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Risk Management and Insurance: Perspectives in a Global
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W. Jean Kwon, Ph.D., CPCU

School of Risk Management, St. Johns University
101 Murray Street
New York, NY 10007, USA
Phone: +1 (212) 277-5196
E-mail: Kwonw@stjohns.edu
 Risk Management and Insurance: Perspectives in a Global Economy

14. External Loss Financing

Arrangements

There are two sections discussing alternative risk transfers.

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and Course Information
Study Points

Risk financing through derivatives

Risk financing through insurance

Integrated loss financing arrangements

3
Risk Financing Through Derivatives

4
The Markets

Barter markets

Cash-and-carry markets

Spot markets

Futures/options markets

5
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.
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Basics

7
Options

Call vs. put option

Option premium

Strike price

European vs. American option

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Options (Figure 14.1)

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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.

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Swaps

The exchange of one security for another

Currency swaps

Interest rate swaps

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Managing Financial Risks

Foreign exchange (FX) risk

Weather risk

Pages 355-358

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Risk Financing Through Insurance:
Focusing on Liability Risk

Refer to Chapter 19 for Insurance

Principles and Fundamentals of
Insurance Contracts
13
Court Awards (Insight 14.1)

Economic (general) damages

Non-economic (special) damages

Punitive damages

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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

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Preventing Employment Practices Liability (Insight
14.3)

Establish hiring practices in compliance with local laws.

Distribute employee handbooks that clearly document the
entitys 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 Insurance

D&O liability coverage

Corporate reimbursement coverage

Entity coverage

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Insurance for MNCs

Admitted insurance

Nonadmitted insurance

Global master program

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Admitted Insurance

Benefits from purchasing coverage locally

The policy will be serviced locally.
Premiums and claims will be paid in the local currency.
The local insurer and broker provide advice and RM services.
The insurance program is complying with local laws.

Disadvantages
Policies difficult to evaluate and manage by the MNCs 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 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.

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Global Master Program (Figure 14.2)

Whole Account Coverage

Umbrella Liability Coverage

Excess/DIC/DIL Coverage
Corporate (Master Policy) Corporate
Office Office
LOCAL INSURER
Primary Primary
Property Other Property & Liability
Coverage Local Coverage
Liability
Compulsory
Coverage
Coverage
Placed Locally

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 Not in the book!

Integrated Loss Financing Arrangements

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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.

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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.

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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

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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

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Other ART Techniques: Contingent Capital

Not in the book!

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Fundamentals

Contingent capital
Simply, an option to issue a corporate security

Contingent capital facility

Right to issue new debt, equity or structured security
During a specified period
At a predefined issue price
On the occurrence of a triggering event
Unexpected & substantial loss by the right holder
High correlation between the loss exposure and the price of the
security

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Contingent Capital - Elements

Underlying
Debt, equity or hybrid security defined at the beginning of the option
period; that is, before the security is issued
Tends to be deeply subordinated debt or preferred stock

Tenor
Limited duration; for example, right to issue five-year, fixed rate
subordinate debt at any time during the next three months

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Contingent Capital - Elements

Intrinsic value (strike price)

Usually at-the-money at inception; that is,
Price set prior to loss realization
Value tied to the price of the underlying on the date of
contingent capital negotiation

Cost-of-capital difference between

[1] One under the arrangement and
[2] The other in the open market at the time of exercise
No option exercise if [1] > [2]

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Contingent Capital - Elements

Exercisability dual triggers

The underlying with a greater-than-market value and an objectively

defined loss event

First trigger usually American, thus giving the right holder to issue
the securities at any time during the tenor period

Instead of loss, the second occasionally tied to a variable beyond the

firms influence, thus minimizing problems of moral hazard
Linking the firms negative earnings shock to the average
industry earnings, for example

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Contingent Capital - Elements

Placement
Commonly a private placement with a (lead) option writer
Until exercise, the writer collects a periodic commitment
(premium) until the facility is exercised
On exercise and in case of a put option, the writer gets a security
in return for the (cash) payment to the owner of the facility

Compare it with an insurance contract!

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Committed Capital Facility Example

Insurer
Purchase the option, pay the
premium until exercise

Issue
Securities Put Option Cash Commitment
w/ Fee/Premium
Collateral

SPV
Prior to exercise, holds capital,
say, commercial papers Investment
Investors
On exercise by the insurer, Coupon + Premium
liquidate its own securities to
purchase, say, preferred stock
issued by the insurer

Trust

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Discussion Questions

34
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?

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Discussion Question 2

Describe two important distinctions between forward and

future contracts.

36
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?

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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?

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