TAKING STOCK OF BALANCE SHEET RISKS

ATLANTA-Increased awareness that unforeseen events can lower shareholder value is prompting many risk managers to look for new ways to protect their companies' balance sheets.

Today, the first question a risk manager or other company official must ask in examining its exposures is, "What effect can this have on shareholder value?" said William N. Thornhill, a senior vp at X.L. Reinsurance Co. Ltd. in Hamilton, Bermuda.

"Five or six years ago, were we asking ourselves this question? I don't think so," Mr. Thornhill said during a panel on balance sheet protection at the American Bankers Assn.'s annual Security, Audit and Risk Management Conference last month in Atlanta.

The "what if?" scenarios that risk managers must examine could involve a single event or combination of events that prevent the company from executing its business plan. Such occurrences could include economic events, regulations, inadequate insurance for catastrophic events, operational and business risks, and various uninsurable risks, he said.

In some cases, contingent liability coverage might be available in the traditional insurance markets, but the limits may be inadequate for a particular company's exposures, said Dominic J. Frederico, executive vp at ACE Ltd. in Hamilton, Bermuda. On the other hand, he said, adequate capacity might be available in the market to cover some "uninsurable" exposures-such as pollution liabilities, product warranty or recall or asbestos liability-but at too high a premium to be cost-effective.

There are various other ways of covering those "uninsurable" risks, though, Mr. Frederico suggested.

One way is through "add-on" coverages, he said. Add-ons involve an endorsement and sublimit of additional coverage linked to a traditional risk-bearing policy that has a larger limit and is written over a multiyear period.

"It simply brings in the non-traditional cover to a traditional policy but on a multiyear basis," Mr. Frederico said.

Typically, the insurer assumes a large amount of risk and the add-ons have a high price, he noted.

Another way of obtaining balance sheet protection is through a "contingent equity" approach. Under such a program, a potential equity position in the insured company-usually in the form of an option-replaces a large premium and is triggered only in the event of a loss.

For example, coverage is triggered if the customer suffers a large loss and a specified additional event, such as a downgrade of its bond rating, occurs. In exchange for coverage, the customer would provide equity options to the insurer with a 10-year exercise period. However, the policyholder could retire the options before they are exercised, by exchanging them for the options' cash value.

For the insurer in such an arrangement, "there is a tremendous amount of financial risk," Mr. Frederico said. "Obviously, the company you want to do this with, you'd better be confident they're going to be there for the long haul."

A third approach is a "second-event cover," a risk financing method that provides multiple limits over a multiyear term, giving the customer protection from catastrophic losses.

In such an approach, the customer's premium would fund the first loss, while a second might be funded by a combination of the premium and investment income on that premium, with the insurer providing excess coverage. The insurer would cover any subsequent losses, within the limits of the policy.

"Typically, the client will fund for one of these events," Mr. Frederico said. "The second event is basically the event that brings the house down."

Such programs generally have a three- to five-year term and three to five large, per occurrence limits.

"From our experience, this is the most popular cover that has been used to address these large, complicated risks," Mr. Frederico said.

"Dual trigger" coverages provide another way to protect balance sheets. Dual trigger plans provide inexpensive coverage that can only be tapped if two distinct events specified in the policy occur at the same time.

Linking the events-such as an increase in sugar prices to a catastrophic property loss at a soft drink manufacturer's plant-gives the underwriter a better framework for evaluating the overall risk than it might have in looking at the "uninsurable" risk alone.

From a buyer's perspective, "as long as the triggers are related, we think this makes sense," Mr. Frederico said. He cautioned risk managers, however, that the two triggers in such a program should be clearly related. He doesn't recommend combinations "such as property cover that pays the claim only if the unemployment rate goes above 10%."

"Derivative enhanced" programs can provide large insurance limits for exposures that lend themselves to being hedged in the capital markets, Mr. Frederico said, such as sharp increases in oil and natural gas prices. Key elements of such programs are very large limits, low premiums and multiyear protection.

ACE is working with a major airline to develop an oil price cap, Mr. Frederico said. It would allow the airline to get multiyear limits on the price of fuel while avoiding accounting problems that might derive from spot price changes on oil futures contracts, which are considered assets.

In general, Mr. Frederico said, the approaches he outlined offer the advantages of spreading the cost of resolving a problem over a multiyear term and providing tax deductibility on the premium or risk financing.

They also remove a liability from the policyholder's financial statements and often provide a profit commission in the event of favorable claims experiences.

The financial markets offer various methods of hedging risks, said Thomas Taylor, president of CNA Financial Insurance Group in New York, a division of Chicago-based CNA Financial Corp.

While some uninsurable risks, such as commodities prices, are perfect candidates for hedging, some insurable risks-directors and officers liability, for example-do lend themselves to hedging rather well, Mr. Taylor said.

D&O claims are highly correlated to stock market changes, he noted, and stock option markets are broad and liquid and may provide a hedging solution if the customer company's stock is publicly traded.

Various institutions make derivative products that provide a hedge over a longer period than available in the traditional option markets, said Mr. Taylor. This is a market CNA is examining and is the reason behind the company's recent purchase of a majority stake in Hedge Financial Products Inc., formerly Centre Financial Products Ltd., he said.

Securitizing risk also holds prom-ise, Mr. Taylor said, adding he believes these various capital market approaches will draw banks and insurers closer together in the years ahead to provide customers with better and cheaper coverage.

While programs can be crafted to protect a company's balance sheet, they often take a year or more to develop and require support from corporate management, the speakers noted.

The experiences of one risk manager in another session provided an illustration as he outlined his company's lengthy-and so far unsuccessful-attempt to shape an alternative risk financing program.

The effort, which began in 1995, has involved identifying the bank's full range of loss exposures, examining ways of financing those risks and selecting and implementing the best options for dealing with them, said Jerry C. Ayers, vp and corporate risk manager of Wachovia Bank of North Carolina in Winston-Salem, N.C.

The "basic proposal" that came out of the process, he said, called for the bank to take "much, much higher retentions," establish a captive to provide coverage above those retentions and look to the capital markets for coverage "for truly catastrophic losses that might blow right through the captive."

But tax issues prompted Wachovia to defer any plans to form a captive, Mr. Ayers said, while plans to create a special-purpose corporation to tap the capital markets in the event of certain triggering events were scuttled because of accounting concerns.

Instead, Mr. Ayers said he's involved in developing a plan that will rely more on traditional underwriters in a large-retention program that probably will see some "blurring of lines of coverage."