Covering Nontraditional Risks

Dec. 21, 2004
Savvy managers are taking a new approach to risk management.
In insurance circles, it's become known simply as "the Honeywell deal." Talk to almost anyone involved in commercial insurance, and the moniker inevitably pops up. What they're referring to is the decision by Minneapolis-based Honeywell Inc. to combine most of its major risk exposures, including its exposure to long-term foreign currency fluctuations, within an integrated insurance program. By all accounts, the $8 billion building-and-aviation-controls company was the first to turn to the insurance markets -- rather than the capital markets -- to cover a financial risk. The program works much like any insurance policy. If the dollar strengthens, thus lowering Honeywell's profits as they are translated from sales made outside the U.S., it activates a claim. The currencies are monitored on a monthly basis, and a claim, if there is to be one, is submitted at yearend. About 20 currencies, representing about 90% of the company's exposure, are included in the program. Tom Seuntjens, director of global insurance risk management, estimates that Honeywell is saving about 20% on its premiums with the integrated program. A large part of that results from the portfolio effect. Because a range of exposures is included within a single program, the insurance company can be fairly certain that a good claims experience in one area will offset a not-so-good experience in another. And, because the policy runs for several years, the insurer doesn't have to worry that Honeywell might have a major claim one year, thus raising the insurer's costs, only to take the business elsewhere the next year. Equally important, Seuntjens says Honeywell obtained the same level of protection against foreign currency fluctuations as it would have gotten by purchasing a more traditional hedging instrument. One year into the program, Seuntjens says, "The products have performed as we had planned." He and his team are looking at including other financial and operational risks not traditionally covered by insurance, such as interest-rate and weather risk, when the current program expires at the end of 1999. "This is just a stepping stone," he says. Executives at a number of companies are taking a new look at their approach to risk management and insurance. The sea changes taking place in the business world -- such as increasing globalization and the growing importance of a company's brand names -- mean that managers can't assume the risks they face today are the same ones they faced a decade or two ago. "Companies are starting to come to the realization that quite often the risks they've traditionally been insuring are not by any means the biggest risks, that they're assuming other risks that could be much more detrimental to the firm," says George R. Keller, president and chief executive officer of Winterthur International America Insurance Co., Dallas. (Winterthur's worldwide headquarters are in Winterthur, Switzerland.) Managers are not only taking a broader look at all sources of risk, they're also trying to figure out how each risk interacts every other risk. The result? A more sophisticated understanding of the total risk facing their organizations. "Risk taken on by one part of the firm might offset risk taken on by another. So, you want to develop an understanding of how the risks work together," says Harold Skipper Jr., professor of risk management and insurance at Georgia State University, Atlanta. Managers are becoming more concerned about the overall dollar amount of losses -- no matter what the source -- that can play havoc with the company's bottom line. "If a company misses its earnings forecast, its stock price gets hammered. That's why CFOs are interested in programs that lend more certainty to operating results," says James V. Davis, chair and chief executive officer with the Advanced Risk Management Services unit of Willis Corroon Corp., Nashville. One type of risk executives now are considering is weather activity. In the past, of course, companies have purchased insurance to protect against a single catastrophic weather event, such as a hurricane or flood. Some new programs protect against cumulative climate activity that isn't catastrophic, but can hurt the bottom line. For example, apparel manufacturers and retailers reported lower sales toward the end of 1998, partly because of warmer-than-normal temperatures across much of the U.S. Several insurance companies now offer such protection. Unwelcome changes in commodity prices is another area. CIGNA Corp., working with J&H Marsh & McLennan Inc., structured a deal for Times Mirror Co. that protects against swings in the price of newsprint, says Michael Luck, product-line manager, CIGNA Combined Risks, Philadelphia. The policy says that CIGNA will reimburse Times Mirror if the company has to pay more than the fair market price for newsprint at the time the contract went into effect last summer. Newsprint is Times Mirror's second largest expense behind compensation, says Bill Wiegand, vice president-newsprint and procurement. It's also a highly volatile one; Wiegand says one index that tracks newsprint prices shows swings of 150% during the last five years. "From an EPS [earnings per share] concern, that's way too volatile." If the price of newsprint, as measured on the index, moves above a certain level, Times Mirror is reimbursed for a portion of the extra expense the company incurs. Should the cost of newsprint get high enough, the company is reimbursed on a dollar-for-dollar basis. The fact that these new policies can cost insurance companies money prompts the question: Why do they want to start protecting against a whole raft of risks that they haven't covered in the past? Simply put, it's self-preservation. "It's very much a buyers' market right now," says Tobey Russ, president of AIG Risk Finance, div. of American International Group Inc., New York. "There's too much capital chasing too little business." Although it may appear that just about any risk can be insured against, that's not quite the case. Marty Scherzer, managing director with insurance broker J&H Marsh & McLennan, New York, lists several criteria necessary for a risk to be insurable. First, the event being insured has to be fortuitous; that is, it must be outside the control of the company or management. Second, the firm underwriting the risk must be able to get solid data that it can analyze and use to determine how to price the program. In addition, the potential risk needs to be weighty enough that a company will be willing to commit the time and resources it takes to put together a deal. Finally, there must be a good business reason for the insurer, as well as the buyer of insurance, to want to do the deal. Risk managers likely will continue to expand their view of corporate risks and try to find new ways to address risk. "Eventually the risk manager will view the firm as one big matrix," says Georgia State's Skipper. "They'll try to understand how every major risk in the firm varies with every other risk. Even though we'll never really get there, the more we think that way, the more we can improve our understanding of risk and how to manage it."
Accounting Rules
Managers thinking about using an insurance policy to cover foreign-exchange and other financial risks will first want to review, with their accountants, the Financial Accounting Standards Board's Rule 133. Some industry experts say that this new rule, which goes into effect for companies' first fiscal year after June 15, 1999, may make the use of insurance policies to cover financial risks less desirable.
Doing It On Your Own
Oil giant BP Amoco PLC (formerly British Petroleum Co. PLC) has taken what might appear to be an approach totally at odds with the idea that more of a company's exposures can be covered via commercial insurance. In 1991 the $73 billion energy and petrochemical company decided to avoid purchasing commercial insurance wherever possible. Instead, management would fund losses from the company's own ample cash flow. "The policy is, essentially, don't buy it unless you have to," says Henry Labram, BP Amoco's head of insurance. (He notes that in some cases government regulations or contractual agreements require the company to purchase insurance from outside buyers.) Labram says the company's analysis showed that the cost of insurance exceeded the benefits over the long run. For example, in the 10-year period leading up to 1991, BP Amoco spent US$1.25 billion in premiums, but had claims totaling only $250 million. Armed with these numbers, management reasoned that BP Amoco could withstand the hits to cash flow that would result from smaller, insurable losses. The company's emphasis on safe operations also helps to reduce the incidence of accidents, says Labram. At the other end of the spectrum, in the event of a very large loss that would materially affect the company, most reliable suppliers don't have the capacity to provide the level of insurance BP Amoco needed anyway, says Labram. "The sort of losses that would hurt [the company] are the sort that the insurance industry is uncomfortable accepting," he says. Although BP Amoco may have had more compelling reasons than some other companies to forgo commercial insurance, it's an issue a growing number of executives at large companies are tossing around, says Harold Skipper, professor of risk management and insurance, Georgia State University, Atlanta. The reason, says Skipper, is the same analysis of costs and benefits that prompted BP Amoco's move. For many companies, the chance of an event (or combination of events) that would materially impact earnings is small. If that's the case, management must decide if insurance protection makes sense. Skipper stresses that he's not suggesting that management not be concerned with risk. However, companies do need to weigh the impact of different events against the cost of protection against them. "A corporation should be neutral in terms of risk. They should just take on activities that increase the bottom line," Skipper says. Since moving to self-insurance, BP Amoco has saved several hundred million British pounds on premiums. "There's been no time that we've felt that we would have been better off during the past eight years if we had had insurance," says Labram.

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