How Captive Insurance and Hedge Funds Can Help Offset Financial Risk Exposures

How Captive Insurance and Hedge Funds

Can Help Offset Financial Risk Exposures

Andy Amalfitano

MSBC Seminar #4 Risk Management

Norwich University

July 31, 2010

In the last two years, many economists were proven wrong as the economy hit the worst recession and downturn since the Great Depression of the early 20th century. Today, missing predictions continues.  One of many examples is offered by Soto (2010).

I n April we said GSCI Total Return Y/Y could appreciate by more than 20% and at the same time we warned Crude Oil Valuation model just reached again its overvalued territory. One month later, we can say we were wrong . It looks like Crude Oil Valuation will reverse completely and there might still be room for more decline ahead [1]

Risk managers try to predict and find easy ways to improve their financial advantage, often listening to economic pundits. Those days are gone. Global supply-demand imbalances in raw materials, and resulting price volatility, will likely continue to impact the profitability and competitive position of many U.S. companies. [2]

This paper describes why a company should consider using various techniques within the financial markets to offset financial exposures.

All businesses face exposures to predictable and unpredictable financial threats which can undermine goal achievement. The worst of these risks will be the unpredictable threats that present the greatest degree of uncertainty. Financial market-specific risks come in many forms:

• Interest rate changes
• Foreign currency exchange rate fluctuation
• Goods and services tax and import/export tariff law changes
• Geopolitical upheaval in areas where business is conducted
• Stock market volatility affecting investments and portfolios
• and more

Depending on the size of the business, some or all of these market levers may impact a business viability. [3] Whats more unnerving is the volatility and unpredictability of these risks. Economists have attempted to manage and predict the future with tools such as the CBOE-VIX [4]. a widely used market analyzer. Academic researchers have attempted to create models to improve predictability. Both set of experts seem to agree that more data and understanding represents goodness, however, no specific model or approach to offsetting financial risk can be a guarantee. [5]

Verni (2005) offers four pieces of advice in managing risks:

• Be skeptical
• Assume Murphys Laws are in force. If anything simply cannot go wrong, it will anyway
• If everything seems to be going well, you have obviously overlooked something
• Every solution breeds new problems [6]

Gathering intelligence on financial risks and understanding what the information means to your business can be a key step in managing these risks. Scholes (2005) describes questions that a company can use to determine the how of understanding asset management which he finds to be a key part of the strategy. [7] In addition, three key asset management criteria that demand understanding are:

1. Capital Allocation: How do we allocate capital to the risks we are taking, to each strategy individually or to a portfolio?
2. Optimization: Risk management is not risk minimization it is risk optimization but what is the right tradeoff between risk and return?
3. Stress Management: How do we handle it, and do we know how to do anything about it? [8]

It is incumbent upon financial risk managers to avoid poor financial investments and make educated risks about trade-offs, alternatives, and options.

After decades of study and trial and error attempts to completely predict and understand financial markets, no one single model has emerged that completely defines how to manage risk 100% of the time or with 100% accuracy.

In a thesis offered by Rörden & Wille (2003) the authors concluded that the only theory which was considered to actually work in practice without any unrealistic assumptions was diversification . [9] Examples of diversification include spreading investments across different market types, investing some money in short-term and other money in long-term instruments, and selecting assets or commodities that are significantly unrelated by most measures.

A business needs to consider who they are as a company, what their tolerance for risk is, and apply some flexibility to their approach in selecting financial risk strategies. What is clear is that the lack of understanding of risks and/or the lack of a strategy will often mean the difference between success and failure of a business.

Here are two of the many options available for consideration by businesses:

• Captive Insurance

• A form of member-owned self insurance, usually in a group of similar companies providing a form of alternative risk financing
• Offers reduced insurance costs, stabilized insurance budgets, direct access to the reinsurance market, improved claims handling and data collection, possible tax benefits, profit center creation, and a negotiation tool. [10]

According to Jay Krafsur of the Krafsur Law Group, captives offer members a significant investment tool to manage insurance costs and reinvestment opportunities in the form of reduced and re-investable loss funding. [11] Approximately 60% of premiums go into loss funding which is mostly reimbursable over time. The other 40% is operating funds which are not recoverable, however all of the premiums are investment funds which provide a broad and rather securable asset which grows over time while simultaneously providing member insurance coverage. Further, captives apply strict rules to membership including letters of credit and other assurances of financial solvency of their members. [12] This strategy provides an avenue that businesses can consider to offset other financial risks that may be occurring within their industry or market space.

Hedge Funds

Usually reserved for the high net wealth individuals or firms [13]. hedge funds can play an important role in offsetting financial risks.  A hedge fund is a n aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns . [14]

Primarily, a hedge fund is a way for an individual or in some cases, a group of people to invest significant sums of money using instruments that provide some security against changes in market value. [15]

The concept of hedging can be applied as a strategy to financial risk management.  The old term dont put all your eggs in one basket may still be wise advice to businesses facing uncertain futures.

There is no one sure-fire answer to how to manage financial risk particularly in the uncharted territory of todays economy. Economists and researchers disagree on the best model or tool to use to forecast commodities, the stock market or other economic changes. Therefore, market volatility continues to plague investment strategy success for many businesses.

Two possible strategies are investment in captive insurance and hedge funds. Both offer unique ways to bring some level of security and risk avoidance to a business. These strategies offer an opportunity for businesses to not place all their investments in the same place and thus help ensure a more balanced financial risk situation.

seekingalpha.com/article/204391-commodities-indicators-may-2010

aimediaserver4.com/chemweek/pdf/deloitte1.pdf

sshuebner.org/documents/Crabb%2010-29.pdf

www.cboe.com/micro/vix/vixwhite.pdf

sshuebner.org/documents/Crabb%2010-29.pdf

[6] Verni, Ralph, (2005), Financial Risk Management in Practice: The Known, the Unknown and the Unknowable . Roundtable 4: Insurance and Reinsurance . The Wharton School, Alfred P. Sloan Foundation, and Mercer Oliver Wyman Institute, 18

[7] Scholes, Myron, (2005), Financial Risk Management in Practice: The Known, the Unknown and the Unknowable . Roundtable 6: Asset Management . The Wharton School, Alfred P. Sloan Foundation, and Mercer Oliver Wyman Institute, 22-24

[8] Schoel, Ibid

[9] Rörden, Sarah & Wille, Kristofer, Ibid

www.captive.com/service/WilmingtonTrust/images%20and%20pdf/captive101whitepaper.pdf

[11] Krafsur, Jay of Krafsur Law Group Captive Insurance Consultants, Chicago IL. Interviewed by Andy Amalfitano July 2010.

[12] Krafsur, Ibid

www.investopedia.com/terms/h/hedgefund.asp

[14] Ibid

www.investopedia.com/articles/trading/09/offset-risk-options-futures-hedge-funds.asp

Risk Management | blogadmin August 9, 2010