Earnings insurance - mission impossible?

Wall Street and its analysts aren't very tolerant of companies that fail to meet earnings targets. Thus, it's no surprise companies seek ways to avoid their wrath. Add the growing percentage of senior management compensation tied to share price and there's more incentive to look for every possible edge. In this context, both buyers and sellers have been seeking the financial "Holy Grail" - a way to insure meeting earnings targets.

While the insurance industry is not, and probably never will be, in a position to actually insure such a thing, the tools and techniques it's developing to pursue it are benefiting many companies. The greatest growth is in expanding globalization of business; advances in technology; convergence of the financial markets; and development of enterprise risk management.

It's A Small World 

Globalization offers advantages as it creates new risk categories. Consider the hazards of setting up shop in countries that didn't exist a few years ago, or of trying to anticipate the effects a single European currency might have.

Mergers and acquisitions also create new risks. As firms consolidate, they have to rely on fewer suppliers, upping the odds of a supply chain breakdown.

Then there's the movement to more consistent financial reporting standards. This creates a more level playing field, but eliminates some of the historic benefits available to companies able to establish contingency reserves on their financial statements.

Firms are examining their traditional business practices to find efficient ways to mitigate or transfer such risks. Two increasingly prevalent tools include forming joint-venture companies or using hedging products. Companies that traditionally "did it all on their own," or those that found hedging too difficult or complex, are reviewing their stand.

The insurance industry is responding with new and redesiged products. Political risk coverage, for example, has existed for years. But increased capacity and broader definitions of loss enhance its value. And business interruption insurance, a mainstay of the standard property policy, can protect against supply chain disruptions.

Information Equality

While globalization has a macro effect on the way companies do business, technology has both macro and micro effects. More powerful computers, web search tools, e-mail and shared databases let virtually anyone in a firm's risk management, corporate finance and treasury departments retrieve previously unavailable, sophisticated models and data. Thus, we see new ideas for addressing risk emerging from throughout an organization. And insurance brokers, risk consultants, investment banks, insurers and other financial gurus have more capability to help their clients analyze risk.

Technology's flip side is the birth of significant new risks. Y2K preparedness, litigation risks due to old e-mail files and greater reliance on smaller, more sophisticated (and often more expensive) equipment are but a few examples. Their impact remains to be seen.

One area where there's a need, as well as a response, is e-business. For an Internet business whose web site can't be accessed by customers or business partners due to a hacker or programming error, traditional property coverage would not apply. An electronic "store" may suffer damage, but not from a fire or other traditionally insured property peril. However, new insurance coverages and risk management solutions address these emerging exposures.

The merger trend will further the cycle of technology transfer between different financial sectors as the distinctions among financial service providers continue to blur. This means buyers now have access through many portals to the best capabilities of the financial service community, and virtually limitless ways to combine technology across disciplines. Insurance companies offer hedges in insurance policy wrappers; securities firms issue bonds that act like insurance policies; and multiple parties are players in the derivative and hedging markets. This creates tighter margins and shorter product development cycles.

Buyers benefit as competition increases and choices proliferate. Only a few years ago to hedge foreign currency meant buying a forward or an option from a bank. Today you can purchase a single insurance policy that combines foreign exchange risk with property and liability risks. The result: a cost-effective, multiyear program that yields foreign exchange protection without the need to enter into a derivative.

While buyers realize some benefits, providers bear the brunt of this new competitive burden. They're forced to adjust faster to the wider spreads and better pricing the most creative products command. This is another factor pushing joint ventures and consolidation, as companies need a larger base to absorb the cost of research and development.

Dynamic Discipline

What's merging all these forces is enterprise risk management, the discipline of systematically and comprehensively identifying, quantifying and addressing the collective impact of critical business risks to maximize shareholder value. It has several key components:

* It's ongoing and dynamic.

* It calls for analysis of hazard, financial, operational and strategic risks.

* It requires that risk be measured and analyzed, not evaluated on a "gut feel" basis.

* It means seeing risks collectively to evaluate their effect on the whole firm, not just on a subsidiary or operating unit.

* And it means the ultimate measure of any risk management program's effectiveness is maximizing shareholder value.

Despite the allure that insuring earnings may hold for some, it makes little practical sense. In the first place, companies hire competent management to provide the vision and leadership to drive earnings. Second, insurers are only willing to cover truly fortuitous events. It's debatable whether insurers would ever cover certain events that are fully under management control. If so, the premium might be unacceptable to buyers. What makes economic sense - for both buyers and providers - is to identify the components of earnings volatility that could cause declines but have nothing to do with management's ability. Insofar as a company can cost-effectively transfer risks that don't represent its core competency, it's logical to do so.

A weather-dependent company - like a manufacturer of snowblowers - is a perfect example. It can't control snowfall, but winter weather can dramatically affect its profits. One marketing tactic would be to offer customers a rebate if it doesn't snow a predetermined amount. But transferring the risk is an equally astute financial maneuver. So, just as companies work to outsource non-core competencies, they should seek to outsource or transfer risks over which they have little control to a third party that may have better analytical capabilities and the ability to aggregate and spread the exposure over a larger pool.

This is where the insurance and financial marketplace can be most effective. Insurance companies' core competency is the capacity to assume and distribute risk. Financial services firms are experts at taking on risk in order to transfer it into the capital markets.

The ability to transfer fortuitous earnings volatility drivers is the key benefit of the quest for earnings protection, as there's proof that reducing volatility enhances shareholder value. What's new is the recognition of a growing appetite and capability in the financial services marketplace to assume different types of risks. Not only is it possible to transfer financial and hazard exposures, but also some operational and strategic risks. Financial products now can insure project performance, such as the number of cars to use a toll road or the ridership on a subway. In the financial risk arena, the ability to transfer risk beyond the capabilities of standard capital market products grows daily. As a result, savvy financial executives should leverage these tools to help put the company on the right quest - not to insure earnings, but to reduce earnings volatility.

Martin H. Scherzer is a managing director at Marsh & McLennan Companies, Inc.