A British oil giant self-funds its losses on a pay-as-you-go basis and at one point considers a loss-financing method that could reward investors in a catastrophe bond issue with an equity stake in the company.

Reinsurers, insurers and brokers labor to tailor finite risk and integrated risk programs that provide risk managers cost advantages and still deliver the tax and accounting benefits traditional insurance provides.

Experts cite several reasons why risk managers have a growing field of complex and less esoteric alternative risk-financing choices.

One pragmatic reason is that the products are another use for insurers' excess capital.

But, perhaps as important, risk managers are becoming more sophisticated in and comfortable with addressing issues like corporatewide, or holistic, risk as well as corporate capital valuation and allocation issues, observed risk management consultant Richard S. Betterley, president of Betterley Risk Consultants Inc. of Sterling, Mass.

At the same time, risk managers' patience with the frictional costs and potential coverage disputes associated with insurance products is dwindling.

One of the most celebrated cases of risk management frustration with the insurance market occurred at British Petroleum Co. P.L.C., which in 1992 adopted a self-funding strategy of covering losses on a pay-as-you-go basis. The oil giant adopted the strategy after a 1991 audit showed it had paid almost five times more in insurance premiums than it recovered in indemnity payments from its insurers during the 1980s.

British Petroleum began covering most losses exceeding $10 million per occurrence as they were incurred.

The $10 million threshold "was no magic number," said John E. Mitchell, a member of British Petroleum's insurance team. The cutoff figure's importance is that it gave the decentralized company's various operations an opportunity to decide for themselves how to best finance risk. "It was a way to overcome anticipated reluctance within the organization" to adopting the self-funding strategy, Mr. Mitchell explained.

Since 1992, those operations largely have concurred with the corporation's outlook and now self-fund most exposures.

Risk managers, though, are not scurrying to copy British Petroleum's self-funding approach.

"Just because you can self-fund something doesn't mean you should," said William J. Kelly, managing director at J.P. Morgan & Co. Inc. of New York.

Risks that stem from a company's "core competency" can be controlled. Companies then effectively can outsource, or insure, fortuitous risks, such as fire and earthquake, he said.

For a very clean risk, "the cost of literally billions of dollars of insurance is virtually nominal," Mr. Kelly said. He observed that he would not want to explain to management why the company incurred a $100 million loss "because we were too sophisticated to spend $20,000" for insurance.

He added, though, that insurance is not cost-effective for all risks and that high deductibles often are the most appropriate risk-financing method.

But, British Petroleum's strategy makes sense on a couple of levels, and it has piqued the interest of at least a few risk managers as well as senior management at other companies, said Gary J. Bausom, a consultant with Towers Perrin in San Francisco.

Mr. Bausom said British Petro-leum's "real risk" in the event of a major loss is the timing of its cash flow. The company's major asset-oil-would not be lost, but profits tied to oil production would be delayed. That delay, though, would not hurt the company's value over the long term, because it still is well-managed, it offers quality products, and it furnishes product-allied services that provide customers with business solutions, he said.

Mr. Bausom said a saw-toothed earnings picture over a five-year period for a company that has adopted a strategy like British Petroleum's would demonstrate the company can manage through disasters "and come out on its feet." The straight-edged, upward sloping earnings chart for an insured company does not show that capability. Indeed, that chart could suggest a "manufactured" earnings picture, Mr. Bausom said.

British Petroleum judges that its strategy works for its investors. Studies show that catastrophic losses have harmed companies share prices only negligibly over the long term, Mr. Mitchell said. It also figures its shareholders have extensive investment portfolios, so a major loss at the company would not significantly impair their overall holdings. Given the company's risk management efforts, investors likely would prefer heftier returns at the company rather than see it buy insurance to cover a loss that will not likely occur, Mr. Mitchell said.

In the event of a catastrophe, the cost of raising capital to cover a major loss would be cheaper than purchasing insurance, Mr. Bausom said.

British Petroleum has access to lines of credit for immediate funds, if necessary, Mr. Mitchell said.

But, in this area, too, the company is investigating new approaches-so-called second-generation risk-financing mechanisms. One possibility British Petroleum's secretary previously acknowledged that the company would investigate is issuing bonds with an equity conversion feature to attract investors.

Mr. Mitchell would not comment on whether British Petroleum still is exploring that.

An alternative risk-financing approach that some insurers and brokers say has greater value for risk managers is finite risk coverage. But, it has to be structured to truly transfer risk and therefore provide both the tax deduction benefits and the balance sheet protection that traditional insurance supplies.

The Internal Revenue Service has not issued any revenue rulings, which would apply to all U.S. companies, on this issue, a spokesman said.

No two finite risk programs look alike, because they are tailored to each company's needs, insurers and brokers say. Generally, though, compared with traditional insurance, multiyear finite risk programs cap insurers' liabilities and require policyholders to pay premiums that are considerably larger as a percentage of the maximum coverage.

For insurers, investment earnings on the premiums are a key underwriting factor.

For policyholders, finite risk programs ultimately can provide relatively cheap coverage for tough exposures, its proponents say. Policyholders at the end of the contract stand to recoup a substantial amount of the premiums they have paid if they file no or very few claims.

Besides exposures for which the insurance market offers inadequate capacity, a finite risk program also can cover traditionally uninsurable exposures, such as foreign-currency exchange and commodity price fluctuations or asbestos liability, said Michael Turk, a vp in New York with Centre Reinsurance Co., which writes finite risk programs.

Not everyone agrees that that approach delivers the goods. For example, Michael R. Levin, senior manager at Deloitte & Touche L.L.P. in Chicago, said the IRS is savvy about the arrangements and will not allow tax deductions because it does not consider finite risk programs to be risk-transfer vehicles. Accounting standards also consider the arrangements deposits, not risk transfers, so "any good auditor" will not allow a company to use such a risk-financing vehicle to remove liabilities from its balance sheet, Mr. Levin said.

Risk managers are investigating finite risk programs because "people are dragging the idea in front of them all the time," he said. "If they're serious, usually they're shot down by the CFO."

Mr. Bausom of Towers Perrin noted that, while he is not a tax expert, he typically has found that sustaining the favorable tax and accounting benefits of financial hybrid products is difficult.

However, the effort the IRS would have to expend to recover the "nickels and dimes" in tax deductions attributable to finite risk premiums would not be an efficient use of the agency's overloaded and ill-equipped staff, Mr. Bausom said.

Some buyers count on that, he said. Others, though, prefer to avoid the risk that the IRS might question the deduction and, as a result, take a greater interest in its overall tax return.

Some insurers, brokers and attorneys, though, assert that properly structured finite risk programs can include enough risk transfer to provide tax and accounting benefits.

"You have to look at the individual product," said attorney Robert Dumont of Baker & McKenzie in New York. Insurers are developing products that qualify for tax and accounting benefits, said Mr. Dumont, who specializes in helping insurers and risk managers develop such programs.

A risk manager can achieve risk transfer when using a finite risk program in a couple of ways, said Thomas W. Kozal, senior vp at Strategic Risk Financing Group, a unit of Marsh & McLennan Inc. of New York.

One example is when finite risk coverage is part of a larger risk-financing program and the finite risk premiums represent no more than 70% to 75% of the finite risk limits.

In that case, the finite risk component would not jeopardize the risk-transfer requirement necessary to obtain tax and accounting benefits, Mr. Kozal said.

Finite risk proponents agree that, largely because of the soft market, risk managers are not tripping over one another to line up finite risk coverage. But, they say risk managers' interest in this alternative is growing. "We are seeing growth in this area," said Centre Re's Mr. Turk.

Union Carbide Corp. of Danbury, Conn., is about two years into a program that combines finite risk and integrated risk elements (BI, Feb. 26, 1996). Integrated, or blended, risk is a relatively new twist on an old concept that reshapes a company's traditional risk-retention picture. Generally, under an integrated risk approach, a company maintains a single retention for many of its property and casualty exposures combined, rather than individual retentions for each exposure. The company's excess coverage is triggered only after that full retention is exhausted.

Swiss Reinsurance Co. reinsures Union Carbide's Bermuda captive with an aggregate of $200 million of coverage over three years and $100 million in any single year. However, there are sublimits for either property or casualty losses, or combined property and casualty losses stemming from a single incident.

If the program is loss-free after three years, Union Carbide is scheduled to recover the value of three-fourths of its premium. However, unlike typical finite risk programs, Union Carbide's premiums are much lower. The premiums equal what Union Carbide would have paid for the coverage under a conventional excess insurance arrangement in today's market, said Rick Inserra, assistant treasurer-risk management and insurance.

Losses could drive up Union Carbide's premium 25%, he said.

The integrated risk program that Norwest Corp. of Minneapolis began forging in 1993 and rolled out nearly a year later also contains a finite risk element (BI, April 24, 1995).

But, unlike Union Carbide's program, Norwest's does not contain sublimits for the bank's property/casualty risks. The bank is subject to a single large retention for all the exposures the program covers. American International Group Inc. subsidiary National Union Fire Insurance Co. of Pittsburgh, Pa., reinsures Norwest's Vermont captive.

Norwest's program has, among other things, helped the bank come much closer to satisfying its risk appetite, cut insurance costs 70% and improved the bank's cash flow, said K.C. Kidder, vp and risk manager.

While Deloitte & Touche's Mr. Levin applauds the benefits of such programs, he emphasized they are not strategic alternative risk-financing approaches. Strategic programs must address all company exposures, including traditionally uninsurable risks such as commodity price and foreign currency exchange fluctuations, to stabilize a company's financial results and enhance earnings per share over the long term, he said.

The programs must be driven by risk managers, not insurers, he said.

While other corporate departments, like treasury, attempt to avoid or control losses from financial exposures, risk management is the company's last chance to protect itself "in case nothing else works," said Mr. Betterley. "So I think it's fairly appropriate that risk managers get involved in providing these solutions."

"I don't disagree" that a strategic approach must consider all of a company's risks, Norwest's Ms. Kidder said. "But, (the concept) was new internally and externally. No one was talking about blended risk in 1993. Our perspective was that it had to be an evolution, not a revolution," she explained. "I really do believe you can't go from A to Z" in one fell swoop, she said.

But, she noted the bank is working on including some traditionally uninsurable risks under the program as it works on renewing the program early.

Because of the insurance industry's large amount of capacity and its plan to capture more market share through new products, the availability of integrated risk programs is growing, said Strategic Risk Financing's Mr. Kozal.

"Like anything else, this could be a passing fad," observed Paul T. Pope, assistant treasurer, risk management with Cleveland-based TRW Inc., which is investigating self-funding traditionally uninsurable risks.

"But, I suggest there is a strong impetus behind this," because the insurers offering integrated risk products are mainstream companies, he said.

The challenge for risk managers now is to define all of their companies' risks and put parameters on them so the insurance market can address them intelligently, Mr. Pope said. He conceded that "is a lot easier said than done."

Meanwhile, risk managers, insurers and brokers continue searching for other approaches to help risk managers structure risk-financing programs that consider corporate risk appetite, capital allocation and tax issues.

In addition, insurers are beginning to give risk managers the opportunity to pay an option fee to change their minds about their self-insured retentions even after a loss.

A dual-trigger deductible or retention is among the various twists on that product. That product restricts a risk manager's ability to exercise the company's option to reduce its retention to periods when the company sustains either a large loss of pre-determined value, a separate financial setback, such as a foreign currency exchange loss, or both events.

With all of the alternative risk-financing option available, risk managers should evaluate the opportunity costs of capital they would spend on any risk- financing mechanism, advised Mr. Bausom of Towers Perrin. Risk managers may find the deal is not as good as they thought.

"I'm in favor of new ideas, but I get frightened sometimes when finance guys run around talking to risk managers' bosses as if the risk managers don't understand it or are afraid of it," said Ken Krenicky, vp-risk management and benefit finance at Rhone-Poulenc Rorer Inc. of Collegeville, Pa.

"Before risk managers do anything too exotic, they should not lose sight of some of the basics they learned in their first risk management classes," Mr. Krenicky said. "I don't think you're a bad risk manager just because sometimes you do traditional things."