A Study On The Strategy Of Integrated Risk Management-Contingent Capital

This paper reports the current trend of risk management in the financial services/insurance industry which is the integration of financial risks and insurance risks. Integrated risk management (IRM) involves the identification and assessment of the collective risks that affect firm value and the implementation of a firm-wide strategy to manage those risks. IRM has only recently become a practical possibility, largely due to the wide-ranging set of financial instruments and markets that have evolved over the past decade.There are three hedging instruments of implementing IRM strategies: asset hedge, liability hedge and equity hedge. A contingent capital facility gives a company the right to issue new debt, equity, or hybrid securities over a specified period of time, usually at a pre-determined issue price, and generally only losses resulting from specified catastrophe perils. And only if the peril occurred and reached a given loss severity, the hedger can finance by debt or equity according to their contract. Therefore, traditional (re)insurance or insurance futures are not included in the field of contingent capital. Capital is defined as all financial resources which is used for production, it is different from legal capital. All of debt capital, equity capital and contingent are included in the resources of capital.Although (re)insurance companies have traditionally used reinsurance treaties to manage their own underwriting capacity, in recent years, a few companies have issued some new hedging instruments to transfer their catastrophe risks to the capital market. In this paper, Catastrophe Bond and Catastrophe Equity Put are supposed as the examples for liability hedge and equity hedge respectively to introduce the contractual terms and pricing model of contingent capital facility, with special emphasis on the potential risks of contingent capital facility relatively to reinsurance treaty.Cox and Pederson pricing model was employed to evaluate the price of Catastrophe Equity Put, this pricing model included two parts, one is interest rate structure model, another considers the probability model with catastrophe risks. Finally, Combing the two parts as a completely model. We use the data of Taiwan Electrical Power company to evaluate 12 kinds of catastrophe bond, the results: the recall rate and trigger loss amount are positive relative influence on the price of catastrophe bond. As to the pricing model for Catastrophe Equity Put, we use binomial model of Amin(1993) to obtain a model with a modified jump process of probability distribution. We use the identical parameters with Amin Model andmodify those factors slightly to examine the influence on the value of Catastrophe Equity Put. The calculating result: the value of Catastrophe Equity Put is 0.5465 less than the value of European Put 0.668 of Amin. In theory, the price of European put should be less than the price of American put (Catastrophe Equity Put), Actually the double trigger events of Catastrophe Equity Put reduce the probability of striking the put, that why the value of Catastrophe Equity Put is less than the value of Amin. The calculating result: the value of Catastrophe Equity Put has a positive relative influence on the strike price, contract period, catastrophic frequency and variance, and contrast with the original price of stock.In additions, We discussed the impact of those hedging instruments on the capital structure. Extending the illustrates and models developed by Shimpi (2001) and Doherty (2003), a balance-sheet model was set up to examine the impact on the firm value for both pre-loss and post-loss events.By analyzing the circumstance of macro-economics, the characteristics of top 100 listed companies and property & casualty (re)insurance industry in China, we try to evaluate the feasibility of developing IRM and contingent capital in this country. First of all, to make the target of performing Integrated Risk Management: (l)to reduce the premium expense of traditional reinsurance treaty. (2)to improve the time difference of post-loss financing. (3)to increase the stability of performing risk management program. (4)to diversify the uninsurable risk. (5)to improve the cash follow. As the internal conditions for performing Integrated Risk Management are : (l)strongly financial capacity. (2)sufficiently risk capacity. (3)good credit rating. (4) correctly loss data. (5)the price of new instruments should be reasonable. So far as the external conditions: (1 Objectively credit rating agency (2)the authority organization of pronouncing loss amount. (3)circumstance of related law and regulations. (4)establishment of trust fund is necessary. (5)the highly development of capital market. (6)the regulative and monitorial system must be efficitively.Overall conclusion:Firstly, the trend from traditional risk management to integrated risk management is inevitable. The main reasons are: (l)the bank, financial institution and insurance companies are reorganized as a big Financial Holding Company which is the main stream of the international financial industry. The components of contingent capital is consist of treating Financial risk by bank as well as treating insurance risk by insurer, and packaged and sold by financial institution to ensure the liquidity ofthose hedging instruments. (2)several kinds of software for financial engineering are created for the evaluation of risk cost which make the result more correct. (3)professional development of frisk management encourages the financial innovations. (4)Information Technology has made the improvement of the liquidity of hedging instruments. (5)the Underwriting cycle is like as business cycle, the hard insurance market will be come again. (6)in the early days. The futures and options markets is hard like as the today market of contingent capital, but noe the markets of futures and options are very prosperity.Secondly, contingent capital is used as a post-loss financing instruments that will affect the capital structure of the firm. This paper finds that there are no significant difference on increasing the value of the firm, F(V), among the three hedging instruments. However, the liability hedge is a best strategy in the pre-loss analysis. For the post-loss analysis, equity hedge is a better strategy to improve the firm value than equity liability. But if a firm employs too many equity hedges, the large outstanding shares may affect the F(V). It could be better to use a comprehensive strategy, employing multiple instruments for the optimal capital structure while the post-loss financing realized.Finally, Along with our analysis, some suggestions are also provided: the performance of Integrated Risk Management should be discreet, the valuation of risk cost is necessary, especially to examine the impact on the capital structure while the post-loss financing is realized. As how to develop the Integrated Risk Management under the circumstances of macro-economics in China, some suggestions are made by the following: (l)to encourage the education and risk management and promoting business culture. (2)to improve the circumstance of relating to the law and regulations. (3)to lunch the strategy of Integrated Risk Management firstly by authoritative business as the example. (4)the catastrophe-linked bond should be the first choice due to it has much experience in practice in the market. (5)to diverse the insurance risk to the international capital market, it is better by the assistance of international financial brokers, by the way, we can learn the experience to connect with the international capital market.