Global Risk Management: Financial, Operational, and Insurance Strategies: Volume 3

A brief survey of the development of the study of risk and probability is given together with some basic observations on their application to insurance. This is followed with observations on the lack of appreciation of probability studies and an elementary feeling for probability by the public at large and a suggestion that the time is ripe for a new science museum involving basic economics and the exposition of the role of probability in finance.

The events of September 11, 2001 have triggered great interest in the identification, assessment, and management of “extreme events.” In this article, we offer a new mathematical framework for the development of financial risk management techniques to address these exposures. Based upon our analysis, we argue that: (1) the decreasing marginal utility of net wealth does not adequately explain the economics of insurance/ reinsurance; and (2) our proposed apprehended value criterion provides approximate justification of mean-third central moment fourth central moment (M-T-F) decision making, thereby “leapfrogging” (skipping over) the variance. Appropriate extensions of traditional financial risk management concepts are then considered, along with their implications for insurer/reinsurer underwriting and investment activity.

The paper presents a treatment for the measurement and disclosure of market and credit risks in the context of capital adequacy regulation. The proposed approach is in conformity with the Basle Committee's latest proposal on risk measurement, and is based on the Value-at-Risk (VaR) methodology. This approach is applied to investments in close-end country funds of emerging markets. For 13 .such funds listed in the New York Stock Exchange during the period October 1994 to December 1997, the average VaR estimate is found to be well above the capital adequacy ratio of 8% required by most regulatory authorities and to be sensitive to the emergence of increased financial turbulence.

This article discusses strategies in which taxpayers use derivatives to attain better tax treatment for hedge fund investments. In response to an early planning strategy, Congress enacted the constructive ownership rule of Section 1260. This measure's success has proved surprising, given the similarity of section 1260 to the constructive sale rule of section 1259; the latter rule, which targets a different use of derivatives in tax planning, has proved easy to avoid. Theoretically, either rule can be avoided through relatively modest changes in economic return. While this strategy is common for section 1259, it is much more difficult for section 1260 because securities dealers cannot supply the necessary derivative. Instead, taxpayers have sought tax-advantaged hedge fund returns through strategies involving insurance and offshore corporations.

Multinational firms will engage in operational hedging only when both exchange rate uncertainty and demand uncertainty are present. Operational hedging is less important for managing short-term exposures, since demand uncertainty is lower in the short term. Operational hedging is also less important for commodity-based firms, which face price but not quantity uncertainty. For firms with plants in both a domestic and foreign location, the foreign currency cash flow generally will not be independent of the exchange rate. Consequently the optimal financial hedging policy cannot be implemented with forward contracts alone but can be implemented using foreign currency call and put options, and forward contracts.

This study develops a model of foreign exchange exposure dependent on only three variables, the percentage of the firm's revenues and expenses denominated in foreign currency and its profit rate. The model demonstrates that foreign exchange exposure elasticities should be largest for pure exporting and importing firms, especially those with low profit margins. Exposure elasticities should be smaller for multinational firms that match their foreign currency revenues and costs. Such operational hedges may help to explain why previous studies have found low or negligible levels of exposure when they studied the sensitivity of share prices to foreign exchange rates.

This paper examines the impact of the Asian crisis on U.S. firms. We find that while neither the average U.S. firm nor the average U.S. multinational was affected by the crisis, U.S. multinationals with presence in East Asia were negatively and significantly affected. On average, these firms experienced a sizable (−1.43%) abnormal return per month during the crisis period. We also find that currency derivatives use and potential operational hedging strategies did not significantly protect firms from the East Asian crisis. This is perhaps due to the magnitude of the shock and the resultant lack of liquidity in the derivatives markets during and after the crisis.

Although political risk assessments have incorporated political violence and acts of terrorism into consideration of where the dangers lay for many decades, the acts of September 11, 2001 have shifted the focus of what is more impactful in international business and investment. Handling many of the risks to foreign investors remains a task for company managers but the nature of this new form of war has forced an interaction with government and international institutions that will be a new challenge for investors. What will remain is the necessity for managers of foreign enterprises to assess political risk along with economic and financial risk and then to determine which management tools are appropriate in dealing with specified risks. This essay discusses the relationship between risks and responses and delineates management methods that can be deployed in response.

The puzzle of underwriting cycles and insurance crises in property-liability insurance has led to numerous economic hypotheses and analyses, yet no single theory seems capable of explaining all of its aspects. Reinsurance is hypothesized to be a potential factor in observed cycles in the primary market; despite this, few underwriting cycle studies focusing on reinsurance exist. The purpose of this research is to apply two principal underwriting cycle theories: the capacity constraint and risky debt hypotheses, to non-proportional property and casualty reinsurance in the U.S. Non-proportional reinsurance is highlighted, since it is designed to cover the tail of the loss distribution and is considered to be relatively riskier than proportional reinsurance as a result. Two professional U.S. reinsurer samples are studied, one for property and one for casualty; U.S. reinsurers in each sample were chosen on the basis of their non-proportional property (casualty) writings. The sample period is 1991 to 1995. The results support both the capacity constraint hypothesis and the risky debt hypothesis, and this is the first research to do so. A major innovation in this study is the use of capacity variables that are broken down by major region of the world