CAPITAL MARKETS

(May 2022)

Often businesses handle their loss exposures entirely through insurance, trading premium dollars for loss protection on a pooled basis. Total reliance on traditional insurance is a poor strategy for several reasons, including the following:

· It is an inadequate method for businesses that need very high coverage limits

Proper coverage is rarely available for businesses involved in very hazardous operations
It is ill-suited for firms with long-tailed exposures
The method is too blunt for firms that require sophisticated risk managing options

Many businesses are attracted to exercising more control over handling their risks. Such operations are becoming increasingly involved in direct transactions with the capital market (such as banks, shareholders and securities investments) rather than accessing the market indirectly through insurers. Of course, these transactions mean that a firm faces a direct and higher exposure to market risk.

Market Risk

This is also called systematic risk and it refers to the chance that asset value can be lost due to fluctuation in the value (prices) of any securities in which an entity invests. Market risk typical involves the following:

· Basis Risk - the different impact of interest rate movement on the value of poorly matched portfolios of assets and liabilities.

Example: Company A's risk manager has been happy that interest rates have been rising over the last fiscal year. However, after he closely studies results, he's disappointed to find that the increased value of Company A's investments has been more than offset by increased liability for their outstanding loans.

· Foreign Currency Risk - faced by assets/investments held in such currency that is losing value (as compared to an entity's home currency value).

Example: On May 1, Macaroni Mart, a U.S. Corporation, buys 100,000 shares of Stable Sun Electronics, a Japanese manufacturer. Macaroni makes the purchase in yen. After six months, the shares' value in yen is unchanged. Disappointed that the value hasn't appreciated, Macaroni sells all of the shares on November 1. However, although the price in yen is unchanged, the currency exchange rate did change, with the value of the dollar rising by five percent. When Macaroni made the purchase, it exchanged $10,000,000 in U.S. dollars. When the same amount of yen is traded for dollars after the sale, Macaroni gets less money. Therefore, after the sale, Macaroni lost $500,000, strictly due to the exchange rate fluctuation.

· Risk of inflation - simply the danger that, with the passage of time, general price levels increase acting to devalue original, invested sums.

· Interest rate risk - rate fluctuations and the corresponding effect on financial holdings.

· Stock Price Fluctuation - overall effect of movement on total investment value.

Market Strategies

A company may face substantial loss exposures involving market risk and, since traditional insurance is not a viable method for mitigating or eliminating such exposures, use of capital markets is necessary. Common strategies for handling or funding risk through capital markets include the use of the following:

1. Derivative Options

2. Risk-Linked Securities (Securitization)

3. Catastrophe Bonds

1. Derivative Options

Derivative options, or derivatives, are contracts between two or more entities. The name comes from the fact that the contract's ultimate value is derived (is the result of) the fluctuation in the value of the asset that is the subject of the contract (underlying asset).

Derivatives are very flexible since there is no limitation on what type of asset a derivative option may make use of. It really depends upon the type of contract two or more parties are willing to accept. Any derivative option (contract) is composed of the following items:

a. The contract specifications (what is being agreed to under the transaction)

b. The underlying asset (item of definite value)

c. The length of the agreement.

Therefore, a derivative option is a type of security (since it has its own calculable value) and its value is based on (derived from) another asset. Derivatives can be used for hedging, dealing or for speculation. As is the case with other techniques, the contracts may be used to smooth out volatile balance sheet performance.

Example: Acme Furnishings has a very successful line of heritage-style furniture that accounts for nearly 80% of its annual sales. The furniture line is made to order and uses a special wood treatment and polish process that depends on certain materials that are fairly expensive. Its supplier for the materials, due to a shortage, increases their materials price by 100%. The cost jump severely increases Acme’s cost and endangers its ability to fulfill many orders. At a subsequent management meeting, a consultant advises Acme to look into the use of derivatives to help hedge against a similar problem in the future.

However, the huge benefit of derivatives also represents their greatest weakness. Derivatives, being highly leveraged instruments are quite vulnerable to counter-party risk. In other words, if a single party involved in the underlying contracts defaults, that event can trigger an entire chain of negative, financial reactions.

2. Risk-Linked Securities (Securitization)

Basically, risk-linked securities (RLS) are a process. An entity selects among its various assets, puts them into a group (pool) and then markets (and eventually) sells those assets as securities. The effect is to enhance an entity's financials, particularly when it is able to securitize debt obligations in order to eliminate or, more likely, substantially reduce a loan exposure. The continued ability to use this method is dependent upon how the transactions are treated by evolving general accounting standards. Risk-linked (also called insurance-linked) securities can be created by selling either bonds, shares or other instruments to cover the cost of an asset sale.

Securitization

Convergence Products

3. Catastrophe Bonds

A dominant type of RLS is a catastrophe or cat bond. Ironically, cat bonds are typically sold by insurers as an alternative to using traditional reinsurance. Through a cat bond, an insurer or a reinsurer obtains securitization of their liability for a catastrophic loss. Cat bonds are typically used to protect an insurer against the severe impact of natural catastrophes such as earthquakes or hurricanes.

Establishing a cat bond, also called an event-linked security, can be complicated. Cat bonds are sold to investors in the same manner as non-cat bonds. In the United States, there are two major differences between the two. One is that cat bonds mandate the creation of a "pass-through" entity called a Special Purpose Reinsurance Vehicle (SPRV). Second is that SPRVs are formed as offshore entities so they avoid U.S. Tax regulations. The insurer or reinsurer creates a cat bond contract with the SPRV.

The bond contract identifies a specific, potential catastrophic event that is to be covered by the cat bond funds. The SPRV sells bonds to investors and the investors' payments are placed in a special trust account (usually made up of high grade, liquid securities such as treasury notes). The SPRV makes interest payments to its investors by using the investment income from its trust account. If the specific catastrophe occurs, then the principal amount of the bond fund is used to make catastrophe claim payments. With cat bonds, it is the investors that bear ultimate responsibility for the occurrence of a specified event. Essentially investors are gambling that, over the life of the purchased bonds, the specified event will NOT take place.

Payment under a cat bond can be designed in several ways, such as:

· Using pre-determined parameters

· Industry index (trigger occurs when entire insurance industry experiences a given level of loss)

· Insurer specific loss level

· Basing the trigger on a formula or a model