Managing Risks

Managing risks is the process of identifying, assessing, and deciding how to handle risks through retention, neutralization, or transfer.

A company’s risk retention decision is how it elects to manage an identified risk. This decision is more than a risk management decision, it is also a financing decision.

The choices are:

• Retain
• Neutralize
• Transfer

Of course, each identified risk faced by the company can be treated in a different way. For each of the three choices-retention, neutralization, and transfer of risk-there are in turn two further decisions as to how they can be handled.

Retained Risk and Risk Finance

The decision by a company of which identified risks to retain is based on an economic analysis of the expected benefits versus expected costs associated with bearing that particular risk. The aggregate of all the risks across the company that it has elected to bear is called its retained risk. Because if a retained risk is realized it will adversely impact the company’s earnings and cash flows, a company must decide to fund or not fund a retained risk.

An unfunded retained risk is a retained risk for which potential losses are not financed until they occur. In contrast, a funded retained risk is a retained risk for which an appropriate amount is set aside up front (either as cash or an identified source for raising funds) to absorb the potential loss. For example, with respect to corporate taxes, management may decide to hold as cash reserves all or a portion of the potential adverse outcome of litigation with tax authorities. This management of retained risk is referred to as risk finance.

Risk Neutralization

If a company elects not to retain an identified risk, it can either neutralize the risk or transfer the risk. Risk neutralization is a risk management policy whereby a company acts on its own to mitigate the outcome of an expected loss from an identified risk without transferring that risk to a third party. This can involve reducing the likelihood of the identified risk occurring or reducing the severity of the loss should the identified risk be realized. Risk neutralization management for some risks may be a natural outcome of the business or financial factors affecting the company.

Consider an example involving a business risk. Suppose that a company projects an annual loss of $30 million to $50 million from returns due to product defects, and this amount is material relative to its profitability. A company can introduce improved production processes to reduce the upper range of the potential loss.

As an example involving a financial factor, a U.S. multinational company will typically have cash inflows and outflows in the same currency such as the euro. As a result, there is currency risk—the risk that the exchange rate moves adversely to the company’s exposure in that currency. But this risk has offsetting tendencies if there are both cash inflows and outflows in the same currency. Assuming the currency is the euro, the cash inflows are exposed to a depreciation of the euro relative to the U.S. dollar; the cash outflows are exposed to an appreciation of the euro relative to the U.S. dollar. If the company projects future cash inflows over a certain time period of €50 million and a cash outflow over the same period of €40 million, the company’s net currency exposure is a €10 million cash inflow. That is, €40 million exposure is hedged naturally.

Risk Transfer

For certain identifiable risks, the company may decide to transfer the risk from shareholders to a third party. This can be done either by entering into a contract with a counterparty willing to take on the risk the company seeks to transfer, or by embedding that risk in a structured financial transaction, thereby transferring it to bond investors willing to accept that risk.

There are various forms of risk transfer management. The vehicles or instruments for transferring risk include traditional insurance, derivatives, alternative risk transfer, and structured finance.

Traditional Insurance

The oldest form of risk transfer vehicle is insurance. An insurance policy is a contract whereby an insurance company agrees to make a payment to the insured if a defined adverse event is triggered. The insured receives the protection by paying a specified amount periodically, called the insurance premium.

The contract can be a valued contract or unvalued contract. In a valued contract, the policy specifies the agreed value of the property insured. With the exception of life insurance contracts purchased by companies, valued contracts are not commonly used as a form of risk transfer.

There are exceptions, of course, such as an art museum insuring valuable works of art with the amount fixed at the time of negotiation of the contract to avoid needing an appraisal of the artwork after the insured event is triggered.

In an unvalued contract, also called a contract of indemnity, the value of the insured property is not fixed. Rather, there may be a maximum amount payable, yet the payment is contingent on the actual amount of the insured’s loss resulting from the trigger event. A contract of indemnity is the typical type of contract used in risk transfer.

Derivatives

As will be explained earlier that, there are capital market products available to transfer risks that are not readily insurable by an insurance company. Such risks include risks associated with a rise in the price of a commodity purchased as an input, a decline in a commodity price of a product the company sells, a rise in the cost of borrowing funds, and an adverse exchange-rate movement.

Derivate instruments, which are capital market instruments, can be used to provide such protection. These instruments include futures contracts, forward contracts, option contracts, swap agreements, and cap and floor agreements.

There have been shareholder concerns about the use of derivative instruments by companies. This concern arises from major losses resulting from positions in derivative instruments. However, an investigation of the reason for major losses would show that the losses were not due to derivatives perse, but the improper use of them by management that either was ignorant about the risks associated with using derivative instruments or sought to use them in a speculative manner rather than as a means for managing risk.

Alternative Risk Transfer

Alternative risk transfer (ART), also known as structured insurance, provides unique ways to transfer the increasingly complex risks faced by corporations that cannot be handled by traditional insurance and has led to the growth in the use of this form of risk transfer.

These products combine elements of traditional insurance and capital market instruments to create highly sophisticated risk transfer strategies tailored for a corporate client’s specific needs and liability structure that traditional insurance cannot handle. For this reason, ART is sometimes referred to as “insurance-based investment banking.”

An example of one type of ART is an insurance-linked note (ILN). This type of ART has been primarily used by life insurers and property and casualty insurers to bypass the conventional reinsurance market and synthetically reinsure against losses by tapping the capital markets. Basically, an ILN is a means for securitizing insurance risk and is typically referred to as catastrophe-linked bonds or simply cat bonds.

The first use of catastrophe-linked bonds in corporate risk management by a noninsurance company was by the owner-operator of Tokyo Disneyland, Oriental Land Co. Rather than obtain traditional insurance against earthquake damage for the park, it issued a $200 million cat bond in 1999. Three years later, Vivendi Universal obtained protection for earthquake damage for its studios (Universal Studios) in California by issuing a $175 million cat bond with a maturity of 3.5 years.

Whereas catastrophe-linked bonds have primarily been used for perils such as earthquakes and hurricanes, corporations are using them in other ways. For example, the risk to the lessor (i.e., the owner of the leased equipment) in a leasing transaction is that the value of the leased equipment when the lease terminates (the residual value) is below its expected value when the lease was negotiated.

Structured Finance

Structured finance involves the creation of nontraditional-type securities with risk and return profiles targeted to certain types of investors. Structured finance includes asset securitization, structured notes, and leasing.