Rethinking Risk Management: The Combination of Financial ...

Rethinking Risk Management: The Combination ofFinancial and Industrial Risk�

by JuÈrgen Zech��

1. Introduction

At the dawn of the new millennium, risk management is taking a different route.International corporations as well as (re-)insurance companies are increasingly turning theirfocus to shareholder value and the optimization of their company's value, based primarily onreturn on capital and the stability and growth of future earnings.

The industrial insurance market has experienced a transition from regulated nationalmarkets (product and price regulation) towards almost total deregulation. One consequence isthe convergence between the insurance and banking industries often referred to asbancassurance. The result is the rapid development of new solutions for the ®nancing ofvarious aspects of risk. Insurance programmes have started to extend their coverage to risksthat have traditionally not been insurable. Capital market products such as options, swaps andbonds, which were the domain of banks, have been adopted for the transfer of underwritingrisk. Industrial insurance companies have started to place non-life underwriting risks directlyinto the capital market, such as earthquake and storm securitization. Across North Americaand increasingly in Europe and Asia, (re-)insurers are striving to extend their product rangeinto the sphere of alternative risk transfer (ART). They are using new ®nancial engineeringtechniques to release hidden values on companies' balance sheets, aiming to serve theirclients better and to afford themselves more ¯exibility in dealing with the marketplace of the21st century. The recent development and the expected increase in alternative risk ®nancingallow large multinational corporations to choose freely from national and global markets andchallenge industrial insurance companies to excel in the development of products whichprovide risk management solutions.

Risk managers today are faced with an ever-greater range of risks, which demand newinnovative solutions. International companies are exposed to various kinds of risk. Tradition-ally, the risk manager was responsible for looking after operating risks, whereas it was the chief®nancial of®cer (CFO)'s responsibility to deal with ®nancial risks. Finally, it was the chiefexecutive(CEO)'s tasktohandlebusiness riskbydevelopingasuccessfulstrategytocompete inthe market. It is therefore not surprising, that although every individual developed the `̀ right''strategy for one risk, the overall, company-wide risk strategy was sub-optimal. This approachoften resulted in internal con¯icts between the various strategies. Today, internationalcompanies are primarily concerned with protecting their bottom-line earnings and balancesheets against all non-core business risk. They are also looking for innovative ways to raise

� Paper presented at the 27th General Assembly of the Geneva Association, held in Zurich, 25±27 May 2000.�� Chairman of the Executive Board and CEO, Gerling Group of Insurance Companies, Cologne.

The Geneva Papers on Risk and Insurance Vol. 26 No. 1 (January 2001) 71±82

# 2001 The International Association for the Study of Insurance Economics.

Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UK.

capital should there be a disaster or where strategic decisions require cash ¯ow ¯exibility. Thebusiness environment has changed dramatically and the scope of a risk manager's responsi-bility is increasingat a fastpace.Companies havelonghadstrategies forbusiness issuessuch asgrowth or customer focus but there has so far been a gap in their strategic thinking in how theyassume and manage risk. Progressive ®rms are trying to ®ll that gap.

This paper will describe the new challenges that arise from integrating these ®nancialand industrial risks. It is illustrated that the emergence of ART changes the face of riskmanagement on both sides of the equation ± those seeking protection and those assumingrisk.

2. The changing role of risk management

Depending on perspective, risk management means different things to different people.Generally, risk management's aim is to reduce the possibility of future events harming anorganization or to control the probability that results will deviate from the expected. The goalis straightforward: to avoid risks and to balance positive and negative results over time. Thistask becomes increasingly dif®cult as companies perform in global markets and face constantstructural modi®cations through changes in their business environment. Besides global risk,such as climate changes or changes in the legal environment over which an organization hasonly limited control, the company also faces the traditional risks, which refer to theorganization's industrial risks. Whatever the de®nition, risk management, including proactiverisk ®nancing, should provide a competitive advantage and allow organizations to experimentand take calculated chances in ways that were not possible before.

Risk exposure can be broadly categorized into operational, legal liability, ®nancial/market and political. An understanding of the interrelationships among all four categories ofrisk is essential, although the correlation among different risks makes it harder for riskmanagers to identify each risk separately. Some major considerations in an effective riskmanagement process are:

· Risk assessment: The identi®cation of both global and organizational risks in terms offrequency, severity, public perception, and the con®dence that the organization has inthese estimates. This process includes quantitative as well as qualitative aspects. Riskassessment is an ongoing process and needs to be constantly revised since it should re¯ectcurrent legal, social, political, economic and technological changes in the environment.

· Risk control: The adoption of a prudent response to risks, such as avoidance, reduction,sharing, contingency planning and establishing corporate goals that re¯ect prevailingsocial and moral standards. These responses relate to the organization's mission and tosociety's mandates on `̀ sustainable development''.

· Risk ®nancing: Making provision of suf®cient funds through self-®nancing or by access tothird-party capital, e.g. insurance/reinsurance or capital markets, so that the organizationcan continue to provide products and services to its customers and maintain its obligationsto shareholders, employees, suppliers, regulators and the public.

· Administration: Guiding and monitoring operating units in a continuing assessment ofrisks, overseeing controls, and assuming the cost effectiveness of the risk-®nancingprogramme.

· Risk communication: Communicating risk management's contribution to the organiza-tion's strategy and shareholders' expectations. This task requires publishing the relation-ship of risk, costs, and rewards to all stakeholders.


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The ®rst critical challenge lies in identifying and assessing all risks the company faces. Thisprocess is often referred to as risk mapping. In identifying a corporation's risk exposure,managers need to understand the organization's structure and business ¯ow and theinterconnection to share price. Although understanding the business and its market is crucial,today's focus of shareholder value forces companies to look beyond the industry-related risksand expand their view towards stakeholders and ®rst of all the shareholders. The task is then tomeasure all the risks in terms of their potential likelihood, their possible consequences, theircorrelation and the public's perception of them. Shareholder value is strongly correlated toconsistency of results. A study by Towers Perrin found that earnings consistency couldaccount for 25 to 33 per cent of the change in a stock's price. It also showed that high-consistency companies on average show twice the `̀ market value added'' of their low-consistency counterparts.

A recent study by Marsh Inc. examines the cause of share price ¯uctuations over the past®ve years among Fortune 1000 companies. It investigates those ¯uctuations where the shareprice dropped more than 25 per cent within one year. It concluded that only 34 per cent of alllosses resulted from operational risk. The main reason (60 per cent) for these losses was due tostrategic and ®nancial risks. The remaining 6 per cent stem from accounting irregularities.The result clearly emphasizes that ®nancial risks are one of the main factors that in¯uenceinvestors' decisions. Taking into consideration the importance of shareholder value and itseffect on strategic decision-making, risk management needs to respond to these challenges.The challenge for risk management must be to strive to eliminate ®nancial and strategic risksor to ®nd ef®cient ways to minimize their impact on share price.

Surprisingly, a 1999 survey by AON Risk Survey revealed that many of the riskmanagers of international companies do not attribute much importance to ®nancial risk.

Loss of reputation

System failure through Y2K

Brand/trademarks

Itellectual property erosion

Fraud

Terrorism

Credit risk

Climatic

Currency risk

Class action

Others

34

30

25

21

14

9

7

7

5

5

4

0 5 10 15 20 25 30 35

percentage

Figure 1: What risks are risk managers concerned about?


RETHINKING RISK MANAGEMENT: THE COMBINATION OF FINANCIAL AND INDUSTRIAL RISK 73

For many companies the primary focus still seems to be on operational risk. This shows amismatch between the shareholder's expectations and the risk management response. Today'srisk managers from international companies as well as insurance companies have the dif®culttask of understanding the relationship between risk cover and its in¯uence on all of thecompany's stakeholders. It will become vital for an effective risk management programme toinclude the diverse perceptions of all stakeholders on what constitutes a risk to a company'soperations. They have to balance the con¯ict of interest that exists between CEOs who seekprotection for their operations, and investors who are less risk-averse and look for high returnon investment.

Another change for the perception of risk results from legal and accounting obligationsfor publicly traded corporations. Many large multinational companies have started to use U.S.accounting standards (U.S. GAAP) to get access to the North-American stock market. This isin line with legislative changes across Europe, which increase the requirements for disclosureof how a company will respond to the risks involved in its business objectives. In Germany, theControl and Transparency Act (KonTraG) has increased the legal framework for acorporation's obligation to check and publish their risk exposure. In the U.K., several reportson corporate governance have been produced with the intention of supporting a more holisticapproach to risk management. Corporations should be encouraged to expand risk assessmentfrom traditional insurable property±casualty risks to include ®nancial risks (such as exchangerate risk, interest rate risk, credit risk), strategic risks (such as acquisitions and investmentdecisions), operational risks (such as information technology and fraud), and intangible risks(such as reputation and brand names).

Due to these obligations, real progress is being made in risk assessment and developingcoherent communication of risk management to stakeholders. Many companies are relying onexternal experts such as consultancies and insurance companies to model tools for riskassessment that vary in name and scope but all try to allow a better evaluation of risk.American, Canadian and U.K. accounting associations are developing analytical procedures.The Australian and Canadian risk management standards outline holistic risk managementtechniques, and the OECD is developing a generic approach to risk assessment, beginningwith environmental and chemical accident events. The increasing efforts to identify,understand and measure different types of risks show the fast pace at which risk managementis developing.

3. The challenge: strategic risk ®nancing

Risk ®nancing is an important element of risk management. It addresses a full spectrumof risks and looks at them both globally and organizationally. With the growing recognitionthat all risks are interrelated and that it is uneconomical to manage them separately, a holisticapproach is evolving. Holistic risk management relies on more traditional risk mitigation andrisk transfer but also takes advantage of any internal risk hedging opportunities. The volatilityof different sources of risk is less than the sum of each risk's separate volatility, since they arenot perfectly correlated. Often a company will not be able to achieve the optimal hedge on itsown. It will then turn to insurance companies with centres of excellence in risk managementand risk-®nancing services.

It remains the company's task to include this risk strategy into the overall businessstrategy. The company has to develop a strategic risk-®nancing model that covers theidenti®ed exposures and minimizes the total cost of risk. In fashioning a strategic risk-®nancing programme, an enterprise must ®rst determine the effect on ®nancial objectives.


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These might include targets over various periods for earnings, net worth, leverage, risk-basedcapital, cash ¯ow, credit rating, cost of capital, and regulatory effects. The enterprise mustalso consider the accounting, regulatory, and rating agency treatments of different ®nancialinstruments, as well as other factors such as covenants, liquidity, and voting/control. Investorsin ®nancial instruments are also sensitive to these, and not just to risk-return trade-offs.Dynamic, interactive models can then assess the after tax bene®ts and costs of various risk-®nancing methods. Strategic risk ®nancing means delivering a strategy that allows ef®cientrisk hedging by applying cost-bene®t analysis. The strategy must support all other businessgoals and be communicated to all people affected. Strategic risk ®nancing will involve closeco-operation between the company's risk managers and the industrial (re-)insurancecompanies. Given the enormous quality increase of information technology, industrialcompanies and (re-)insurers must establish close links to allow optimal customized risk®nancing. (Re-)Insurance companies must be seen as partners rather than some externalservice provider to the company. Gerling General Insurance, for example, has established asystem that allows international companies to communicate online to get up-to-dateinformation on their insurance and claims records. It allows both parties to monitor businessdevelopment constantly and make strategic adjustments as early as possible.

4. The new risk manager

As the scope of risk widens, risk managers will have to expand their knowledge fromtheir current skill base to understand the wider business risks which face their organization ±that is once again to take a holistic approach. The idea is that risk management must become adiscipline, which includes the protection of industrial risks as well as ®nancial exposures inthe balance sheet. It aims to secure the assets and pro®ts of an organization by reducing thepotential for loss before it occurs, and by ®nancing through insurance and other means,potential risks to catastrophic loss, such as natural disasters, human error or court judgements.

Today's risk manager is a co-ordinator of the various functions that have elements of riskmanagement in their responsibility. Therefore he or she needs to have skills in human resourcemanagement, communication, and vision strategy, analytical and ®nancial skills, and a clearunderstanding of the company's business and overall risk exposure. As with any departurefrom conventional practice, integrated risk assessment requires a dedicated individual withthe vision and the diplomatic skills to forge a new approach. In some organizations, thisperson becomes the `̀ Chief Risk Of®cer'' (CRO). As substantial knowledge of variousbusiness areas is needed, the CRO would then form a risk group to oversee the initialassessment and continue the work with operating committees. The CRO will also ensure thatstrategic risk ®nancing is applied and alternative risk-®nancing solutions are in line with thestrategic corporate objectives.

5. The convergence between ®nancial and industrial risks

As risk management is changing, insurance companies are taking a new route to allowand support this process. As stated above, multinational companies are interested in theintegration of all types of risk and are turning their interest more and more to balance sheetprotection. Traditional insurance is no longer able to provide this cover on its own but needs tobe supplemented by new, alternative products. Most large international companies are able tocover the high frequency/low severity risks they face. The real danger lies however on the



opposite side: low frequency/high severity risks can impose a threat to the company's short-term performance thereby, as shown above, signi®cantly in¯uencing a company's share price.

It is almost impossible to clearly de®ne the border between what is known as`̀ Insurance'' and what is considered `̀ Finance''. At the same time it is dif®cult to draw ahard line between what falls into traditional (re-)insurance, and what is described as non-traditional or alternative insurance products. In the past, traditional insurance clearly includedmono-line policies with ®xed annual premium income. But how far any of these parametershave to be changed to transform into an alternative solution is not set in stone. Therefore thebest approach for a de®nition is to look at it as the transfer or ®nancing of risk by means otherthan traditional (re-)insurance. However there is no doubt, particularly in the industrialinsurance, that alternative risk ®nancing solutions continue to grow at a fast pace. Accordingto Swiss Re, the ART worldwide premium accounts to US$28 billion, which representsaround 8 per cent of global commercial insurance premiums. They will for the most part notsubstitute conventional risk transfer but rather supplement the traditional covers allowingholistic risk management to be truly effective.

The idea of alternative risk transfer dates back a long time but developed in the 1960s and1970s by the increasing number of (re-)insurance captive companies established around theworld. This development stemmed from corporations'desire to greater self-retentions, whichallowed them to reduce the overall cost of external risk. It also helped them to optimize thecost of risk by locating those entities in lower-taxed countries. In that context, ART becamethe domain of reinsurers rather than industrial insurance companies, structuring ®nancial or®nite insurance and retro covers to insure the captive.

Today, alternative solutions have expanded well beyond this. Industrial insurance

Figure 2: Alternative risk transfer and capital markets


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companies have developed expertise in tailoring individual solutions for internationalcompanies that offer new formerly not insurable risk protection to their clients. Most of thetransactions in the 1990s underline the convergence of insurance and capital markets. Theyreceive increasing public attention and are classi®ed under the heading of insurance-linkedsecuritization. Natural catastrophes like Hurricane Andrew in 1992 focused alternativesolutions to transfer catastrophic risks. More recently, insurance companies are alsobecoming more innovative in contract design. Most alternative solutions are characterizedby at least one of the following features: (1) traditionally uninsurable risk; (2) innovative,customer-designed structure, sometimes not even in the form of an insurance contract; (3)multi-line and/or multi-year contract often including aggregate coverage; (4) complex,integrated solution that allows an optimal hedge between different risk classes; (5) explicitrecognition of investment income; and (6) risk- and pro®t-sharing. Alternative risk productdevelopment places emphasis on custom-designed, comprehensive and longer-term risk®nancing needs. As part of the process, the different layers of risk in a corporation's `̀ exposureportfolio'' are examined and the outcome will re¯ect the individual corporate appetite forrisk. Due to the individual character of ART solutions, they need to be sizeable to justify theefforts on both sides. The following examples re¯ect the more recent developments ofalternative products and show the insurers' responses to a holistic risk approach.

6. Integrated programmes

One of the areas of increasing growth over the last ®ve years has been the development ofmulti-line and multi-year solutions. In practice, they are often referred to as `̀ blended'' or`̀ cross-class'' covers. These `̀ integrated solutions'' (IS) take into account the whole range ofrisks in a common approach by both the insurer and the insured. In the past, integratedprogrammes were criticised as the simple allocation of traditional insurances. The`̀ innovative'' character was therefore reduced to the policy document that labelled thisproduct as multi-line. This misperception no longer holds true for most of the large industrialinsurers. Today's innovative IS are individually tailored to the company's risk pro®le, takinginto account legal, regulatory, accounting and reporting issues. They include industrial as wellas a whole range of new risks such as interest rates, foreign exchange rates, commodity prices,credit risks, and other operational and strategic risks.

Bundling various risk types and aggregating them offers various advantages. First of allthe aggregate volatility of the transferred risk will be less than the sum of the eachcomponent's volatility. This results in a more ef®cient coverage and is likely to producepremium savings. Cost savings also result from lower administration cost. Since the insurancecover is handled as one product with one consistent wording and one contract duration, onlyone renewal negotiation will occur. Even though this will be more complex, it still offerssubstantial savings in handling costs and overall administration. Most integrated solutions aremulti-year, giving the company predictable rates, conditions and limits. This form ofoptimized risk hedging allows the company to smooth earnings and achieve stability forfuture cash ¯ows. On top of the traditional lines of insurance, IS allow ®nancial risks to beincluded. Including ®nancial risk increases the hedging effect since the addition ofuncorrelated ®nancial risks further diversi®es a risk portfolio, and converts to a lossdistribution that becomes more predictable over time. Besides these factors, which are veryimportant from a ®nancial perspective, integrated solutions offer invaluable support to riskmanagers since they are the most effective tools to respond to the challenges of holistic riskmanagement. One of the ®rst groundbreaking and most publicised multi-line programmes



containing ®nancial risk was the Honeywell Programme. The US$100 million programmewas structured for a two and a half year term and, besides traditional lines like property,casualty, and directors' and of®cers' liability, included Honeywell's exposure to currencytranslation risk on their foreign pro®ts and hazard risks.

7. Double/multi trigger

Double trigger solutions are regarded as a variation on integrated solutions. As holds truefor most alternative products, double trigger solutions started out as reinsurance products andhave developed into innovative tools for companies' risk management. They target mostlylarge international companies that can realize substantial internal hedging opportunities butneed cover for low frequency/high severity risks. The underlying idea is that companiesgenerate earnings from different sources. Likewise, their performance is exposed to differentkinds of risk that are less than fully correlated. That means a loss in one business sector of adiversi®ed company can at least be partially absorbed by revenues from another performingsegment. Companies might therefore not be interested to insure shortfall if it can becompensated for by overperformance at other places within the organization. What doesaffect a company's performance is underperformance in two areas at the same time. The mosteffective solution therefore is one that is triggered only if both negative events happentogether.

To illustrate this, assume a power plant that provides electricity to its clients at a ®xedprice. If the plant has to be shut down for whatever reason, the company needs to buy electricpower from the spot energy market to ful®l its contractual obligations. If the spot price at thistime happens to be unusually high, the company's performance could be signi®cantly affectedsince it could not transfer the extra cost to its customers. A double trigger could be structuredto trigger when the spot electricity price exceeds an agreed price and the power plant has to beshut down. In this example the insurance would then cover the difference between the agreedprice and the spot electricity price.

Although some of these covers could be achieved by derivatives, double trigger solutionsoffer various advantages. In contrast to capital market products, double triggers can betailored to the client's preferences and appetite for risk. On the one hand, the price of theproduct depends on the correlation between the two triggers. The lower the correlation, theless expensive the insurance will be. On the other hand, a reasonable correlation needs to existto provide cover for the risk. In the power example it would not be rational to set a price that isvery unlikely to be exceeded because it will decrease the probability of the policy beingtriggered. Therefore, after applying strategic risk ®nancing, a company should be able toidentify the cover needed. By using a double trigger, a company eliminates the basis risk ±that is the difference between the performance of a capital market instrument and the buyer'sactual experience. Although a company might bene®t from a desirable development of thederivative, double trigger solutions allow them to eliminate the risk and to invest the money inthe company's core business. Double trigger also helps reduce the cost of insurance. Becauseof a negative correlation of the exposures involved, the insurance is less expensive thantraditional covers or derivatives. Since the price of insurance depends on the probability of aclaim, this insurance will be cheaper as long as the chance of one trigger being pulled at thesame time as another is less than 100 per cent.


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8. Contingent capital

One of the major in¯uences that changed the global business environment at the end ofthe second millennium and is continuing to do so is the concentration of companies in theform of mergers and acquisitions. This development challenges not only the strategicpositioning of a company in its market but also requires ®nancial ¯exibility to respond tounforeseen changes. Companies require capital to recover fast from catastrophes that wouldmake them otherwise vulnerable for hostile take-overs as well as to respond to opportunitiesthat need substantial investment.

Contingent capital is seen as such a risk liquidity instrument. Increasingly, insurance andreinsurance are being viewed as a supplementary or an off-balance-sheet form of capital. Thisrefers to alternative insurance products that provide contingent capital to an organization thatcan be accessed either at a company's own volition or at previously agreed events. Contingentcapital solutions can take various forms. Two of the main instruments that deliver contingentcapital in a debt-like form are contingent surplus notes and contingent equity puts.

Contingent surplus notes enable a company to issue notes to speci®c intermediaries orinvestors if a predetermined event occurs or even at the company's call. Usually a ®nancialintermediary in the form of a special purpose vehicle (SPV) will be set up, which will sellnotes or certi®cates to investors and use the proceeds from the sale to invest in low-riskgovernment bonds or other liquid securities. The insurance arrangement would give thecompany the right to issue surplus notes to the SPV in exchange for cash or liquid assets. Thiswould in turn give the SPV the right but not the obligation to substitute the surplus notes forthe securities held by the trust. If the company decides to issue surplus notes, it would then beresponsible for paying interest and principal to the ®nancial intermediary. This process allowsoff-balance-sheet ®nancing for the issuer and higher returns for investors.

Another form of contingent capital are equity puts. Insurance companies can providethese products to allow tailored solutions that are speci®cally geared to internationalcorporations. Contingent equity puts are options that give companies the right but not theobligation to sell a predetermined amount of stock at a ®xed price. In turn, the company pays afee comparable to an option premium. In the case of the predetermined event occurring, thecompany will be able to issue preference stock to access additional equity precisely when theyneed funds to cover catastrophic events. A possible threat to this solution is the credit risk forthe company meaning the investors' ability to buy the stock at the time the option is executed.To minimize this risk, companies will turn to insurance companies with superior creditratings. If the options are exercised, companies might face the threat of change in controlbecause the transfer of stocks also changes the structure of voting rights. To avoid this, thecompany can base the options on preferred stock without voting rights that will only turn intocommon stock if the company cannot repay investors in a certain period of time. Contingentequity puts offer important advantages over capital market products.

The most important, as holds true for most alternative solutions, is its ability to betailored to the needs of the industrial company. Unlike standardized capital market products,contingent equity puts can be triggered precisely when the company experiences a sequenceof losses that will signi®cantly affect its business performance. To identify the right trigger,companies will work jointly together with insurance companies to evaluate the risk, shareinformation, and ®nd the required rate of return for all affected parties. From a ®nancialperspective, contingent capital reduces the amount of equity a company needs to carry on itsbalance sheet. Since it is usually cheaper than equity, this treatment lowers a company'sweighted average cost of capital and increases its return on equity.



9. Finite risk solutions

It should be clear by now, that alternative risk transfer not only is an effective riskmanagement tool for industrial risk cover but also offers substantial assistance to manage®nancial and accounting needs. As the previous examples showed, ART not only allows acompany the chance to raise capital at more favourable rates, but also safeguards the ®nancingof planned investments. Another approach is not to insure the risk per se but rather its negativeconsequences. This can be achieved either by reducing the leverage, that is the ratio of debt toequity capital, or by allowing companies to self-®nance certain business risks which is thegoal of ®nite solutions.

The basic reasoning behind ®nite risk solutions is to spread individual risks over time. Asopposed to traditional insurance, which achieves risk transfer by grouping similar risks, thisalternative approach accomplishes risk transfer by spreading the risks for one policyholderover time. Consequently, one key feature of ®nite products is that the contract usually extendsover multiple years. This facilitates the diversi®cation of risk and helps to stabilize cash ¯ows.Since the insurance company provides full coverage of the sum insured from the contract'sbeginning, ®nite solutions help to reduce the effect of a catastrophic event on the annualreported earnings and smooth the balance sheet over time. It is important to note that ®nitesolutions do not allow the full ®nancing of any kind of business risk. As the name suggests,®nite solutions refer to a limited transfer of risk. In addition to insurance risks, companies arealso able to transfer ®nancial risks such as interest rate risk (drop of interest rates below theguaranteed interest rate on the experience account), credit risk (inability to repay ®nancedclaims) and exchange rate risk (if claims and premiums are denominated in differentcurrencies). A ®nite risk cover not only allows anticipated future catastrophes (prospective) tobe covered but also enables a retrospective contract to be structured that includes lossesincurred already. The most common forms of ®nite solutions include:

· Loss portfolio transfer (LPT): The company cedes outstanding claims reserves or liabilityprovisions to the insurer and receives in turn the net present value of the ceded balanceadjusted for its risk components. It can use the proceeds from this transaction forinvestments to achieve higher returns and help management focus on its core business. Italso affects ®nancial reporting and helps to improve balance sheet ratios.

· Retrospective excess of loss covers (RXL): The insured company pays a premium for theassumption that claims might exceed provision already made for certain catastrophicevents. This can be arranged either on a stop loss basis or catastrophe excess of loss basis.

· Prospective excess of loss covers (PXL): The insured company either pays annual orsingle premiums. To manage a PXL, premium and claims payments are handled in anexperience account. Any interest income earned on a positive account balance during thepolicy term is taken into account and shared with the company. This facilitates includingthe time value of money to increase the cost ef®ciency of the policy. From inception, thecompany has the full contractual insurance coverage, which can well exceed the existingexperience account balance. If premium payments exceed claims payouts, companiesusually receive a signi®cant pro®t share at the expiry of the contract.

It is important to note, that the applicability of ®nite risk solution differs from country tocountry and depends on the respective regulatory and legal frameworks. Although ®nitesolutions become more popular to ®nance risk exposure over time, many countries have notyet ®nalised their implications for balance sheet and tax purposes. The U.S. FinancialAccounting Standards Board (FASB) has taken the initiative to end confusion in the U.S.


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market by formulating the accounting treatment in Directives No. 60 and 113. In mostEuropean countries a response is missing as yet.

10. Implications for insurance companies

The rapid development of the alternative risk product market not only expands thebusiness arena for insurance companies but also imposes various challenges on them. Productmanagers as well as underwriters need towiden their current knowledge base and expand theirexpertise to insurance as well as bank issues. They need to understand the holistic approach ofcompanies' risk managers, and structure products that re¯ect the changes in the legal,accounting, and tax environment of the different countries of operation of their internationalclients.

Ensuring the insurance character of their products, insurance risk managers must try toidentify objective trigger(s) to protect a client's risk exposure. In ®nding the adequate price foran alternative product, actuaries have to consider an increasing number of industrial and®nancial risks from various industries. This complexity will result in innovative pricingtechniques which go beyond the traditional insurance business. If the expertise cannot beprovided internally, insurance companies will have to turn to external consultants whichincreases costs.

Due to the radical changes in an insurance product's design, corresponding reinsurancemight not yet exist or be too immature to provide suf®cient cover. Insurance companies mighttherefore have to look for alternative solutions.

11. Conclusion

The focus on shareholder value and the ongoing global concentration through mergersand acquisition will have a lasting in¯uence on risk management for internationalcorporations and for insurance companies. To create value for all stakeholders, effectiverisk management of the future needs to include industrial as well as ®nancial risks in solutionsthat allow optimal risk hedging for the company as a whole.

Corporate risk managers will have to take a holistic approach identifying all risks thataffect a company's long-term performance. The ultimate goal must be to achieve consistencyof income and earnings, which is strongly correlated to shareholder value. A risk strategymust then be aligned with the ®nancial objectives of the organization and result in strategicrisk ®nancing. The risk manager's role will change from solely providing protection ofindustrial risks to becoming a co-ordinator of all functions that have elements of riskmanagement in their responsibility. Risk managers will have to turn into Chief Risk Of®cerswho will use there knowledge of various business departments to align risk strategy with theorganization's overall strategy.

Insurance companies will have to continue to support this process and offer innovativesolutions that ®t the individual needs of their clients. The emergence of the alternative risktransfer market and its increasing speed of growth underline the continuing demand fortailored products. Future insurance products must secure cover for industrial risks and provide¯exibility to support a client's strategy whenever capital is needed. At the same time, thedevelopment of new products must re¯ect the companies'desire to maintain a reasonable costof risk and result in optimized solutions applying a cost-bene®t analysis.

These changes will only be successful if companies and industrial insurers work closelytogether as a team to achieve solutions that combine ®nancial as well as industrial risks.



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