Insuring

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INSURING EARNINGS:

A QUEST WORTH PURSUING?

by Martin H. Scherzer and Stephen E. Usher

While the insurance industry is not, and most likely never will be, in a position to insure that earnings targets are met, the tools and techniques being developed in pursuit of this objective are providing benefits for many companies. Most noteworthy have been the developments in the following areas: the effects of the expanding globalization of business; advances in technology; the convergence of the financial markets; and the development of Enterprise Risk Management.

Each of these factors, by itself, is an important trend, but when viewed together in the context of the need and ability to insure earnings, their effects are magnified.

Globalization

Globalization provides business with a number of advantages, but it also increases the risk profile of firms seeking to compete in the global marketplace. One of the most profound effects of globalization is the emergence of totally new categories of risk. For example, companies may be looking to establish operations in countries that did not even exist a few years ago. Or perhaps they’re trying to anticipate the impact on busi-ness of a single unified currency in Europe.

Globalization has also spawned more mergers and acquisitions. This means operations are leaner and more efficient , but there’s far less room for error. Firms are now forced to rely on fewer suppliers as industries consolidate. If one supplier fails to come through, the breakdown in the supply chain is much more serious as there are fewer alternate suppliers available. Moreover, while consolidation means there may be fewer competitors, those that remain tend to be stronger. Competition also intensifies as companies seek expanding growth opportunities and move beyond their core businesses into new areas.

Globalization has in addition spurred the movement toward more consistent financial reporting standards. Often, these standards follow the more stringent U.S. model. This makes for a more level playing field, but companies that had the ability to establish contingency reserves on their financial statements may no longer be able to do so.

As firms examine their business practices to find efficient ways to minimize these risks, more are turning to either forming joint-venture companies or using hedging products as possible tools to mitigate risk. Even companies accustomed to “doing it all on their own,” or firms that felt that hedging was too difficult or complex, are reevaluating their options in the face of the pressing needs of the global economy.

The insurance industry, not surprisingly, is also responding to these challenges by creating new products and by developing new applications for existing ones. Political risk coverage, for example, which has been in existence for years, is an effective way to protect operations in newly formed countries thanks to increased capacity and broader definitions of loss. Business interruption insurance, a mainstay of the standard property policy, can protect against supply chain disruptions by providing contingent business interruption coverage that protects against loss due to damage of a key supplier.

Convergence

The mergers of global financial institutions that cross disciplines illustrate how globalization and technology have helped to drive the convergence of financial markets. Credit Suisse’s purchase of the Winterthur Insurance Company and the merger of Travelers and Citicorp into Citigroup are just two examples of the consolidation effects of a globalized economy.

This merger trend will advance the cycle of knowledge transfer between different financial sectors, and the distinction between financial services providers will continue to blur. This gives buyers access through any one of a number of portals into the best capabilities of the financial services community, as well as almost limitless ways to combine tools across disciplines. Insurance companies are providing hedges in financial instrument wrappers; securities firms are issuing bonds that act like insurance policies; and multiple parties are emerging as players in the derivative and hedging marketplace. This has tightened margins and shortened product development cycles.

Buyers are benefiting as competition , and choices , increase. Only a few years ago, hedging foreign currency meant contacting a bank to buy a forward contract or an option. Today it is possible to purchase an insurance policy that combines foreign exchange risk with property and liability risks. The result is a cost-effective, multi-year program that provides foreign exchange protection without the need to enter into a derivative contract.

For providers, the added competition represents a significant challenge. They are being forced to innovate with ever-increasing speed in order to capture the wider spreads and better pricing available for the most innovative products. The constant need to innovate is yet another factor in the increase in joint ventures and consolidation as companies need a larger base over which to spread the cost of research and development efforts.

Enterprise Risk Management

The trend that is bringing these forces together is the movement toward Enterprise Risk Management. Enterprise Risk Management is best described as a process of systematically and comprehensively identifying critical risks, quantifying their impacts and implementing integrated risk management strategies to maximize enterprise value.

There are several key components of this definition:

? It involves an ongoing, dynamic process, not a one-time event.

? It requires comprehensive analysis of hazard, financial, operational and strategic risks.

? It forces companies to rigorously quantify and analyze risks, rather than just evaluate them based on a “gut feeling.”

? It evaluates the overall effect risks have on a firm, not just how they affect the risk profile of an individual subsidiary operating unit.

Within the ranks of top management, there is a need and desire to gain a better understanding of the diverse risks facing businesses and the best ways to address them. When executives see the dire effects of risk management techniques that in hindsight proved to have been inadequate, such as the significant derivative losses experienced by several companies, they recognize that the need for proactive risk management processes is an imperative, not a luxury. Consolidation adds another dimension to this equation as it often creates more exposure to risk, not less, because firms need to address differing cultures and new exposures they were not necessarily prepared to handle. An acquired firm may in fact have a risk position that increases the acquiring firm’s risk (e.g., greater foreign currency risk or increased reliance on a single supplier).

So where does this leave the quest for earnings insurance? Globalization provides the need. Technology and the convergence of the financial markets provide the means. Enterprise Risk Management provides the impetus. The result is buyers who are looking for solutions and providers who have the desire and the ability to deliver products and services that can help stabilize earnings by controlling volatility.

That said, despite the allure that insuring earnings may have for some segments of the investment community, it makes little sense, either from a practical or theoretical standpoint, to insure the ability to meet specific earnings targets. To begin with, companies hire competent management to provide the vision and leadership to drive earnings. Moreover, it’s debatable whether insurers would ever cover (or even want to cover) any event that is fully under the control of management. If they did, chances are the premium for that coverage would be unacceptable to buyers.

In the world of financial and economic theory, the Froot, Scharfstein and Stein model is the leading edge paradigm. This model links insuring and hedging to shareholder value and implies there is no sense in the objective of insuring earnings. The right objective is increasing the probability that cash flow is sufficient to finance value creating strategic plans with internally generated cash. This provides a true increase in shareholder value, since external cash is more expensive because investors have less information than management. Because they have less information, investors require a higher return; thus, internally generated cash is cheaper. Indeed, mature firms seldom issue new shares because of the significant negative impact on share price.

To the extent that a company can, on a cost-effective basis, transfer risks that do not represent its core competencies and are not correlated with its strategic investment plans, it is a sound idea to do so. The correlated risks require a special analysis to determine whether they should be transferred or retained.

Let’s use as an example a company whose business is dependent upon the weather. A manufacturer of snow blowers cannot control the amount of snowfall, and weather conditions over the course of a winter season can have a dramatic effect on its profitability. Providing customers with a rebate when they buy a snow blower in the event it doesn’t snow a certain amount is an effective marketing tactic , transferring this risk to another party is an equally astute financial maneuver.

Just as companies work to outsource non-core competencies, they should also seek to outsource or transfer the risks over which they have little control. Why not transfer non-core risks to a third party who may have better analytical capabilities and the ability to aggregate and spread this exposure over a larger pool, instead of having a single company attempt to retain the risk on its own?

Here is where the insurance and financial marketplace can be most effective. Insurance companies have as their core competency the ability to assume risk and spread it over a large portfolio. Financial services firms, meanwhile, are experts at assuming risk to transfer it into the capital markets. Companies that fail to take advantage of the competitive edge offered by the insurance and financial services industries are in fact ignoring highly important competitive tool.

The recognition that there are a growing appetite and capability in the financial services marketplace to assume many different types of risks is an emerging end. It is now possible to transfer not only financial and hazard exposures, but also some operational and strategic risks. Financial products are available to insure project perforce, such as the number of cars to use a toll road or the ridership on a subway. In fact, thin the financial services arena, the ability to transfer risk beyond the capabilities of the standard capital markets or traditional insurance products grows every day. As a result, today’s savvy financial executive should seek to take advantage of this capability and use these tools to help his or her company attain the real Holy Grail , not to “insure” earnings but to maximize shareholder value by using the financial services market to help fund of management’s value-creating strategic investments.

Martin H. Scherzer is a managing director in Marsh’s New York office. Stephen E. Usher is a vice president of National Economic Research Associates in White Plains, N.Y. This article is adapted from one that appeared in the May/June 1999 issue of Financial Executive, published by Financial Executives Institute.

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