Risk Management in the Global Economy

Issues and Strategies

Multinational Enterprises

International businesses may be classified as either limited international enterprises (LIEs) or multinational enterprises (MNEs). An LIE is a business whose major activity is either exporting its product to other nations, or importing the products of foreign firms. By contrast, an MNE not only sells, but also produces, in foreign markets.

International Risk Management

1.

Why do companies seek cross-border transactions?

Why do countries seek to protect their domestic markets (including insurance)? What is the real impact of international trade on domestic economies? How can an enterprise manage the risks associated with cross-border transactions?

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3.

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International Risk Management

How does risk management in an MNE differ from that in a domestic firm?

In principle, the concepts of protecting the organization against unbearable loss are the same for both types of companies. However, the environment in which these decisions are made can be quite different.

International Issues for Risk Managers

Local insurance regulations and practices

Prohibitions against non-admitted coverage Centralization vs. decentralization of risk management (global vs. local coverage) Local support for risk management (e.g., loss prevention, loss reduction)

Valuation of property for coverage purposes

Foreign currency fluctuations

International Issues for Risk Managers

Local legal environment (due process)

Impact of language on coverage issues Cultural differences: religious beliefs, gender roles, work attitudes, etc. Economic systems: planned vs. market Political structure

Local/Admitted Coverage

What is it? What are the advantages?

Compliance with local law, good citizenship Often needed for local financing Premiums paid locally are tax-deductible Claim payment income not subject to tax Local servicing of claims and coverage issues Premiums and claims paid locally are insulated from exchange rate fluctuation Overcoming local currency restrictions

Local/Admitted Coverage

What are the disadvantages?

Higher costs from bureau rates/tariffs Coverage possibly not as broad as domestic (e.g., U.S.) policies Incompatibility with global insurance programs in terms of renewal dates, limits, deductibles, etc. Possibly difficult to manage (decentralized)

Piecemeal approach can result in costlier program with coverage gaps

May be contrary to risk retention strategy

Local/Admitted Coverage

What are (more) of the disadvantages?

Local services may not be sufficient/appropriate (e.g., loss prevention, loss reduction) Sense of urgency may not be sufficient Potential financial solvency/capacity issues Language issues, coverage interpretations

Non-Admitted Coverage

What is it?
What are the advantages?

Potentially lower costs

Potentially broader coverages

Standardization of expiration dates, limits, deductibles, etc. Easier to manage (centralized) Common currency Greater stability of markets

Non-Admitted Coverage

What are (more) of the advantages?

Common language Coverage disputes subject to domestic law

Non-Admitted Coverage

What are the disadvantages?

May be prohibited by local laws; possible fines and penalties, loss of good citizenship status Domestic premiums not tax-deductible locally or domestically Taxes on claim payments Claims management may be difficult without local service Local management may purchase local/admitted coverage anyway

Centralization vs. Decentralization: Strategic Issues

Should decision making with respect to pure risks be delegated to the management of foreign subsidiaries/affiliates?
One answer: Since the decision to commit assets to foreign operations is made by the parent corporation, the parent should likewise make the decision regarding the methods best suited for protecting those assets.

Agree or disagree?

Centralization vs. Decentralization: Strategic Issues

Can an MNE with a centralized risk management program still buy insurance locally?

Centralized risk management is not inconsistent with decentralized insurance purchases. Purchase of insurance might be delegated to the foreign affiliate, but with guidelines and strict performance standards.

Centralization vs. Decentralization: Strategic Issues

Often, foreign affiliates prefer to deal with local insurers.

In cases where a foreign affiliate was acquired by an MNE, the affiliate may have long-term relationships with local insurers. Reciprocal business advantages may be gained from local purchase of insurance.

Centralization vs. Decentralization: Strategic Issues

In countries where a competitive insurance market does not exist, the MNE may be faced with excessive prices. Are the economic benefits from non-admitted coverage sufficient to offset local financial penalties and escape local insurance entirely? Sometimes, risk managers purchase the minimum permissible amount of insurance locally, and cover the bulk of exposures under a non-admitted difference-in-conditions policy.

Difference-in-Conditions Policies

An MNE with multiple insurance purchases in different jurisdictions can purchase a difference-in-conditions (DIC) policy that serves as a wrap-around, bringing the overall level of protection to a specified level.

A DIC property policy typically affords openperil protection covering losses that local/admitted named-peril policies do not cover.
A DIC policy typically accounts for other coverage differences as well

The Global Insurance Program

A global insurance program is purchased centrally, with a master contract covering all the MNEs risks.

Negotiated in the MNEs home country Combines benefits of non-admitted and admitted coverage Combines coverage of both the MNEs domestic and foreign exposures

One obvious advantage is the potential economy from centralized buying

The Global Insurance Program

One potential difficulty is finding an insurer with a global network of engineers, claim adjusters, and other service personnel. An MNE can easily segment its foreign and domestic exposures, setting up a foreign insurance program separate and distinct from its domestic program.

Global Insurers

Leading U.S. insurers with a significant presence in the international market include AIG, CIGNA, Ace, and Chubb. Non-U.S. insurers with a significant presence include Zurich, Winterthur, Swiss Re, Gerling, Allianz, XL, et al. Buyers usually can access global programs through New York, London, or other major financial centers.

Global Brokers

Several leaders have emerged from a combination of U.S., U.K., and other international brokers:

Marsh, Inc. (MMC) Aon Willis IRMG

These international brokerage/consulting firms are present in most countries, maintaining contacts with local admitted insurers, and capable of creating global programs.

The Global Master Policy

A global master policy is issued on a nonadmitted basis.

The global underwriter instructs local affiliates what policies to issue (subject to local regulations). The master policy provides excess and DIC over local/admitted policies.

Increased limits may be needed if there is a possibility of liability in a country other than where damage occurred (e.g., Bhopal).
A major issue is communication.

Global Communication

Among . . .

Corporate risk manager Local affiliate managers Global broker/consultant Local broker/consultant Global underwriter Local underwriter

Who monitors this complex web?

Foreign Exchange Risks

One of the most significant risks facing an MNE involves variations in foreign exchange rates. An exchange rate represents the number of units of one currency that can be exchanged for another. When a foreign currency declines in value relative to the dollar, a U.S. company suffers a loss from any assets payable in that currency.

Approaches to Dealing with Foreign Exchange Risks

Minimize holding of foreign currencies

Retain currency risks internally. Hedge in the options/futures market for foreign currencies.

Political Risks

MNEs are frequently exposed to political risks.

These are caused by any local governments action (or failure to act) that diminishes the value of a firm operating within its borders. These risks include:

Acts of local governments Acts of local political organizations

Acts of local competing businesses

Acts of terrorists/criminals

Major Political Risks

Expropriation, confiscation, or nationalization of assets of a local subsidiary/affiliate without sufficient compensation Contract frustration or repudiation Changing restrictions on convertibility of currency Damage to property or personnel by antigovernment activity Kidnapping/murder of firms employees War, insurrection, terrorism

Milder Political Risk

Local actions that differentiate between local and international firms:

Changing requirements that MNEs employ some minimum percentage of local nationals Changing requirements that MNEs invest in local social and economic projects Discriminatory practices (e.g., higher taxes, higher utility charges)

Requirements to pay higher wages than a local company

Expectation of bribery/political payoffs

Political Risk Identification

Consider local government history - how power is transferred, etc.

Consider the stability of both national and sub-national governments. Who influences power? Is the rule of law - due process - afforded both locals and foreigners? How can religious/cultural issues impact MNEs employees, product/service reception?

Managing Political Risks

Shared ownership reduces both the likelihood and the potential severity of loss. Enter into a joint venture with local investors:

to establish local support for the firm, and to provide better information on the countrys political/economic conditions.

Limit the amount of capital invested in the local subsidiary/affiliate.

Managing Political Risks

Integrative strategy:

Integrate within the social/economic fabric of the local country.

Borrow funds locally to lessen investment exposure should nationalization occur.

Train managers to become familiar with local culture, customs, and managerial styles.

Managing Political Risk

More Defensive Strategy:

Keep fixed investments and assets to a minimum by leasing whenever possible, and by retaining R&D activities domestically. Maintain ability to move operations quickly and easily to another country. Minimize reliance on local services and utilities.

Political Risk Insurance

Political risk insurance provides protection against three broad types of risks:

Seizure of assets

Currency inconvertibility
Interference with contractual performance

Does not cover credit risk or kidnap-andransom risks.

Political Risk Insurance

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Sources of political risk insurance are extremely limited:

1. 2. 3.

OPIC and MIGA AIG, Chubb, ACE, Zurich Lloyds of London