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Currency exposures: lessons learned in Mexico.

Major and continuous devaluations of a nation's currency have long been a reality of the global economy, with the recent peso crisis in Mexico among the more newsworthy. These realignments of international monetary parity present multinational risk managers with a challenge that calls for their best insurance, financial, analytical and political skills. To deal effectively with this exposure, risk managers and their organizations must first recognize the problem, develop a means of predicting it and have a plan of action in place should a devaluation occur.

Reduced to its simplest terms, the devaluation of a country's currency means that it costs more of a nation's devalued money to buy foreign funds. When a country devalues its currency, thus making foreign currencies more costly, it follows that imported goods also become more expensive. In most emerging economies (where devaluations tend to be more common), sophisticated industrial machinery is often imported as a matter of necessity. In the case of certain companies such as those in the pharmaceutical, electronic and chemical industries, raw materials may be imported as well.

To illustrate how drastically values can change, consider the hypothetical case of XYZ Corporation operating in Mexico (Table 1). In Mexico, the use of fire forms that require 100 percent insurance to value are still the prevalent market practice. Usually they are denominated in pesos (U.S. dollar policies are available, but not common). Failure to insure to full value can result in the application of a "proportional clause" or coinsurance penalty. Assuming it failed to adjust values after devaluation, XYZ Corp. could have been subject to a 37 percent coinsurance penalty on losses. In this example, drawn from an actual situation, the insured went from a sound insurance program to an unchosen and unanticipated retention of US $9,278,000 (assuming a total loss). Additionally, many Mexican business interruption policies contain wording that links coverage to the adequacy of values reported under the property damage policy. Noncompliance with this condition could complicate or jeopardize a business interruption loss settlement. Clearly, then, the loss potential presented by a major currency devaluation is nothing less than catastrophic.

Table 1 XYZ Corporation

Value in U.S. Dollars (Actual)

Imported Machinery

US $15,000,000

Peso Equivalent Before December 1994 Devaluation (US $1 = 3.44 Pesos) and

Amount Insured

Pesos 51,600,000

Peso Equivalent After December Devaluation (US $1 = 5.47 Pesos)

Pesos 82,050,000

Underinsurance in Pesos and Dollars

Pesos 30,450,000

US $5,567,000

Value in U.S. Dollars (Actual)

Imported Raw Materials and Finished Product Purchased from Abroad for

Resale

US $10,000,000

Peso Equivalent Before December 1994 Devaluation (US $1 = 3.44 Pesos) and

Amount Insured

Pesos 34,400,000

Peso Equivalent After December Devaluation (US $1 = 5.47 Pesos)

Pesos 54,700,000

Underinsurance in Pesos and Dollars

Pesos 20,300,000

US $3,711,000

HANDWRITING ON THE WALL?

No one can predict with certainty the impending devaluation of a country's currency. Nonetheless, most devaluations have been preceded by one or more of the following major warnings that should alert the risk manager and other parties involved to the possibility of a devaluation:

Increasing foreign indebtedness. This situation requires government intervention to protect the integrity of the country's currency.

Deficit trade balance. As a devaluation acts as an immediate incentive for additional exports (which have been made less expensive and thus more competitive in world markets) and a disincentive for imports (that, conversely, are made more costly), the government may decide a devaluation is the best corrective measure available.

High inflation and increasing rates of inflation. If domestic prices rise above levels found in other countries, a devaluation may be necessary to regain economic equilibrium.

Changes in quotations on the foreign exchange markets. The traders in these markets are professionals with substantial research backing up their buy/sell decisions. By following their quotations, corporations can benefit from the considerable investigation they have conducted.

Capital flight. When capital begins to leave the country, it indicates that domestic investors have lost confidence in their own currency. The capital depletion affects local industry, thus beginning a vicious cycle.

Of all the resources available to alert managers to the possibility of a major devaluation, probably none is more accessible or suitable than his or her own international financial department. The key factor is close coordination and communication. Financial personnel must be advised that the corporate team responding to a devaluation should include at least one representative of the risk management department.

PLOTTING A STRATEGY

The following is a checklist of actions that companies should take to insure the adequacy of an insurance program affected by a devaluation:

Property Damage and Business Interruption

For a multinational insured that has a controlled master program supported by locally issued policies, the master property damage/business interruption policy should have a devaluation clause providing nonadmitted protection for changes in values and the possible application of coinsurance deficiency penalties. Including this clause could be crucial, because adjusting local values may take some time.

Locally insured values for imported machinery, raw materials and finished products imported for resale should be adjusted immediately, if only on a provisional basis, until the situation is stabilized. Alternatively, where both possible and appropriate, consideration should be given to issuing local policies on a dollar-denominated basis, particularly for the imported goods mentioned above. If done before a devaluation, there should be no exposure to a shift in currency alignments.

The devaluation will increase local inflation and thus affect the adequacy of values insured for buildings and other domestic items. While the effect on these items is not immediate, it can take place very quickly and should be monitored closely.

A new business interruption work-sheet should be completed locally. The insured earnings could change, with a decrease in values especially likely for companies with imported raw materials and government-controlled prices for finished goods.

Local inflation endorsements, designed to adjust values automatically, should be reviewed before and after the devaluation for adequacy. Do not let such an endorsement lull you into a false sense of security.

Local and nonadmitted deductibles should be reviewed. In dollars, the local deductible at a given location could be decreased by the devaluation. Taking a higher, local currency deductible may help to partially offset the additional costs of increasing sums insured. Conversely, what may have once been an acceptable deductible for a local subsidiary to bear on difference-in-condition perils losses could now be much too high.

Transport Insurance

Policy limits should be reviewed for imports as well as exports. On open policies requiring monthly reports, imports should be reported at a new exchange rate.

Sales terms may need to be modified. It may no longer be possible or practical for the affected subsidiary to insure in dollars. Shipments to the foreign subsidiary may now be protected most effectively if purchased on a cost, insurance and freight (CIF) basis, if the laws of the receiving country permit it.

CGL, Crime/Fidelity and Other Lines

If the intended structure of the program was for the local and master coverages to "dovetail," check to make sure that this goal is still being achieved after the devaluation. (See for example Table 2.)

Table 2(*) XYZ Corporation

CGL Limit in US Dollars

$1,000,000

Peso Equivalent Before Devaluation ($1 = 3.44 Pesos)

Pesos 3,440,000

Peso Equivalent After Devaluation (US $1 = 5.47 Pesos)

Pesos 5,470,000

"Gap" After Devaluation

Pesos 2,030,000

US $370,000

(*)Assuming a worldwide liability program that contemplates US$1,000,000 underlying layers.

Local limits also need to be reviewed in the country following the devaluation. For example, a government-decreed wage increase may follow a devaluation. In countries where blue-collar payroll is often paid in cash, this has an immediate effect on the adequacy of limits for crime coverages.

Also, ensure that local limits required to comply with worldwide program requirements are not excessive or, perhaps, even unobtainable following the devaluation. A new, higher exchange rate may mean that minimum requirements for underlying layers expressed in dollars (when converted to the local currency at the new exchange rate) can become absurdly high or not available from local underwriters. Restructuring the master policy or a "dip-down" endorsement for the country affected may be necessary.

There are other considerations as well. For example, following the devaluation, the market security of all indigenous insurance carriers utilized in-country should be reevaluated. To the extent that they are subject to debt denominated in a "foreign" currency (i.e., non-peso), the cost of repayment escalates dramatically, balance sheet quality is affected and credit ratings can decline. The global program, placed with a controlling insurer (or panel of insurers), allows one to mitigate this exposure in part by writing "cut-through" wording into the master policy.

If a company has a captive, the procedure for handling foreign exchange rates should be written clearly in the reinsurance contracts. This critical step affects not only income but also expenses regarding pending losses, "incurred but not reported" (IBNR) losses and acquisition costs. The captive should not bear foreign exchange risk.

It is also important to adjust values for insured royalty and licensing fees (usually nonadmitted). Contracts regarding these fees should be written with a foreign exchange provision explaining how a devaluation will be handled. Also, the company should review its interdependency exposures to determine if they have been affected. This might be true if the affected country is used as a sourcing point for other subsidiaries.

Finally, verify at what exchange rate pending claims will be paid. Is a past loss adjustment to be recalculated? Much of this should have been spelled out in the master policy. A company relying on purely admitted coverage may take a foreign exchange loss on a claim settlement. Management should contact tax counsel in these situations because the loss may be offset partially through tax considerations.

TRANSLATING WORDS INTO ACTION

While the logic of these steps may be apparent, their implementation will require a good deal of tact and, occasionally, clout. Following a devaluation, local general and/or finance managers may discover, among other things, that their planning and budgeting for the year must be redone; that unions want emergency pay raises; and that the government will not allow an increase in prices on controlled items. Myriad problems relegate the insurance program to the back burner. At times such as these, it is crucial that the company's risk manager and international broker act as a catalyst to bring local management's attention to the problem.

A legitimate concern likely to be raised by the local subsidiary is the increasing cost of maintaining adequate insured values. In the XYZ Corp. example, the peso cost of maintaining insured values in compliance with the valuation clauses of the local policies (100 percent) increases dramactically. (See Table 3.)

Table 3 XYZ Corporation

Dollar Value (Actual)

Machinery

US $15,000,000

December 1, 1994 Peso Equivalent ($1 = 3.44)

Pesos 51,600,000

January 13, 1995 Peso Equivalent ($1 = 5.47)

Pesos 82,050,000

Premium (Calculated at rate of .12 percent)

Dec. 1 Pesos 61,920

Jan. 13 Pesos 98,460

Dollar Value (Actual)

Raw Materials

US $10,000,000

December 1, 1994 Peso Equivalent ($1 = 3.44)

Pesos 34,400,000

January 13, 1995 Peso Equivalent ($1 = 5.47)

Pesos 54,700,000

Premium (Calculated at rate of .12 percent)

Dec. 1 Pesos 41,280

Jan. 1 Pesos 65,640

Note: Comparative exchange rates drawn from The Wall Street Journal using pre-devaluation date of December 1, 1994, and post-devaluation date of January 13, 1995.

As indicated, simply to maintain the same actual values insured for machinery and raw materials alone, the total premium in pesos climbed from 103,200 to 164,100--an increase of 59 percent. It is unlikely that the subsidiary's income would have increased proportionally. Thus, all possible savings in the insurance program would now become more crucial than ever.

PREPARATION AND VIGILANCE ARE ESSENTIAL

To deal successfully with the risk of devaluation, international risk managers must have the means of identifying potential candidates. Risk managers should also know in advance the steps that need to be taken because a loss closely following a devaluation could be devastating. A properly conceived plan will reduce the time lost in making necessary adjustments. Finally, the company's financial management should be sensitive to the situation facing local management and not expect their response to be immediate without considerable communications. This requires the use of all resources in implementing the necessary changes. This combination of anticipation, preplanning and implementation of the actual plan will ensure that the problems of devaluation have been well-managed.
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Title Annotation:risk managers dealing with devaluation of currency
Author:Hutchin, James W.
Publication:Risk Management
Date:Jul 1, 1995
Words:2110
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