Captives give companies access to the professional reinsurance market, allowing them to transfer risks at lower costs. Securitization This is the practice of bundling cash ows, liabilities or assets into pools or portfolios and issuing tradable shares or bonds secured by the cash ow from those portfolios. Mortgage securitization is a fairly common example. Mort- gage lenders sell mortgages to an entity that assembles them into a portfolio and issues bonds. The payments derive from repayment of the portfolios mortgages. Securitization techniques have also been applied to consumer credit, corporate debt and such. By securitizing their debt portfolios, lenders reduce their exposures and risks, obtain cash and expand their investment options. A captive is a closely held risk channel that is used to facilitate a companys in- surance/reinsur- ance program and retention/transfer activities. Despite certain tax complexities and ambiguities, it is clear that cap- tives, RACs, reten- tion groups, and similar structures are part of the mainstream of the risk management markets. Multi-risk prod- ucts are an in- tegral element of the risk manage- ment sectors and offer companies a range of exible alternatives. Ultimately, how- ever, contingent capital products must still be ac- commodated within a rational cost/benet frame- work, and they must only be con- sidered one part of a nancial solution rather than a com- plete risk manage- ment tool. Alternative Risk Transfer Copyright 2004 getAbstract 5 of 5 Securities with insurance characteristics These include catastrophe bonds, weather bonds and similar instruments. Traditionally rms reduced their risk of loss from earthquakes or hurricanes by purchasing standard insurance contracts. Recently, rms have found less costly coverage in the capital markets. Oriental Land, Co., the owner of Tokyo Disneyland, opted not to purchase earthquake insurance on the theme park in 1983, because it was not available for the specic risks the company wanted to mitigate. Insurance markets at the time offered coverage for property and casualty risk, but not for the economic losses the rm might suffer in an earthquake. In 1999, Goldman Sachs and Oriental Land came to market with a $200 million secu- rities issue in two tranches. The rst tranche protected the company against business interruptions due to an earthquake, and the second tranche offered reconstruction money in the event of earthquake losses. The market has seen similar securities linked to catastrophe risk, hurricanes, temperature extremes and other events. Contingent capital structures These embrace contingent debt and contingent equity. Contingent debt structures include contingent surplus notes, issued in the context of special trusts, contingency loans arranged with banks in advance of a possible loss, nancial guarantees, residual value guarantees and so on. Contingent equity structures are variants of put options. A put option gives the buyer the right but not the obligation to sell equity at a particular time or in case of a particular dened triggering event. Loss equity puts and put-protected equity are the most common contingent equity structures. Insurance derivatives These include exchange-traded futures, options and options on futures as well as over-the-counter forwards, options and swaps. The value of a derivative depends on the value of some underlying commodity, currency or index. A residential heating oil supply company might hedge its exposure to weather by purchasing an exchange-traded temperature derivative whose value increases as the temperature increases. When the temperature increases, the companys customers will use less heating oil, but the increase in the value of its temperature derivative would provide a hedge against lost sales. Derivatives have been or can be designed to address almost every conceivable risk. Weather derivatives have provided protection against rain or snow, drought, wind and so on. The increasing popularity of enterprise risk management suggests a strong future for ART. Companies that use ERM do not approach risks one-by-one, insuring against re today, theft tomorrow, currency risk next week. Instead, a companys enterprise risk manager analyzes all of the rms risks in a single portfolio of risks. This risk pooling approach reduces the rms demand for discrete insurance products but may increase its demand for specialized products and services to suit its unique risk prole. About The Author Erik Banks has held senior risk management positions at several global nancial institutions and has written various books on risk management, emerging markets, derivatives, merchant banking and electronic nance. Performance monitoring is an essential element of the ERM pro- cess; integrated management of risks does not end when a specic program is created the process actually com- mences. The ART market of the twenty-rst century should continue to adapt to reect the new requirements and realities of the global nancial and economic sys- tems.