Risk Management Essay

Introduction:
This essay is focused on the analysis of the problems that corporations experience in financing their potential losses from catastrophes (from here on cats) and their subsequent attempts to overcome such problems. From the literature, we observe that the problems described stem not much from the corporations in need of the cat financing, rather from the insurance markets themselves. As we will see, the core problems come from the capital markets and not insurance markets following the arguments by Jaffee and Russell (1997). In summary, the main problem is the skewed nature of cat risk that requires the insurance industry or the corporation to have a large enough pool of capital for the contract period which in turn makes it difficult to match the size of annual premiums and maximum annual losses (Jaffee and Russell, 1997). The premium setting process for cat is ambiguous, due to the early hit possibility. Cat futures and options have problems with valuation and performance (writers may not honour position when cat hits). The reinsurance industry, though attractive for dealing with cat risks lacks the incentives and capital to meet the maximum possible losses. Financial innovations, such as Act of God bonds may have the potential to provide liquidity for cats but their pricing doesnt fit in neatly with the modern capital asset pricing theories and their capacity is inadequate therefore they are still unpopular. For solutions, captive insurance is discussed, followed by investment in mitigation and finally the near-miss concept as analysed by Kleindorfer and Oktem (2012).

By convention and calculation, the higher the possible losses the higher the premium for the coverage and the higher the capital required by the insurer. Fig. 1, shows the world cat losses from 1970 to 2009, from both natural and man-made (like terrorism) events. Lets take for example, the year 2007 which had about $40 billion in cat losses. If the probability of the cat occurring is 0.01 annually, the actuarially fair premium would be $400 million per year. The capital required by the insurer to provide coverage for this loss is 1/0.01 times $40 billion which is $4 trillion. Such huge pools of capital do not exist and thus, insurance companies have exited the market coverage for cat losses.

Fig 1: Cat losses Source: Guy Carpenter and Company, LLC Reinsurance Market Review 2010

Even companies that can afford a $400 million premium per year still cant get coverage due to the reluctance of insurance markets to venture in. The difficulty lies in the accumulation of the capital required. Jaffee and Russell (1997) identify three main reasons why it is difficult for both corporations requiring the financing and the insurers to accumulate enough capital to provide coverage for the potential cat losses. First we have the surplus cash problems that lead to takeovers. Blanchard, Lopez-de-Silanes and Sheliefer (1993) found that firms that held a reserve excess cash, for whatever reason became an attractive takeover target. In the paper, it is said ...takeovers by bad acquirers make agency problems worse, since fear of takeovers by acquirers who themselves will waste money prompts managers that might otherwise act in the interest of shareholders to themselves waste money. This is illustrated by the Chrysler case when the company held a $7.5 billion cash reserve as a rainy day fund for the possible losses in the next recession. The result was a textbook one. Kerkorian, the single biggest shareholder aggressively took over Chrysler for a bid of $20.5 billion in 1995. Second the current accounting standards do not allow corporations to treat anticipated losses as current liabilities. Under F.A.S.B. 5, Accounting for Contingencies it is stated that mere exposure to risks of those types does not mean that an asset has been impaired or a liability has been incurred...the accrual condition is not met with respect to injury, damage, business interruption that may occur after the financial statement date...losses of those types do not relate to the current or

prior period but rather to the future period that they occur. Therefore, to hold reserves specifically earmarked for future cats is against current accounting standards and the financial statements would not be approved for publication. Granted that accounting regulations were nonexistent, the tax provisions pose a problem. All retained earnings are taxed as the standard profits, even if they were invested in a fund specifically for meeting future cat losses. This way, there is no incentive for companies to hold such funds therefore the difficulty in dealing with cat losses when they occur. The government could modify tax laws to remove the tax on funds that are set aside for meeting possible cat losses, but moral hazard would be prevalent because the corporations would have a perverse incentive to use the tax free funds for other purposes (a form of cross-subsidization). The regulatory costs of making sure the accumulated funds are used only for cat losses would bring us back to step one. With the above failures of providing internal funding, cat losses top external capital source has always been the reinsurance markets. Reinsurance is insurance for the insurers and is effectively a transfer of risk for the insurer and diversification for the general insurance market. However, the reinsurance markets have three major problems that reduce their effectiveness when it comes to cat insurance. First are the capacity problems - figures from Guy and Carpenter (largest catastrophereinsurance broker for U.S. catastrophe exposures) put it at roughly $100 billion. The $100 billion is an aggregate and doesnt mean that a single insurer can be covered to that amount. A single insurer can get a maximum of say, $800 million in coverage because more than that would defeat the purpose of spreading the risk. Second, reinsurance has become quite unaffordable for many insurers as Kleindorfer and Kunreuther (1999) say it is due to the limitation placed by regulatory authorities on the premium levels insurers can charge. These premium caps do not meet the demands of the reinsurers to to provide the required coverage layers. Fig 2. illustrates the sharp rise in premiums following a catastrophe - this phenomena has been investigated by Froot and OConnell (1999) who found the reasons to be (1) market imperfections that bid prices up and decrease the supply of insurance after the catastrophe hits, (2) the perception of risk drastically increases after the catastrophe and as reinsurance companies update their probabilities the premiums adjust upwards. Third, in reinsurance the aggregate risk is not reduced at all, it is repackaged albeit some benefits of repackaging Jaffee and Russell (1997) state that when the contracts of insurance and reinsurance are considered together, the ratio of losses to premiums in any one year is what it was before the reinsurance and is potentially high in the case of catastrophes.

Fig. 2: U.S. Cat Reinsurance Price Indices. Source: Cordella and Levy Yeyati 2007; Lane Financial 2007.

Internal funding, insurance and reinsurance markets have the above problems. Corporations turn to the capital markets for potential cat losses funding. Gaining popularity insofar is the catastrophe bond market. Guy and Carpenter figures (see Fig 3) show that cat bond issuances have risen from $633 million in 1997 to a record $7 billion in 2007. From 2007 to 2011 issuances have reduced, but the capital outstanding was at about $10 billion in 2011. Cat bonds work by paying an above average return to the investor for purchasing the bond and assuming the risk of the catastrophe that is being financed. If the catastrophe occurs, the investors lose their capital - which would be used to fund the losses. Theoretically, these bonds should be attractive due to their low correlation with the market returns (for diversification) and fairly high returns on their own. In practice though, due to the high risk faced by these bonds and the non-repayment of capital, they get a speculative grade rating by S&P and Moodys and portfolio managers do not consider them a good investment which in turn reduces the maximum amount of the bonds that can be

issued.

Fig 3: Cat bond capital issued and Outstanding Source: Guy Carpenter & Company LLC

The derivative market has innovations such as cat futures and options that can help corporations finance such events. Catastrophe futures are securities which pay an amount that depends on the value of an index of insurance claims paid during a year. The index could be based on any class of catastrophes - earthquake, hurricanes, terrorism etc. A corporation wishing to hedge itself against losses from an earthquake would take a short position on the cat future or option. These futures began trading in 1992 in the Chicago Board of Trade. However, to-date they havent picked up and reached market expectations. Eramo (1999) notes that these futures have low extremely poor liquidity, infrequent trading and low open interest. The main reason for this situation is the lack of robust valuation models (like the Black-Scholes for stock options) for the options to help the market players correctly price the instruments. The other reason is performance of the counterparty, many of them default on the long position when the catastrophe hits and because the BOTCC has limited funds to deal with such cases, the overall demand reduces. Finally we have the availability and capacity problems, Japanese companies financing possible (certain) losses from the next earthquake will find it difficult to get a counterparty taking the opposite position.

The following table summarizes the problems discussed:

The corporate approaches to financing possible cat losses.

The problems faced

Internal Financing (i.e. accumulating surplus cash - The current accounting requirements (F.A.S.B. 5) reserves) forbid - The current tax provisions tax internal accumulated funds, therefore no incentive - Takeover risk by accumulating too much cash Insurance and Reinsurance Markets - The current capacity is inadequate - The difficulty in estimating possible losses and probability of occurrence - Lack of capital drives out insurance firms for the risk of solvency - Regulation constrains the ability to set high premiums to reflect risk - Market imperfections and human behaviour causes volatility in cat premiums

Capital Markets (Catastrophe Bonds, Act of - Inadequate capacity Bonds) - Reluctance of investors to add them to portfolio - Problems with pricing - Non investment grade rating Derivative Markets (Catastrophe futures, options, - Low interest, liquidity and trading volume equity puts and event-loss swaps) - Not available for all catastrophes - Unavailability of robust valuation models - Counterparty insolvency - Marking to market does not provide accurate picture of position payout

Following here is a discussion of the attempts of corporations to overcome the problems discussed. Captive insurance is one solution that is used by the oil giant - B.P (and nearly all big companies AT&T, Exxon Mobil, Johnson & Johnson etc). Captive insurance companies are insurance companies whose specific objective is to finance potential losses from a parent company. The parent company will either take over an insurance company or form a new insurance subsidiary. This risk financing technique is used when it is not economically viable for a corporation to pay the extremely high premiums it would be charge had it opted to purchase insurance - i.e. when the corporation is aware of the high risk environment it operates in. England, Druker and Keenan (2007) discuss the advantages of using captives as the tax-deductibility of the premiums as most of the captive

insurance companies are located offshore (Bermuda, Cayman Island and Vermont being the leading domiciles). This tax-deductibility translates to more favourable premiums than the traditional insurance market. Another advantage is the consolidation of all coverage, centralized administrative support and the considerable decline in insurance expenses that results from the ownership of the captive insurance company by the parent. Lastly, it is the establishment of a better claim experience, because the parent will be have control over the claim process - the problem caused by the incentives of the traditional insurer to pay as little as possible in claims is eliminated. The figure below shows the increasing growth of the captives insurance markets as an alternative to traditional insurance.

Fig 4. Growth in captives. Source: Towers Watson, Captives 101

Another solution adopted by corporations is investment in mitigation. This is an ex-ante attempt to finance possible catastrophe losses. Mitigation refers to all attempts by the corporation to prevent hazards from developing into catastrophes or reduce their spiral effects. The main point is that investment in mitigation now will reduce the loss from the catastrophe in the future - the difference between the expected loss and the actual loss due to mitigation is effectively the saving from mitigation. Mohtadi and Kinsey (2007) modeling the optimum investment level to mitigate cat risk found that capital investment in mitigation pays off compared to the purchase of insurance after a certain number of years (5 years for a capital mitigation investment of 0.05% with a possible loss of $3.75 billion). The paper was focused on firms in the food industry facing risks of chemical biological and radionuclear attacks. The table from the paper shows that the optimum investment in mitigation as a percent of potential loss increases with the time horizon and the estimated size of

loss. What this means is that corporations that face the highest risks over a long period of time should invest in risk mitigation as one strategy for reducing potential losses from future disasters. Kleindorfer and Oktem (2012) discuss the near-miss approach to dealing with the possible losses from catastrophic events. This is also an ex-ante attempt rather than a post-ante. They define near as events with minimal consequences to a particular company - e.g. a category 4 hurricane missing a nearby populated region is a near-miss because other companies can learn the damage potential and take necessary precautions, the blinding lack of problems leading to the financial crisis of 2007 are also examples of near misses that were ignored and caused huge losses for the corporations involved. The problem, as analysed by the researchers is the lack of learning from the near-misses and past events - BPs Deepwater Horizon explosion could be avoided if it did not cut cost whilst compromising safety and the disabling of important warning systems should have been a wakeup call. Another example was the recall of over 120 million products due to faulty laptop batteries produced by Sony. The near miss was the overheating issues reported in laptops that Sony ignored and continued producing the batteries which ended up costing Sony well over $500 million. The paper details a framework (which is outside the scope of this essay) for applying the near-miss approach to deal with disaster financing.

Conclusion
Corporations have different approaches to handling catastrophic events. In fact, a true analysis of the problems faced and their subsequent solutions is outside the scope of any research. The problems are diverse because they depend on a lot of factors like the level of risk exposure, the regulatory environment, the management attitude and risk appetite, the size of the company, the country of operation, pressure from environmental groups etc. All these and many more factors complicate the analysis because each factor needs to be examined both in isolation and in connection with the others.

Word Count: 2093

References
Blanchard, O. et al. (1993) What Do Firms Do With Cash Windfalls? Journal of Financial Economics, 36 p.337-360. Casualty Actuarial Society (n.d.) Insurance Catastrophe Futures. [online] Available at: www.casact.org/pubs/dpp/dpp96/96dpp047.pdf [Accessed: 1/4/2012]. England, P. et al. (2007) Captive Insurance Companies: A Growing Alternative Method of Risk Financing. Journal of Payment Systems Law, (June), p.701-714. Froot, K. and O'Connell, P. (1999) The Pricing of U.S. Catastrophe Reinsurance. In: Froot, K. eds. (1999) The Financing of Catastrophe Risk. 1st ed. Chicago: University of Chicago Press, p.1950-232. Guy Carpenter, LLC (2010) 2010 Reinsurance Market Review. Capital Ideas. Guy Carpenter, LLC (2011) World Catastrophe Reinsurance Market Review. Jaffee, D. and Russell, T. (1997) Catastrophe Insurance, Capital Markets and Uninsurable Risks. Journal of Risk and Insurance, 64 (2), p.205-230. Kleindorfer, P. and Kunreuther, H. (1999) Challenges Facing the Insurance Industry in Managing Catastrophic Risks. In: Froot, K. eds. (1999) The Financing of Catastrophe Risk. 1st ed. Chicago: University of Chicago Press, p.149-194. Kleindorfer, P. and Oktem, U. (2012) Assessment of Catastrophe Risk in Industry. FOCAPO Conference 2012. Mohtadi, H. and Kinsey, J. (2007) Optimum Investments To Mitigate Catastrophic Risk: Application to Food Industry Firms. Sloan Industry Studies Working Paper Series, 23. Towers Watson (2010) Captives 101: Managing Cost and Risk. Perspectives.