Last November, Robert Merton, the Nobel prize-winning
finance professor, wrote an article for the Harvard Business Review arguing that a bolder approach to risk management could double, or even triple, a company's ability to invest in its core business. Rather than just hedging against the risk of interest rate and commodity price fluctuations, he wrote, derivatives could be used to transfer away all of the risks in which a company does not have a natural advantage--goodbye to the risk of supplier delays or business interruption and the risk of fraud or lawsuits! All of these non-core risks could be shipped off to someone else, leaving the company with more capital to invest in the risks it is in business to take--whether that's designing and marketing automobiles, mining or brewing beer.
Alert readers may have spotted a flaw in Merton's argument: The derivatives needed to transfer these risks don't exist. But that's a picture some specialists are trying to change.
One firm that's working to usher in this brave new world of risk transfer is Giuffre Associates, a small Wilton, Conn.-based boutique. Sandra Giuffre, the firm's founder and one of three principals, offers a similar argument to Merton. She believes that every company has a continuum of risk. Some of these risks lie in the company's "sweet spot." These are the risks which a company knows more about and is better at managing than anyone else. Other risks are less familiar.
CONQUERING THE UNKNOWN
As an example, nobody is going to insure a film producer against making a flop. That's what the company is in business to do--it knows the industry better than anyone else and delivers value to shareholders by picking the right films. But a film could be a flop for reasons that a producer has no control over--such as the outbreak of a pandemic that leads to a decline in the number of theater-goers. It's these awkward risks, which companies aren't well positioned to manage, that Merton--and Giuffre-- believe should be transferred away.
As things stand, some of these non-core risks are covered by insurance, others by equity or--in the case of catastrophic losses--by bondholders. Giuffre's argument for transferring these risks away is that other entities like banks, insurers or investors may have a sweet spot for them. The aim--and it's nothing if not ambitious--is to find the best place for all of these different risks to reside. In theory, the result would be a far more efficient, flexible and resilient economy powered by companies who were able to focus solely on doing what they do best.
Giuffre and her colleagues are, as far as they know, the first firm to enter this potential market. Currently, they're accepting mandates from companies who want to sell risk and then looking for people who are better placed to take that risk. Most of the companies trying to sell risk are non-financial corporates. Says Giuffre: "They get it. They also tend not to overcomplicate the trade."
None of this new breed of derivatives has yet been transacted, but Giuffre says it's only a matter of time. The firm is well-advanced in a transaction that would see $100 million of fraud risk transferred from one company to another. It also has orders outstanding to transfer business interruption risk and is working on a transaction that would protect pension funds from longevity risk--the threat that employees could live longer than expected. It's a ticklish process, involving a lot of to-ing and fro-ing, and Giuffre is prevented by non-disclosure agreements from talking in detail about deals that are in progress. The firm is also keen to keep its specific approach under wraps for fear that others will try to muscle in.
The advantage of derivative-type structures is that they avoid some of the claims and coverage pitfalls that infuriate insurance customers, she says. Insurance contracts appear to offer comprehensive cover, but then chip away at that cover with a series of exclusions and conditions, resulting in a transfer of risk that can be miles away from what the company was expecting. Often, the gaps in coverage are only discovered when a claim is made--and even successful claims can take months, or even years, of arbitration and litigation to settle. Giuffre, who used to work at insurance giant Marsh Inc., claims these problems stem from a "productized" approach to insurance: "When I worked in insurance, I had to understand a company's risks and write cover to match. If cover didn't exist, I was expected to go to the market and create it. Today, it's about selling a product--it's like using a calculator and not understanding the underlying math. There aren't enough people in the industry that understand the underlying math."
By contrast, derivatives can be tailored to cover very specific risks: "We work with our clients to define what's bothering them really clearly. It's about getting it worked down to a really tight point." Contracts are then drawn up which incorporate objective triggers, which result in the hedger being paid. Giuffre suggests the example of a derivative in which payment is triggered by a magnitude 6.0 earthquake: "If it's 5.9, it doesn't pay out. If it's 6.0, it does. Either way, we don't wait until after the event and then look for loopholes in the coverage."
The structures being used to transfer the risk vary. In some cases, a straightforward swap-like structure makes most sense. In others, she says, a single company poses too much risk for a single transfer. Instead, Giuffre pools similar risks from many sellers, and this achieves diversification, because it's highly unlikely that all of the risk sellers will be affected at the same time.
Giuffre stresses that the risks are not new; she and her colleagues are simply looking for a better home. She also has no illusions about the task facing her firm as it tries to singlehandedly create a market. Still, it must be helpful to have luminaries like Merton on her side: "It's about taking baby steps, and the first step is for people to accept that the risks they always thought were not transferable could be." - Duncan Wood
Visa and Deloitte report on the best practice advice systems integration
It's no secret that after years of hearing about the advantages of automating the procure-to-pay process, many companies continue to stumble when it comes to the final part, integrating an automated payment process. Breaking old habits is downright difficult, especially when it comes to replacing traditional checks with methods such as automated clearinghouse (ACH) or commercial cards.
Visa U.S.A., with help from Deloitte Consulting, studied the habits of 20 highly successful companies that built ERP, accounting, procurement or other systems and have also successfully integrated an automated payment process at the end. The findings are contained in a 60-page paper, the Practical Guide to Commercial Card Integration with e-Procurement and ERP Applications.
Perhaps the biggest commonality among the companies studied was the amount of forethought that went into best-practice operations, including such organizational steps as creating a payment integration team to establish strategies and tactics and then document the process. "These high performing companies are getting the maximum business potential," says Laima Kardokas, director of program optimization in the commercial solutions area at Visa U.S.A. "[Other] companies can glean from all that variation out there some basic key architecture techniques banks and companies should follow to integrate final payment into the process."
The high payment achievers also created guidelines for three other payment integration steps involving purchase, reconciliation, and payment and settlement procedures. The switch to integrated payment didn't come cheap; the companies' costs for integrating the commercial card with their e-procurement or ERP systems ranged from $140,000 to $1.3 million. But they also are finding annual savings from integration, ranging from $360,000 to $900,000.
The study found efficiency benefits involved more streamlined processes, including cutting back on time and labor involved with accounts payable and accounts receivable processing, and faster reconciliations. "They reduced the time employees need to touch transactions, with less paper coming in and reduced fees," says Kardokas. "They were also able to allocate employees to more valuable types of enterprises and jobs." Cost savings included more access to rebates from member banks based on their growing card program volumes. They also were able to leverage a newfound wealth of spending data to negotiate better prices and consolidate spending with vendors. Visa is providing the report to member banks, so they can pass it on to their corporate customers. -- John Labate