14' External Loss Financing Arrangements

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14. External Loss Financing Arrangements

• Dr. Jan-Juy Lin
• Dept. of Risk Management and Insurance
• ETP course, CNCCU

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Introduction

• Risk financing through derivatives
• Risk financing through insurance
• Integrated loss financing arrangements

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• Risk Financing Through Derivatives

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The Markets

• Barter markets
• The exchange of non-standardized goods or
  services not involving currency.
• Cash-and-carry markets
• Goods and services are purchased with cash and
  taken away.
• Spot markets
• Where standardized goods are exchanged via
  currency transactions.
• Futures/options markets
• Delivery at some future point

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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.

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Forwards and Futures

• 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
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Options

• Call / put option
• The right of holders to purchase / sell an asset
  at a specific price before a specific date /
  during a specific period.
• Strike price (exercise price)
• The right of holders to buy (sell) assets at a
  specific price during a specific period
• Protection against an unfavorable price movement
  the owners loss is limited to the options
  price.

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Options

• Option premium
• At the time the holder obtains the right
• The holder pays the other party in the contract
  the options price
• The time of the exercise right
• European (style) options be exercised only on
  the contract expiration date
• American (style) options be exercised at any
  time from the date of purchase until contract
  expiry.

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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
• One party that owes the greater of the two
  interests calculated on the settlement date pays
  the other party the difference.

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Managing Financial Risks

• Foreign exchange (FX) risk
• An Australian MNC borrows US 90 M from a US
  pension, and shall repay US 10 M. (P356)
• Via a current forward or future contract.
• Weather risk
• Weather Derivative v. Weather Insurance
• How to measure? By index (the underlying)
• Temperature derivative Case study (P357)
• Users insurers, reinsurers, banks, energy co.

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• Risk Financing Through Insurance

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Liability Insurance for MNCs

• General business liability
• Employment practices liability
• Directors and officers liability

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Court Awards (Insight 14.1)

• Duty of care to a third party depends on the
  status
• a guest (invitee)
• a licensee
• a trespasser
• Economic (general) damages
• Result directly from an injury
• Non-economic (special) damages
• From the consequences of economic damages
• Punitive damages
• Financial penalties arising from tortuous acts

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EPL insurance

• Employment practices liability insurance
• A rise in the number of employers claims
• Q Junior student trainee Dismissal by FCB
• Trends (see Insight 14.2)
• Allegations from unfair dismissal
  discrimination retaliation.
• Numerous employment-related law
• Coverage
• Insure the corporation and its subsidiaries
• The insured directors, officers, and employees

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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

• DO liability coverage
• Defend and indemnify any directors and officers
  of the insured entity
• With allegations that they failed to carry out
• Corporate reimbursement coverage
• Indemnify the entity that it incurs in defending
  its directors and officers
• Entity coverage
• This extension covers any resulting financial
  liability from a wrongful act of the entity

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Insurance for MNCs

• Admitted insurance
• via host country insurers
• Nonadmitted insurance
• via home country insurers
• Global master program
• A combination of host and home countries
  insurer,
• Need to appoint a lead insurer or a lead
  broker

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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.
• Premiums paid locally usually are deductible as a
  business expense for tax purposes.
• The local insurer and broker can provide advice
  and risk management services.
• The insurance program is complying with local
  laws.

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Admitted insurance

• Disadvantages
• A local policy may be 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.
• Coordinating local programs with a common RM
  philosophy is difficult.

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Nonadmitted Insurance

• Benefits
• Centralized administrative control, much easier
• 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.
• Any coverage dispute subject to home country
  legal system and court.

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Non-admitted Insurance

• Disadvantages
• Claims settlement can become more complicated
  without local coverage and the assistance of
  local insurer representatives, particularly true
  in liability claims.
• Local management may not understand the
  non-admitted coverage.
• Discussion Suppose a Taiwanese product exported
  to the US, for the product liability protection,
  where to buy is more appropriate?

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Global master program

• Often use an international insurer and its net
  work of subsidiaries, affiliates or both to
  structure the program.
• Or trough an international broker
• Local accountability- local condition determine
  the local coverage
• The lead insurer provides excess cover
• DIC, DIL for a uniform coverage
• Lead insurer is expected to provide direction in
  claims administration and other services, such as
  loss control

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Global Master Program (Figure 14.2)
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• 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 with 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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• Discussion Questions

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Discussion Question

• Suppose a Taiwanese product exported to the US,
  for the product liability coverage, where to buy
  is more appropriate? Taiwan or US? Please reason
  it.
• Compare with the important distinctions between
  weather derivatives and weather insurance.
• Describe two important distinctions between
  forward and future contracts.

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Discussion Question

• As a employer, how to handle employment-related
  issues such as age and gender discrimination or
  what is defined as unlawful discharge from
  employment in your opinion?
• A multi-trigger policy contains a condition that
  the traditionally insurable loss event must be
  the first trigger, followed by a financial loss
  as the second. Please provide an example for such
  arrangement.