The University of Nottingham

CONTINGENT CAPITAL SOLUTION: INTEGRATING CAPITAL MANAGEMENT INTO RISK MANAGEMENT by Luong Thi Thanh Huyen

2006

A Dissertation presented in part consideration for the degree of MA Risk Management

Acknowledgements
I would like to express extreme gratitude to my supervisor Professor Bob Berry who gave me insightful comments and suggestions during the course of my dissertation. His supervision directed me throughout establishing this work, overcoming difficulties during my progress, and also challenged me with constructive questions to develop and refine my ideas.

Im also indebted to my family, friends and colleagues who have continuously given me support throughout the hard days of my studies. I would like to express my deepest gratefulness to my parents who gave me life and nurtured me with their endless love and educational parenting that guide me through the path of my life.

Finally I would like to thank all the staff at Nottingham University Business School whose dedicated course administration has made my time at Nottingham a rewarding and unforgettable educational experience.

Abstract
This dissertation studies a risk management approach which integrates capital management into risk management by enabling post-loss capital issuance at pre-loss terms, the contingent capital approach. This new approach is examined following an evaluation framework used in studying the value of risk management. The analytical evaluation suggests that using contingent capital brings in benefits in mitigating underinvestment problem and reducing cost of issuing capital, but its impact on tax liabilities, agency conflict, and costs of financial distress might not result in value enhancement as the theory predicted. It is therefore advisable that firms take into account various effects of different risk management approaches, especially those involving integration of different corporate functions, to make appropriate decisions for their risk management programs.

List of figures and tables

Figure 1: Major categories of corporate risks Figure 2: Risk Management Process Figure 3: Risk Management Choices Figure 4: Convexity in tax schedule Figure 5: Contingent capital contract when set up and when triggered Figure 6: Life of a contingent capital option Figure 7: Classification of contingent capital instruments Figure 8: Contingent debt facilities - Pre-trigger and Post trigger Figure 9: Contingent Surplus Notes Pre-trigger and Post-trigger Figure 10: Loss equity put Pre trigger and Post trigger Figure 11: Reverse convertible bond Pre-trigger and post trigger Figure 12: Reverse knock-in put option Figure 13: Contingent capital option Figure 14: Traditional view of corporate capital structure Figure 15: The Insurative Model

Table 1: Comparing after-tax profit of volatile and fixed earnings in progressive tax rates Table 2: Directory of Contingent Capital Deals Table 3: Impact on tax liabilities of using contingent capital Table 4: Impact on manager-shareholder conflict of using contingent capital option Table 5: Impact on cost of issuing capital of using contingent capital option.

Table of Contents
Chapter 1 Introduction 5
Background......................................................................................................................5 Objectives and Structure..................................................................................................6 Methodology....................................................................................................................7

Chapter 2 Overview of Corporate Risk Management

What is Corporate Risk?..................................................................................................8 The Risk Management Process......................................................................................10 Development of Risk Management Approaches ...........................................................11 Overview of Alternative Risk Transfer .........................................................................16 Why Do Firms Manage Risks?......................................................................................19 What Make Managing Risk Difficult? ..........................................................................25

Chapter 3

Introducing Contingent Capital

28

Contingent Capital Defined ...........................................................................................28 When Do Firms Need Contingent Capital? ...................................................................28 Construction of Contingent Capital Facility..................................................................30 Classification of Contingent Capital Instruments..........................................................35 Pricing Issues .................................................................................................................41 Contingent Capital as a Component of Corporate Capital Structure.............................44 Market and Participants .................................................................................................48 Featured Case ................................................................................................................51

Chapter 4

How Might Contingent Capital Add Value?

54

Impact on Tax Liabilities...............................................................................................54 Impact on Financial Distress Costs ...............................................................................57 Impact on Shareholder Manager Relationship ...........................................................60 Impact on Underinvestment Problem ............................................................................64 Impact on Costs of Issuing Capital................................................................................66 What Make Using Contingent Capital Difficult? ..........................................................69

Chapter 5

Conclusions

72

Does contingent capital add value? ...............................................................................72 Is it here to stay? ............................................................................................................73 Limitations.....................................................................................................................74

References

76
4

Chapter 1
Background

Introduction

Risk management has increasingly been given attention over the past two decades as a function within corporate financial management as well as a new academic area developed based on established disciplines. According to a global survey on corporate finance practices conducted on 334 corporations across industries and geographical areas, risk management function is considered a component of the overall finance function which is reported to contribute 11% to the value of the firm. The risk management function is reported to contribute 3.8% of the market capitalisation of a firm, which is about 35% of the overall finance function (Servaes and Tufano, 2006). Many corporations have appointed Chief Risk Officer to be in charge of risk management issues, reflecting increased board attention given to this function (Butterworth, 2001). As a new academic area, risk management has been introduced in many university courses bringing together knowledge in finance, insurance and corporate management. This blend reflects the evolution of the area from being dominated by traditional insurance to incorporating the development of the concept of risk diversification in finance, and now being considered a strategic function dealing with competitive, corporate governance, and regulatory concerns. In the market of risk management solutions, insurance is still the most popular solution with a large majority (83%) of corporations in the study of Servaes and Tufano (2006) reporting using insurance, followed by derivative securities such as foreign exchange derivatives (82%), interest rate derivatives (79%). Being the market leader, the insurance industry has undergone substantial changes to cope with changing risk appetite and environmental risks to protect themselves and develop their risk-trading business. As specialists in risk pooling and diversifying, insurers also suffer from systematic risks, i.e. risks that cannot be diversified across insurance policies, such as natural catastrophes and terrorist attacks (Munich Re, 2001). The traditional channel for insurers to hedge against such risks is the reinsurance market where insurers buy insurance coverage for their portfolios and ensure sufficiency of their inventory, i.e. capital stock. As the level of natural catastrophe increases in terms of loss amounts and intensity, the reinsurance 5

market appears to get saturated and insurers start to approach the capital markets to hedge their risks, creating a new range of solutions that provide capital assurance (Munich Re, 2001). In addition, increased competitive pressures make corporations more concerned about integrated solutions to manage their multiple risks coming from natural disasters, supply disruptions to employee actions. The aim of corporations in undertaking risk management is to ensure sufficiency of funds to finance their investment opportunities (Froot et al, 1993). This aligns with the above trend in the insurance industry leading to some insurance risk solutions being introduced to non-insurance corporations. One of those solutions is contingent capital which has grown from a capital arrangement scheme among insurers and reinsurers to a risk financing facility for non-financial clients (Banham, 2001). Such evolution requires thorough study to explore its implications, drawbacks and potential to promote its use in an informed way. This is the also ultimate aim of this dissertation.

Objectives and Structure

To achieve the above aim, the dissertation will go into answering the following questions: What is corporate risk management? What are the approaches to manage corporate risks? What is contingent capital? How has it been used? How might it add value? Will it stay?

These questions are constructed to lay a firm ground in general risk management before approaching the practical issue of contingent capital. First, chapter 2 will present an overview of corporate risk management including general classification of corporate risks, risk management approaches, and the rationales for firms undertaking risk management. The idea is to introduce the origination of risk management and the framework used to evaluate risk management activities. This chapter also outlines Alternative Risk Transfer solutions which have been developed as a new trend in the field. Subsequently, chapter 3 will introduce the risk management approach in focus, contingent capital. Apart from general information such as construction and usage of contingent capital, this chapter also 6

summarises some discussions on pricing based on option pricing framework, and a model that views contingent capital from the perspective of capital structure. The idea of including these arguments is to introduce different viewpoints about contingent capital and give audience a broad view before coming into analysis. These arguments, however, are still subject to debate hence will not be used as the basis for analysis in the subsequent chapter. The analysis in chapter 4 is based on the framework of valuing risk management activities introduced in chapter 2. This part aims at investigating whether using contingent capital results in similar benefits as the theory of general risk management predicted. Additionally, this chapter highlights potential difficulties in using contingent capital observed from some cases widely known in the field. Finally, chapter 5 presents conclusions from the analyses and predictions about the prospects of contingent capital.

Methodology
This dissertation approaches the issue of contingent capital via summarising a range of literature on corporate finance, risk management, and insurance, to argue for the role of the new risk management approach. The extensive literature review aims at providing a comprehensive background for the topic which stands among different academic areas. Moving on from this background, the study employs an established framework used in evaluating general risk management activities to study the value of contingent capital. The analytical framework used has been referred to in a number of articles both on theoretical as well as empirical sides (see chapter 2). Therefore, it serves as a fruitful setting to explore a new issue in practice. The analytical arguments presented will be illustrated by examples constructed in generalised contexts to prove and synthesise the point being discussed. Given the small number of contingent capital deals known to date, the generalisation approach employed fares better than empirical study in enabling a view of the issue free from noise, i.e. specific details of cases with different patterns which could cloud the analysis and result in inconclusive arguments (Mackzyk, DeMatteo, and Festinger, 2005). This approach, however, has certain limitations which are discussed at the concluding chapter of the dissertation. 7

Chapter 2 Overview of Corporate Risk Management

What is Corporate Risk?
Corporate risk is concerned with possible reductions in firm value which depends fundamentally on the expected size and timing of the firms future cash flows (Harrington and Niehaus, 2003). Therefore, major sources of corporate risk are unexpected changes in expected future net cash flows which can be broadly categorised as price risk, credit risk, and pure risk.

Major categories of corporate risks

Corporate Risks

Price Risk

Credit Risk

Pure Risk

Output Price Risk

Input Price Risk

Damage to assets

Commodity price risk Exchange rate risk Interest rate risk

Legal liability

Worker injury

Employee benefits

Figure 1: Major categories of corporate risk (Harrington and Niehaus, 2003).

Price Risk refers to unexpected changes in output and input prices which place uncertainty over the magnitude of future cash flows. While output price risk is concerned with demand for the firms goods and services, input price risk is concerned with costs of labour, materials, capital associated with the firms production process. Both input and output price risks are influenced by fluctuations in prices of three core elements: 8

commodities, exchange rate, and interest rate. These three specific types of price risk reflect the uncertainties in doing business that every firm has to face directly or indirectly.

Credit Risk refers to the possibility that the contractual parties of a firm fail to make their promised obligations. Most firms are exposed to credit risk by either selling on credit to customers or lending money to other firms. When the firm borrows or buys on credit, it in turns increases credit risk for the counterparty and thus faces higher costs in borrowing.

Pure Risk refers to the uncertainties in running day-to-day operations of a business. This is also the focus of traditional risk management which primarily employs insurance to reduce risk and finance losses. The categories under pure risk are concerned with physical assets, product liability, and employee welfare, which typically have the potential to create large losses for firm value but little potential to bring in large value gain (Harrington and Niehaus, 2003). These pure risks are also more controllable by the firm than price risk and credit risk as internal preventive measures could be taken in day-to-day operations to reduce the frequency of the underlying causes of pure risk (Williams et al., 1998).

There are also a variety of other risk classification schemes which are considered different angles to look at the same picture (Harrington and Niehaus, 2003). The distinction among risk categories has been emphasised to refer to different risk management approaches such as insurance, derivative hedging, and product diversification that serve some particular risk categories, but the broad management strategies are the same for all types of risks. In fact, the importance of differentiating risk categories has become less profound as risk management approaches have integrated to serve different sources of risk (Banks, 2004). This will be further explored in a later section of this chapter. Lets now take the beginning definition of corporate risk as a central theme and look at the process of risk management to see how the broad strategies can be applied for different kinds of risk as a whole.

The Risk Management Process

Despite different risk categories, risk management strategies can be summarised by the key steps in the diagram below.

Risk Management Process

IDENTIFY significant risks

EVALUATE potential frequency and severity of losses

DEVELOP AND SELECT methods for managing risk

IMPLEMENT the risk management methods chosen

MONITOR the performance and suitability of the implemented methods on an ongoing basis Figure 2: Risk Management Process (Harrington and Niehaus, 2003). This process shows that a risk management method can only be selected after risks are identified and evaluated in terms of frequency and loss severity. Once selected and implemented, the method will be monitored throughout the course of its implementation. Therefore, although different risk classification schemes can help to better understand the nature of the risk being managed, they do not influence the sequential steps that a risk manager has to undertake. Moreover, with the dramatic growth and a trend of integration of different risk management approaches such as insurance, financial derivatives, and other structured financial products, it is increasingly necessary that corporate risk managers have a broad understanding of business risks and different approaches available to tailor their risk management programs (Shimpi, 2001).

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Development of Risk Management Approaches

With each kind of risk which has the possibility of influencing a firms future cash flows, the firm has a number of choices to respond which can be summarized in the diagram below.

Risk Management Choices

Avoid Accept

Prevent Transfer or Finance

Reduce Diversify

Retain or Self-Insure Insure Derivative hedging Other contractual risk transfers Sub-contract or Outsource Enter joint-ventures Alternative Risk Transfer (ART)

Figure 3: Risk Management Choices. Source: Adapted from Billings and OBrien (2006). As the diagram shows, with any risk that arises, a risk manager can choose to either avoid it totally, i.e. not getting involved in the activity that is exposed to the specific risk, or accept it and consider how to go about managing it. The choice at this stage must take into account the strategic objectives of the firm in considering whether to undertake the risky activity and the firms available resources in managing the arising risk. A manufacturing firm exposed to oil price risk may have to accept the risk and think of ways to mitigate it but can consider avoiding an agreement to sell on credit to a dubious customer.

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For firms who choose to take risk, there are four choices to consider: Risk prevention: This approach aims at preventing risks from happening by reducing the frequency of their occurrence (Harrington and Niehaus, 2003). This is an ex-ante approach to risk management as it manages risk before the loss ever takes place. This approach is representative of the antipationism school of thought, the mainstream view in risk management, advocated by authors such as Turner (1994), Blockley and Toft (cited in Hood and Jones, 1996) who believe that an organisations proneness to failure can be identified and hence the related losses can be prevented. Actions that can be taken to prevent risk include regular inspection of safety procedures and quality assurance, and staff training to increase awareness of possibility of loss occurrence. Risk reduction: Unlike risk prevention, this approach focuses on reducing the magnitude of potential losses that could occur (Harrington and Niehaus, 2003). It is an ex-post approach to risk management as it attempts to recover to the greatest extent possible of the loss incurred. This approach is representative of the resilience school which argues that it is too difficult to anticipate and prevent all risks and that risk management should focus instead on reducing the impact of loss (Billings and OBrien, 2006). Specifically, this approach views risk as arising from a chain of causation, i.e. one event happening causing another leading to another and ultimately resulting in loss, so the cause of loss can only be identified with hindsight. For example, a fire in a plant could happen because of employee negligence in performing safety procedures, which could be the result of inadequate training and lack of regular inspection, or irresponsibility due to poor compensation and working conditions. Therefore, a series of non-risky or low-risk factors can link together and churn out unexpected events, making tracing the source of loss to prevent a problematic task (Turner, 1994).

Examples of actions taken to reduce risk include installing sprinkler systems in factory to minimise damage of a fire, and making contingency plans to adjust manufacturing systems in case of a supply disruption.

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Risk diversification: In addition to risk prevention and reduction which typically involve operational measures, businesses can select internal risk reduction via strategic diversification of their activities. Examples of this type of technique include diversifying product lines, customer groups, and suppliers. Together with risk prevention and reduction, risk diversification is also an internal non-financial approach which a business can select to use to manage the risks it has accepted. The basic premise of this diversification approach lies in a fundamental concept in finance that when risky factors are pooled together, the resulting risk will be lower than the sum of the individual risks pooled, as long as they are not perfectly positively correlated (Doherty, 2000).

Risk transfer or finance: This approach involves using financial resources to either transferring the accepted risks to another organisation or financing the loss once incurred. There are four broad methods of this type including (1) retention, (2) insurance, (3) hedging, (4) other contractual risk transfers which can be further classified into subcontract or outsourcing, alternative risk transfers, and entering into joint-ventures.

o Retain or Self-Insure: Businesses can choose to retain the accepted risks and hence become obliged to pay for part or all of the losses once incurred. This also means that they self-insure or finance the risks themselves without employing external sources. Losses can be financed by internal cash flows set aside from ongoing activities or investments in liquid assets or external capital via borrowing and issuing new equity. The last option is typically more costly and results in increased burden for the capital structure, i.e. either higher leverage if borrowing or diluting stockholding if equity is issued.

In addition, insurance-related services such as claims handling, loss adjustment can be brought in as necessary. In practice, self insurance tends to be used in specialist industries such as nuclear power whose idiosyncratic risks are not insurable by conventional insurance, or in multinational corporations with sufficient resources and capability to bear and diversify risks by themselves (Billings and OBrien).

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o Insurance: This method involves a contract between an insurer and an insured company which would result in compensation paid out by the insurer if a loss happens to the insured as specified in the contract. Effectively the company is transferring some risk of loss to the insurer who will then pool a large number of individual client risks to achieve risk reduction via diversification. A typical insurance contract includes the following legal principles which bind the parties rights and obligations (Williams et al, 1998): Indemnity: insurance will compensate the insured up to the previous position so that the insured will not profit from the claim paid out. Insurable interest: the insured should have a legal interest in what is being insured, e.g. ownership, relationship, etc. Utmost good faith: the insured is obliged to provide the insurer with all relevant information and take responsibility in protecting their own wealth. Subrogation: the insurer is entitled to any recovery from the loss whose claim has been paid out. The insurance market is one of the largest and most developed financial markets and is also the focus of traditional risk management which primarily hinges on managing pure risks (Harrington and Niehaus, 2003). Therefore, insurance companies have specialist risk expertise making them the pioneer in introducing new risk management solutions to cater to the evolving needs of clients (Russ, cited in Risk, 2000). Leading players such as Swiss Re, a Switzerland-based global reinsurer, provide a range of financial solutions from asset management, investment banking, to structured credit and alternative risk solutions including contingent capital (Swiss Re, 2001).

o Hedging: Like insurance, this approach is also a risk transferring method which employs external contracting to transfer the accepted risks to another willing risk-taking party. Payoffs from hedging contract are used to offset losses emanating from price risks such as fluctuations in commodity prices, interest rates, and exchange rates. Financial derivatives such as forwards, futures, options, and swaps are the focus of this hedging approach which has 14

also begun to be used in pure risk management (Harrington and Niehaus, 2003). The market for financial derivatives have been evolving rapidly since Black and Scholes developed the option pricing framework in 1973 that enabled mass commercialisation of financial options. This development is also an important pillar in the evolution of risk management field. Nowadays a large proportion of businesses are using financial derivatives in various activities, most notably in foreign exchange and interest rate dealings (Servaes and Tufano, 2006).

o Other contractual risk transfers: Apart from the above more prevalent approaches in risk management, other contractual risk transfers are also gaining momentum. For example, subcontracting, outsourcing, and entering joint ventures have been used as a precautionary approach to enter new markets as the risk is shared between partners. A business contemplating to enter a new country might sign a joint venture contract which mitigates the risk of loosing money for red tape due to lacking of local knowledge and connections. These methods tend to be more specifically tailored to the needs of the two partners rather than following market conventions like insurance and derivative hedging (Billings and OBrien, 2006).

Similarly, alternative risk transfers (ART) are also customised risk transfer contracts which have grown out of the traditional insurance and hedging methods. However, alternative risk transfers involve transferring risks via financial means rather than operational means like in subcontracting, outsourcing, and entering joint ventures (Culp, 2006). Therefore, an ART contract often has a financial institution, instead of a trade partner, as the counterparty for a risk-taking company. This is a new and rapidly growing segment in the risk management market and will be the focus of the next section.

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Overview of Alternative Risk Transfer

Despite having rapidly gained popularity in the field from its introduction in the late 1990s, Alternative Risk Transfer has not had a concrete definition, but is generally referred to as any risk mitigating approach which is distinguished from traditional risk transfer and risk financing (Harrington and Niehaus, 2003). However participants in the market have identified the common features of ART as follows (Swiss Re, 1999) It is tailored to specific client problems; It provides multi-year multi-line cover; It spreads risks over time and within the policyholders portfolio, making the assumption of traditionally uninsurable risks possible. It involves capital market institutions and securities.

Initially established as capital arrangements between insurers and reinsurers to provide mutual support through the insurance cycle, ART solutions are increasingly standardised across different providers. The major categories among those solutions are summarised below: Captives:

Captive insurance refers to financing losses for a large corporation by making payments to a wholly owned subsidiary who then pays for the losses. In other words, a corporation creates its own insurer who could either insure the parent corporation only (pure captive) or insure other wholly owned subsidiaries of the parent (brother-sister transactions) or even insure other businesses not related to the parent. The major driver for the establishment of captive is seeking favourable tax treatment as captive transactions are often treated as insurance transactions which enjoy tax advantage over risk retention (Harrington and Niehaus, 2003). Moreover, corporations can enjoy further advantage by locating captive insurers offshore in places with low taxes and fewer regulations like Bermuda, Cayman Islands, and Barbados. Catastrophe bonds:

The basic structure of catastrophe bond involves a bond issuer promising to make interest and principal payments unless a catastrophe occurs as stated in the bond indenture. This 16

mechanism is typically organised via a special purpose vehicle which receives bond proceeds from investors, invests those proceeds in high grade investments, and stands ready to liquidate those investments to provide compensation for the issuer in case a catastrophe occurs. The market for catastrophe bonds has remained flat at around $1 billion since 1997 with more than 60 bonds have been issued (Billings and OBrien, 2006; Harrington and Niehaus, 2003). The majority of investors have been insurers and pension funds with around 100-150 active investors currently participating in the market (Billings and OBrien, 2006). Insurance derivatives:

These are derivative instruments which can be used to hedge losses from catastrophes and other kinds of natural variables such as weather and temperature. These instruments can provide an effective means for insurers to re-balance their portfolios which could be heavily damaged by large amount of claims in case of catastrophe. In addition, businesses also find these instruments useful in hedging against losses emanating from unexpected changes in weather and temperature. For example, agricultural companies can purchase temperature derivatives to protect their crop against unexpected heat or cold during their harvesting season. This market has been growing very fast with weather derivatives being the most popular solution sought after by energy companies. According to Swiss Re, one of the largest four providers in this market, since inception in 1997 weather derivatives have reached more than USD 7.5 billion in capacity, and in winter 2000-2001 alone approximately USD 2 billion of capacity was created (Swiss Re, 2003). Investment banks such as Socit Generale, Goldman Sachs, and Deutsch Bank have also been keen players who leverage on their client relationships, marketing and trading experience. Finite risk insurance:

Finite risk solutions refer to multi-year contracts in which losses incurred will be compensated by accumulated periodic premium payments of the insured and the remaining contributed by the insurer, provided that the insurer will be reimbursed by future periodic premium payments. Therefore, the insured will pay for most of the losses herself but the payments are spread over time. The major benefits of finite risk contracts are reducing moral hazard as the insured is responsible for most of the loss, and increasing 17

limit of insurability for clients who lack of loss history to enjoy beneficial treatment in actuarial pricing. According to Swiss Re, the global market for finite insurance is approximately USD 27 million for both corporate and insurance clients (Swiss Re Sigma, 2003). Contingent capital:

The basic structure of contingent capital is an option which gives the holder a right to sell her own securities to another party and use the proceeds to finance a loss. This is a special ART solution which is often referred to as a convergence product since it connects insurance and capital markets. The combined features of an option a capital market product, and risk financing a risk management approach, make contingent capital an interesting structure to study. This approach will be explored extensively in the subsequent chapters. As seen from the description of major ART solutions above, these strategies are often used to manage risks with high loss magnitude and significant severity such as catastrophes and business interruptions. Although varying in terms of approach to transfer risks, these strategies serve similar objectives which are considered the rationales for their development. Firstly, ART strategies help to increase risk managing capacity because some risks are considered good risks but may be uncoverable by traditional strategies due to their sheer size (Harrington and Niehaus, 2003). By tapping directly to the capital markets via securitisation, these strategies aggregate capacity of financial institutions to provide coverage for traditionally uncoverable exposures such as catastrophes with estimated losses up to $10 billion (Swiss Re, 2003). According to Michael Leybov, Senior Vice-president at Lehman Re, at an ART seminar organised by Risk Magazine, providing ART is a step to diversify financial institutions risk management portfolio and reduce the overall risk and cost (Risk, 2000). Moreover, the development of ART strategies responds to the need of integrated solutions to be applied to individual client problems (Millard, 2005). Combining techniques such as insurance and hedging provides specific applications that allow flexibility for firms to capture differential benefits in accounting, regulatory, legal issues associated with those forms (Russ, CEO of Chubb Financial Solutions, cited in Risk, 2000). Therefore, the prospect of ART looks promising as the risk management market develops in volume and in sophistication of client needs. 18

Why Do Firms Manage Risks?

Having described corporate risk management in general and an evolving segment of the field, the alternative risk transfer approach, we turn to look at the rationales of risk management before coming close to the approach in focus of the dissertation contingent capital. The question of why firms engage in risk management has been raised and attempted to answer in the finance and economics literature over the last two decades (Froot et al, 1994; Mayers and Smith, 1982; Smith, 2006). On the practical side, a number of studies have also questioned corporate managers about their views on the value-adding effect of risk management (Dolde, 1995; Servaes and Tufano, 2006; Judge, 2006). This section will provide a review of the major lines of thought on the question in focus.

First, its important to review the theory of firm value. According to corporate finance theory, firm value is determined by discounting the expected future cash flows generated by firm activities at the opportunity cost of capital demanded by the firms financial claimholders (Brealey, Myers, and Allen, 2006). Therefore, to increase firm value, any strategic decisions will have to either increase expected cash flows, or reduce the cost of capital, or improve the efficiency of value creation process (Smith, 2006). A well known proposition of Modigliani and Miller (1958) in corporate capital structure theory suggests that given capital markets functioning in perfect conditions, firms capital decisions are irrelevant in affecting firm value. These perfect conditions are assumed to alleviate taxes, transaction costs, information costs, bankruptcy costs, investor irrationality and to fix corporate investment decisions. Therefore the theory suggests that shareholders will not be concerned about how their firm employs different types of capital as they are able to diversify their holdings and obtain a desired leverage structure on their own (Brealey, Myers and Allen, 2006).

In the context of this discussion, the so-called M&M proposition implies that risk management decisions will not reduce cost of capital especially for widely held firms whose shareholders are able to obtain their desired risk level via portfolio diversification (Smith, 2006). Effectively, risk management activities such as insurance and hedging are attempts to transfer risks to another party whose business is pooling risks from different clients and achieve risk reduction from diversification. This risk pooling role is similar to 19

shareholders holding different stocks in perfect capital markets (Mayers and Smith, 1990). Given firm value is affected by both idiosyncratic risks of each individual firm and systematic risks of the whole market, engaging in risk management can only help firms reduce the idiosyncratic or diversifiable part of risks, while leaving systematic or nondiversifiable part of risks unaffected (Froot et al, 1993). The argument also goes further in that even if transferring risks to another party can reduce systematic risks, it would be done at a cost that offsets the risk reduction benefit since the counterparty will be asking for additional compensation to bear a risk that could not be diversified in the market (Harrington and Niehaus, 2003).

Given the value of a firm being determined by expected future cash flows and the opportunity cost of capital, the above argument that risk management does not reduce cost of capital in perfect capital markets leads to a proposition that to increase firm value, it must increase the expected cash flows or improve the efficiency of the value creation process when the assumptions of perfect capital markets are relaxed (Stulz, 1996; Smithson, 1998; Smith, 2006). The following discussion will investigate this proposition in more detail by examining the theory and evidence of value-adding effect of risk management via reducing expected tax payments, reducing bankruptcy costs, and facilitating optimal investment decisions.

Managing Risk Reduces Expected Tax Liabilities

In a world of progressive tax system, i.e. tax rates are higher for higher income level making high income companies facing disproportionately higher tax liabilities, companies with volatile pre-tax income can expect to incur higher tax liabilities than those having more stable income (Smith and Stulz, 1985). This is often referred to as the convexity of tax schedule, illustrated in the diagram overleaf. As pre-tax income increases, tax liabilities of the progressive schedule increase at an increasing rate. The effective tax schedule is more convex because of the progressitivity of the tax system and the existence of tax preference items such as tax credits and tax loss carryforwards (Smithson, 1998; Smith, 2006).

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Tax liabilities

Progressive tax schedule Linear tax schedule Pre-tax income

Figure 4: Convexity in tax schedule (Smithson, 1998). The effect of cash flow variability on tax liabilities can be illustrated in the table below with company A having volatile earnings and company B having fixed earnings. The tax rate is 34% for profit below $25 and 45% for profit above $25. Company A Probability 0.4 0.3 0.3 Expected values Company B 1.0 Pre-tax profit 30 20 15 22.5 22.5 After-tax profit 30 * (1-0.45) = 16.5 20 * (1-0.34) = 13.6 15 * (1-0.34) = 10.2 13.74 15.3

Table 1: Comparing after-tax profit of volatile and fixed earnings in progressive tax rates As can be seen from the table, company A with volatile earnings has higher expected tax liabilities and lower expected after tax profit than company B because of the non-linear increase in tax liabilities. The effect of risk management on reducing tax liabilities is therefore explained primarily based on the premise of smoothing earnings to safeguard after-tax income, especially for firms facing high probability of negative earnings but unable to carry forward previous period losses (Smith and Stulz, 1985; Smith, 2006). Studies have found that the more likely a firm faces convex tax schedule the more likely it is to use hedging to smooth earnings and reduce tax. While Mian (1994) found significantly positive relationship between foreign tax credits and the use of hedging 21

instruments, Nance et al (1993) also found similar correlation between risk management instruments and investment tax credits.

Managing Risk Reduces Bankruptcy Costs

Financial distress occurs when creditors liabilities are dishonoured or honoured with difficulty, with some possibility of leading to bankruptcy (Brealey, Myers and Allen, 2005). Costs of financial distress can offset the value of tax shield which is often enjoyed by levered companies due to the tax deductibility of interest on debt, thereby reducing value of the companys securities. Due to the perceived closeness between financial distress and bankruptcy, these costs are often referred to as bankruptcy costs, which are legal expenditures incurred when creditors take over a firms assets after the firm fails to service their debt and shareholders exercise their put option on these assets then walk away. These costs are often anticipated by creditors who factor them into the cost of capital they provide, thereby decreasing the value of the firm and limiting its access to further external financing (Kwon, 2003). In addition, the indirect costs of financial distress include increased costs imposed by suppliers, employees, and increased bargaining power of customers. These financial distress costs are correlated with the probability of bankruptcy which is often measured by some proxies such as gearing ratio, interest coverage ratio, and credit rating (Judge, 2006). Risk management, by mitigating the volatility of cash flows, reduces the value of the put option possessed by shareholders, thereby decreasing the probability that a firm is unable to repay its debts and increasing its debt capacity (Froot et al, 1993; Stulz, 1996). Moreover, the costs from suppliers, employees, and bargaining power of customers can also be reduced by showing financial viability of a far-from-distressed balance sheet. Therefore, the higher the probability of encountering financial distress, the more benefit risk management is perceived to bring to firm value (Smith and Stulz, 1985; Froot et al, 1993). In practice, studies have found evidence consistent with this argument. Both Dolde (1995) and Samant (1996) found that the higher leverage, the more the use of derivative hedging instruments. In addition, Mian (1994), Geczy et al (1996) found that the more

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foreign operations (a proxy for foreign exchange rate exposure) a firm has, the more the use of currency derivatives.

Managing Risks Facilitates Optimal Investments

Corporate investment decisions, apart from facing market factors such as taxes and bankruptcy costs, often confront organisational conflicts that could hinder the optimality of the decision made. These conflicts arise as a result of interest misalignment between bondholders and shareholders, and between shareholders and managers (Froot et al, 1993; Smith and Stulz, 1985). First, shareholder-bondholder conflict arises in leveraged firms which act in shareholders interest and in some states will forgo valuable investment opportunities to avoid investment benefit being accrued to bondholders to an extent that the shareholders will be worse off than had the investment not been made (Myers, 1977). This is often called underinvestment or debt overhang problem which refers to investments being overhung by heavy debt liabilities. The problem is more even pronounced when leverage increases as shareholders become more risk averse and have incentive to reject positive net present value projects. Potential bondholders typically anticipate such opportunistic behaviour and depress the price they pay for the firms bonds (Smith and Stulz, 1985). Secondly, the shareholder-manager conflict is a classic example of the more general principal-agent conflict which addresses differences in ownership interest and controlling role of the two parties. Managers hold a time limited and non-tradable claim on the firms reported earnings, whereas shareholders can have a tradable claim on the firms indefinite life. Moreover, managers are charged with the overall running of firm but do not have the advantage of diversifying risks as shareholders have with their portfolios. Therefore, managers have a tendency to refrain from risky investment projects to protect their performance-based compensation at the expense of shareholders (Mayers and Smith, 1982). The dysfunctional effects of these organisational conflicts on investment decisions can be mitigated by the use of risk management activities in two ways. First, risk management 23

can protect the stream of income from investment projects, thereby ensuring shareholders that the cash flows will be sufficient to service debt and provide them with positive returns (Froot et al, 1993). In other words, risk management can give shareholders confidence that wealth transfers will not occur as a result of undertaking profitable investments.

Second, risk management can help managers reduce the risk of their non-diversifiable investment in the firm, thereby mitigating their risk aversion which affects the firms investment decisions (Stulz, 1984). Another theory of hedging based on asymmetric information suggests that managers are better off undertaking risk management as the labour market revises its opinions about their performance-based ability thereby influencing their market value (DeMarzo and Duffie, 1995).

In practice, studies have reported positive relationship between the level of investment and the use of risk management instruments. For example, Nance et al (1993) and Dolde (1995) both found positive correlation between R&D expenditure, a proxy for investment activities, and the use of risk management instruments. Moreover, Nance et al (1993), Mian (1994) and Tufano (1996) report that larger firms are more likely to hedge. This evidence is consistent with the argument that managers of larger firms have more incentive to mitigate the risks of their personal investment and feel more confident in undertaking investment decisions.

In summary, the above arguments and the reported evidence show that the rationales for firms to engage in risk management activities is to obtain value enhancement via reducing tax liabilities, reducing bankruptcy costs, and mitigating organisational conflicts to facilitate optimal investments. However there are certain practical difficulties involved which make the decision to manage risks a major consideration by many corporations. These issues will be discussed in the next section.

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What Make Managing Risk Difficult?

There are a number of issues involved in the decision to manage risks which might deter the effort of corporations to undertake risk management. Some of these issues are highlighted below.

Costs
Like other strategic decisions, undertaking risk management involves significant financial expenditure including costs to design and implement appropriate programs and ongoing monitoring throughout the implementation. A recent survey conducted on global practices of corporate finance and risk management shows that managers view the greatest drawbacks of undertaking risk management are the direct costs involved in purchasing insurance or hedging instruments (Servaes and Tufano, 2006). Moreover, another study on risk reporting in UK public companies reveals that risk management practices are more popular at large firms than small firms, which suggests that undertaking risk management also involves large administration and organisation expenses apart from the direct costs in using risk management instruments (Linsley and Shrives, 2005).

Cost constraints dictate every firm determined to undertake risk management activities to seriously ponder what their risks are and which risks should be avoided or accepted to be managed. The decision to select which risks to manage should be determined by the effect of those risks on firms strategic operations (Meulbroek, 2001). For example, studying CFOs views on risk exposures considered in terms of their likelihood and magnitude of cost to the business in the next five years, Servaes and Tufano (2006) revealed that foreign exchange risks, strategic risks, financing risks, and competitive risks are the top considerations. This evidence shows that firms are concerned about risks that have imminent effects (foreign exchange rate risk) as well as those with long term consequences (strategic and competitive risks). With such variation in range of top risks of concern, it seems plausible that getting them under control requires a seriously planned budget share.

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Design of appropriate risk management solutions

In addition to the costs, the effort of undertaking risk management could be deterred if the risks selected could not be properly covered by an appropriate solution. Given the range of risk management approaches discussed previously in this chapter, it is puzzling to decide which approach could match both risk characteristics and objectives of management. Study of Servaes and Tufano (2006) shows that one of the top considerations of managers regarding their risk management decision is the effect on long term opportunity costs, as some risk management activities such as a forward or swap contract could eliminate the upside potential to protect the downside of a transaction. This is a drawback of risk transfer or finance approaches but would not be a material consideration if a firm chooses to diversify its risks (Harrington and Niehaus, 2003).

Moreover, within a risk management approach under the ad-hoc classification discussed previously, there are a myriad of instruments available for use which could further complicate the decision making task. There was a time derivative hedging was on hot discussion among managers for its effectiveness in mitigating a range of risks and even bringing in profitable trades. The burst of large corporations due to huge losses from derivative trading such as Long Term Capital Management and Barings Bank in the 1990s depressed such eagerness of managers and raised questions on which should be the safest way to manage corporate risks while still maintaining upside potential (Jorian, 2001). On the other hand, insurance, the traditional risk management channel, has also been criticised for its limits of coverage as some risks are not coverable by insurers, and for prices to fluctuate from year to year due to the underwriting cycle created by industry-wide events such as catastrophe losses (Swiss Re, 1999). These issues are of paramount importance as firms with sufficient resources and intention to undertake risk management would not do so if they are not well-informed of the costs of the chosen solution and its ability to cover the selected exposures.

Recently, the risk management market has developed a range of new solutions aiming at combining different techniques, notably the Alternative Risk Transfer solutions discussed previously. It is expected that this convergence trend will increase capacity and provide customised solutions for various individual risks of firms (Risk, 2000). 26

Moral hazard
Once a suitable risk management program has been designed and implemented, it does not always bring in the benefits expected by shareholders and other stakeholders. In any risk management practices, there is always some degree of moral hazard, which refers to managers actually amplifying risks rather than managing risks (Ramamurtie, 2003). The well-publicised case of Enron can illustrate this argument as the group was praised for having comprehensive risk management programs using both operational diversification and a range of instruments to protect its trading (Meulbroek, 2001) just before it went to bankruptcy due to managerial fraudulent activities. The erected risk management programs protected shareholders confidence that the firm was being run prudently, giving way to managers to manipulate reported figures for their own benefit. The case draws a lesson that no matter how good risk management technology is, the system may not work if there is not good alignment between managements interest and the shareholders interest (Ramamurtie, 2003). Moreover, the relationship between the firm seeking risk management solution and the solution provider is also prone to opportunistic behaviour (Doherty, 1997). This is often referred to as the risk thermostat problem in which the party whose risks are managed changes their behaviour and seeks the level of risk they find themselves comfortable with after having their exposures covered, thereby exposing the counterparty to higher risk levels than expected in agreement (Billings and OBrien, 2006). For example, a firm which has bought property insurance might become less prudent in applying safety procedures and hence increase probability of property damage which would be covered by the insurer. This moral hazard problem leads to the counterparty imposing more stringent due diligence and limiting the amount of coverage which reduce the appeal of risk management. In summary, the decision to manage risks face cost constraints, design difficulties, and moral hazard, all of which could make a risk management program fail to achieve its expected goals. Resolving these issues requires not only the firm undertaking risk management but also the solution provider who will design an appropriate solution that minimise the negative impact. The next chapter will introduce a risk management solution to illustrate efforts of two parties in increasing firm value while also attempting to mitigate these issues. 27

Chapter 3

Introducing Contingent Capital

Contingent Capital Defined

Contingent capital can be broadly defined is a standby source of capital which would be injected into a firms balance sheet when some specified conditions are reached. It is therefore often referred to as an off-balance-sheet capital source as opposed to other onbalance-sheet capital sources reported as having been raised to finance a firms operations. A contingent capital facility is an option that gives a firm a right but not the obligation to issue new equity, debt, or hybrid securities over a specified period of time, at a predefined issue price, and following losses resulting from some specified risk (Culp, 2002c).

The condition that the option is exercised to allow capital injection only after a loss makes contingent capital facility similar to an insurance contract in that the beholder will be compensated after suffering from some damage in value. Moreover, the fact that it is an option to issue capital securities aligns it with other company-issued options which also result in issuance of new equity securities upon exercise such as warrants and executive stock options. The difference is that the option holder in a contingent capital structure is the company holding the underlying securities, not external investors in other financial options. Therefore, the nature of contingent capital option as a capital raising mechanism to compensate for losses make it a link between insurance and capital markets, which results in converging implications of the two areas.

When Do Firms Need Contingent Capital?

Among the multiple endeavours that most corporations pursue to maintain their presence in the market, raising capital to fuel continuous growth and keep up to date with competitors is of vital consideration. However, growth opportunities may crop up at times that corporations are not in their best shape to raise capital at the most effective terms.

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This may be created by exogenous events or internal business cycle. For example, a downturn in the computer manufacturing sector makes the cost of raising capital of a constituent firm to finance new patent approved technology more expensive, or a corporation which has just completed significant plant or equipment and needs more capital to equip latest technological developments has to face stringent scrutiny of potential creditors for new capital raised. Another example is an earthquake that destroyed supply of major inputs for a manufacturing plant, leading to long term interruptions in the supply chain and making new financing at concessionary terms more desirable (Neftci, 2000).

For such contingencies that require infusion of new capital, firms are often faced with the choice between using internal capital, securing a credit line from a bank, or arranging a contingent contract which makes capital available when it is most needed. Given the low probability but high magnitude characteristics of certain risks, neither bank credit line nor internal funds can prove effective in satisfying the needs of the loss-stricken firm. Internal funds can be seen as the most cost effective resources for financing new investments. However keeping too much internal funds on balance sheet puts pressure on earnings due to the cost of capital demanded by claim holders (Culp, 2002a). On the other hand, bank credit lines are often provided on a short term basis to support working capital needs rather than long term capital required for strategic investments (Sawyer, 2002).

Therefore a contingent capital facility is considered a desirable alternative in cases where large capital issue is needed when market conditions for capital raising are not favourable after some risky events have occurred. Such risky events have some common parameters as follows (Neftci, 2000). First, these events are either too specific to firms or systematic that are not coverable by other insurance contract or hedging instrument. They may have either very small probabilities or very large potential losses or both, and are exogenous to the operations of the firm and statistically independent of other market or credit events. Second, the risk is so firm-specific that poses difficulty for standard models to be appropriately applied. Other risk factors such as market volatilities and credit spreads are often modelled by standard tools such as stochastic and Martingale processes, but firm idiosyncratic dynamics are not yet well captured by probabilistic models (Neftci, 2000).

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Construction of Contingent Capital Facility

A generic structure of a contingent capital deal involves a company and a capital provider both of whom have to agree on the terms and conditions of a private capital placement which would take place when a loss event occurs according to the agreed terms. Stated simply, a company pays some commitment fees to a capital provider to be assured that in the event of a loss they will get access to capital at predetermined terms. The capital provider often then diversifies their risks in the capital markets by distributing the claim to a group of investors or via a special purpose vehicle.

Contingent capital set up

Option to issue capital Diversify risks

Company

Capital provider Commitment fees

Capital markets

Contingent capital when triggered Proceeds Company Capital provider Securities Securities Proceeds Institutional investors

Financial loss

Trigger event

Figure 5: Contingent capital contract when set up and when triggered (Banks, 2004.)

This section will provide an overview of the common terms in a contingent capital instrument. It is easy to see that these terms resemble characteristics of a financial option which should not be surprising given the nature of contingent capital is an option on paidin capital. These terms include: (i) (ii) Underlying security Time to maturity 30

(iii) (iv) (v)

Strike price and contract fees Exercise Covenants

Underlying security
Each contingent capital option contract provides a right to issue one of the types of financial securities such as equity including common and preferred shares, debt, and hybrids, i.e. capital claims having both equity and debt features. The decision of which securities to be issued under contingent capital structure often involves different ensuing considerations from both the company and the capital provider (Culp, 2002a). If it is equity, the most important consideration is of dilutive effects since equity issuance will dilute shareholders claims. If it is debt or preferred shares, other issues such as leverage, subordination, maturity, callability and dividend treatment must be taken into account by the option purchaser. Liquidity is also of an important consideration especially when hybrid or equity is concerned. In these cases, the convertibility of the securities once issued into tradable securities could be considered an attraction to the capital provider. Moreover, since contingent capital is often viewed as a means to demonstrate financial strength in terms of regulatory capital, regulatory environment is also a critical factor in determining the type of security to be issued. In the financial services industry where equity is seen as buffer against contingencies in risk-trading business, common or preferred shares will likely be chosen to be under contingent capital schemes, whereas contingent debt will more likely be favoured by manufacturing companies which prefer committed capital without diluting shareholders claims to maintain their support (Culp, 2006).

Time to maturity
Under a contingent capital structure, the option to issue capital usually has limited time to maturity although the holding period of the underlying securities could be either limited (for debt securities) or unlimited (for equity securities). For example, a contingent debt facility gives a firm the right to issue ten-year fixed rate junior subordinated debt at any time over the next three years.

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Similar to financial options, contingent capital facility can be American, European, or Bermudan style, although American style has been most popular among contingent capital facilities issued to date (Culp, 2002c). These facilities allow capital to be issued anytime during the life of the option upon the occurrence of the triggering event, and usually after a short lockup period following the agreement. The life of a contingent capital option can be illustrated using the above contingent debt facility example as follows: t=0 Option time to maturity t=3

Option purchase

Triggering event

Option exercised T= 0

Option expires Holding period

Debt repayment T = 10 years

Figure 6: Life of a contingent capital option (Shimpi, 2001). Although the option time to maturity is usually shorter than the holding period of the capital issued, the former is normally longer than the time to maturity of financial options. This gives enough time for the triggering event to occur and for management to consider issuance of capital according to the agreed terms (Culp, 2006).

Strike price and contract fees

Similar to other options which have exercise price at which the underlying asset can be traded, contingent capital structure sets out exercise price at which new securities can be issued. This price is set prior to the realisation of a specific loss and usually uses the current price of the underlying security on the agreement date as benchmark. Therefore contingent capital option is normally set to be at-the-money at its inception.

The contract fees often include a periodic (or upfront) commitment fee payable to the capital provider regardless of the exercise of the option and an underwriting fee on the underlying security in case of exercising the option. If the contract allows the capital

32

provider to terminate the agreement prior to expiration, the commitment fee could be returned to the option buyer (Culp, 2002a).

Exercise
The exercise right of a contingent capital option is typically activated by two triggering clauses or simply called triggers. The first trigger is automatically pulled when the option goes in-the-money, i.e. when the intrinsic value becomes positive. However, this trigger is a necessary but not a sufficient condition for exercise to take place, rather the exercise right is only activated upon a second trigger being pulled. Therefore this first trigger is not usually considered critical in negotiation between two involved parties.

This second trigger varies contract to contract and typically references a pre-defined loss agreed upon by the contract parties. This loss can be measured either based on a specific loss of the firm or proxied on a market wide index. The purpose of designing this second trigger is to make sure capital is only provided when it is needed most, which resembles the indemnification principle of insurance that insurance can only bring the insured back to the situation had the loss not occurred. This feature also highlights the objective of managing risk of contingent capital facilities as opposed to rather speculative investment in using derivatives instruments.

However the design of this trigger could create problems that make this purpose unfulfilled. If the loss is firm-based, for example consecutive negative earnings, there is moral hazard problem as management can exercise discretion over when the loss reaches the prescribed amount and activates the option. If the loss is proxied on market index, for example GDP of the country where the firm domiciles, there is basis risk as the movement of the index and the firm loss value might not be perfectly correlated. These issues will be referred to in the discussion of pricing issues later in this chapter.

Covenants
Apart from second trigger which is designed to protect capital provider against adverse consequences of asymmetric information, covenants are also sometimes put in place as further protection for participants in this newly emerged market. For example, the option 33

holder company has to prove that it is at least financially viable when option is exercised, therefore the obligation of the option writer could be void if the company faces bankruptcy or its net worth falls below a minimum amount. Other covenants can be put in place to restrict certain activities of the firm during the period of the option such as investment decisions and changing of control (Shimpi, 2001).

Some covenants include restrictions known as material adverse change clauses, or MAC clauses, which state that a firm cannot access its contingent capital arrangement if there had been MAC in its financial condition or credit quality (Shimpi, 2001). This condition is more commonly seen in committed letters of credit to protect capital providers against adverse changes in the firms conditions, yet it has become a major source of criticism as it restricts the availability of capital then it is most needed (Culp, 2002c).

The purpose of these covenants is to mitigate moral hazard problem often arising from the contractual relationship between the option holder and the capital provider. With these covenants in place, the likelihood of the option being exercised is more limited even when the trigger is based on some loss under control of the option holder. Moreover, the fact that the firm is still viable after the loss provides some sense for capital issuance and makes the contingent capital facility marketable. It is this point that differentiates contingent capital facility from insurance contract in which the insurer is liable for the loss satisfying the prescribed conditions regardless of the insureds post-loss situation (Culp, 2002b). However the use of covenants does not entirely wipe out information costs and some capital providers, especially insurers, tend to rely more heavily on ex-ante screening and due diligence than on ex-post restrictions as discussed in the next section on different contingent capital facilities (Culp, 2002b).

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Classification of Contingent Capital Instruments

There are several ways contingent capital structures can be classified. The simplest way is to use the type of underlying paid-in capital as categorising benchmark, which results in two main categories: contingent equity and contingent debt capital (Banks, 2004). Under each of these two categories, there are a myriad of structures as each contingent capital contract is dedicatedly design to suit particular needs of a buyer. The following chart gives an overview of the major contingent capital structures which will be discussed in this section:

Contingent capital

Contingent debt

Contingent equity

Committed capital facilities Contingent surplus notes Financial guarantees

Loss equity puts

Put protected equity Reverse convertible bonds

Figure 8: Classification of contingent capital instruments (Adapted from Banks, 2004).

Contingent Debt Capital

These facilities give the buyer an option to issue debt capital to the option writer within a period of time upon some specific loss. Committed capital facilities In the most basic form, these facilities are letters and lines of credit provided by banks to companies in need of regular infusion of capital to finance their operations. In the form of contingent capital, however, committed capital facilities are arranged by insurers or 35

reinsurers with the aim to provide capital support only in time of loss. This distinction is embedded in the second trigger which addresses a defined level of the loss incurred and determines when access to funds is granted. The first trigger, as in other contingent capital structures, is automatically pulled when the company has experienced some loss and cannot afford to obtain funds at current market rates, i.e. the option is in-the-money.

Pre-trigger
Company

Commitment fees Capital provider Commitment to give access to credit facilities

Post trigger
Issue fixed income claims Company Proceeds Figure 9: Contingent debt facilities pre-trigger and post trigger. Once these two triggers are both pulled, i.e. when the company has experienced some loss up to a certain level, it will be able to draw funds within a given amount from the capital provider in terms of loans at pre-defined interest rates, typically a base rate plus an adjustable margin (Culp, 2002a). The terms of these facilities often include specifications of the debt claim to be issued such as interest, maturity, subordination, repayment schedule, and coupon. These committed capital facilities are therefore a very common form of pre-loss financing among financial institutions such as banks and insurance companies. For example a bank who would like to ensure that its reserve capital is adequately supplied even in case of large credit losses will contract an insurer to get hold to a credit line which will be available as convertible bonds. These bonds will be issued when the banks loan portfolio referenced by external loan index suffers from severe losses and requires capital replenishment (Banks, 2004). Among non-financial companies, committed capital facilities have also emerged in the form of contingency loans which are granted only after some specific event has occurred. Capital provider

36

This embedded condition underlines the role of the facility as risk mitigation mechanism rather than simply a standby credit facility for any purposes.

Contingent surplus notes These instruments are very popular among insurance and reinsurance companies who would like to protect their investment portfolios by using intermediary security distributor. The name surplus notes was given by insurers who often call their own capital as surplus capital from premiums paid by policy holders. Under these structures, an investment trust is established between a company and investors and plays a dual role: both as an issuer and a capital provider. As an issuer towards the investors, the trust issues notes with enhanced yield and uses the proceeds to invest in high grade securities in the capital markets. As a capital provider for the company, when contingent capital triggers are pulled, the trust will liquidate investments in high grade securities and buy notes issued by the company. The proceeds distributed by the trust to the investors will then be generated from these notes of the company instead of the high grade securities as before.

Pre trigger
Trust Investments High grade securities Capital markets Notes with enhanced yield Investors

Proceeds

Post-trigger
Company CSN Proceeds from CSN Trust Investors

Proceeds

Liquidation proceeds when CC is triggered High grade securities Capital markets

Figure 10: Contingent Surplus Notes Pre-trigger and Post-trigger. 37

While the attraction of contingent surplus notes to investors is high yield of the trustissued notes as compared to other securities, the company is drawn in by having secured financing at predetermined terms. This helps to explain why these facilities are very popular among insurance and reinsurance companies who are exposed to fluctuations in the insurance cycle and required to maintain sufficient regulatory capital (Nieham, 1999). Financial guarantees: Financial guarantee is a contract between a company and a financial guarantor both of whom agree that access to capital would be granted to the company in case a loss trigger is breached. It is simply a protection given by the financial guarantor to a company to hedge against event loss or to give signal of credibility in issuing securities. In the former case, risk is fully transferred from the purchaser to the capital provider who assumes the role of shelter for the company in hard time. Most guarantees of this kind have addressed credit default as the triggering clause which once pulled will lead to the guarantor paying out up to the policy maximum (Culp, 2002a). For example, exchanges and clearing houses use guarantees to ensure capital availability to execute all transactions even in the event of large losses (Banks, 2004). With such focus on risk transfer, financial guarantees resemble traditional insurance to a larger extent than any other contingent capital structures.

Guarantees also act as signaling capital which gives credit enhancement to capital issuance of companies with low credit ratings or of special purpose vehicles (SPVs) artificial entities set up to issue capital on behalf of companies. In the most basic and popular form, these guarantees are bond insurance provided by monoline insurers for fixed income securities issued by SPVs (Culp, 2002c).

Although the screening and due diligence process is rather stringent to mitigate asymmetric information, once obtained, guarantees stand ready as a secured source of capital which is close to internal funding available for companies in case of losses. Guarantees are therefore often called synthetic equity, or a nearly substitute for new equity (Culp, 2006).

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Contingent Equity
Loss equity puts: Loss equity put is contingent capital structure which gives a purchaser a put option on its equity capital which is triggered by a specific loss predefined at time of agreement by the two parties of the transaction. The issuance of equity capital is typically in the form of a private placement in which in the capital provider will subscribe to all the shares issued at the terms agreed upon before. This capital provider is in many cases an intermediary who redistributes subscribed shares to a group of institutional investors once those shares are received.

Loss equity put Pre trigger

Put option premium Company Put option Capital provider

Loss equity put Post-trigger

New shares Company Capital provider Underwriting fees + Proceeds Figure 11: Loss equity put Pre trigger and Post trigger Loss equity puts are often written on preferred shares rather than common shares to avoid dilutive effects on equity issuance (Shimpi, 2001). Another case is convertible preference shares which typically includes a condition that the shares distributed will remain as preferred shares until redemption instead of being converted into common shares (Culp, 2006). Put protected equity: Similar to loss equity put, put protected equity is put option purchased by a company on its own stock but the aim is to profit from the decline of stock value in case a loss is incurred. That is, the only difference between put protected equity and loss equity put structures is that the former does not have a second trigger as the latter and other 39 Proceeds New shares Institutional Investors

contingent capital structures. Therefore, put protected equity can be triggered anytime the stock price goes under the strike price stated in the put option contract. The exercise of these put options can provide additional cash to retained earnings when share price declines or protect share issuance against low issuing price. Since put protected equity does not have a second trigger to regulate its loss fixing role as other contingent capital structures, the purchase of these facilities can be viewed as a pessimistic sign toward the companys stock since it implies management thinking that share price might go down. Reverse convertible bonds Reverse convertible bonds are fixed income securities which give the issuer the right to choose to redeem in shares instead of cash at a specified exercise price. They are effectively the reverse of convertible bonds which give holders the right to receive redemption in shares instead of cash at a conversion price. The option of reverse convertible is only exercisable after the issuer has suffered a specific loss which makes the current share price lower and the amount of shares to be issued at strike price worth less than the value of the bonds to be repaid (Culp, 2002b). These facilities are very popular in Switzerland and Germany1.

Pre trigger
Coupon + Put option premium Company Bond proceeds Investors

Post trigger
Shares issued at strike price Company Investors

Figure 12: Reverse convertible bond Pre-trigger and post trigger.

The first issues of reverse convertibles occurred in 1998 in Germany with one issue of DaimlerChrysler offering DM680m. Since then, the market has broadened dramatically with several smaller abut regular issues of 20m 25m typically being offered each week (Diener et al, 2000).

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Pricing Issues
As a relatively new facility with little attention being given by academics, contingent capital option has yet a dedicated framework to give accurate pricing. Some practitioners have used the analogy with reverse put option to describe the pricing issues of contingent capital and the difficulties involved (Culp, 2002b; Neftci, 2000).

Consider a reverse put option which gives the owner the right to sell equity capital at predetermined price X when the underlying share price gets below K (K<X). This is called a knock-in put option because the price at which the option can be exercised is lower than the strike price, thereby creating a knock-in condition for the exercise apart from the fact that the option is in-the-money. However calculation of option value is still based on the original strike price, i.e. the price at which the option goes in-the-money. The following graph illustrates the payoff of a knock-in put option in comparison with payoff of a traditional put option. The thick lines show that the knock-in put option can only be exercised when share price gets below K, although the traditional put option is already kicked in when share price crosses barrier X.

Reverse knock-in put option

Gain/Loss (net of premium) Traditional put payoff Knock-in put payoff

K-X

Underlying price

Figure 13: Reverse knock-in put option (Culp, 2002). The characteristic of the knock-in price is similar to that of the second trigger in a contingent capital contract as described in the previous section. Consider a contract which 41

also gives the owner the right to issue equity capital as the reverse knock-in put option above. The second trigger also works to regulate the exercise of the option and plays an important role in limiting moral hazard problems. However, unlike the knock-in condition, the second trigger is typically not based on the same variable that is used to activate the first trigger but on some loss event occurring in the future which affects the underlying price of the option. For example, assume the contingent capital contract above can only be exercised if total catastrophe losses in Florida exceed $100 million in a reporting year. If this trigger is activated, share price of the option buyer, for example an agriculture producer with exposure to catastrophe risk in Florida, will be influenced but the impact is not known in advance with certainty. Therefore, in pricing contingent capital contract, the probability distribution of the underlying price as a result of the occurrence of this event must be taken into account. The following graph illustrates the presence of this probability distribution in regulating the exercise of contingent capital option. Instead of a fixed barrier as the strike price in a normal put option, the bell-shaped curve shows that when the trigger is activated, the underlying price will fluctuate about the range Kd-Ku and have an expected value at K. The shape of the distribution depends on the specifications of the contract and market perception. If the option contract is designed to bring in adequate capital to fill the gap after the loss, its exercise will smooth out cash flows of the option buyer so that market perception will not change much, making the underlying price fluctuate very close to the expected strike price (Neftci, 2000).

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Contingent capital option

Gain/Loss (net of premium) The probability distribution of the underlying price as a result of the occurrence of the loss event

Contingent capital option payoff

Expected value of share price if the event occurs Underlying price

Kd

Ku

Figure 14: Contingent capital option (Adapted from Neftci, 2000). The illustration above suggests some difficulties involved in pricing the contingent capital contract. To be able to price contingent capital contract in a similar way to a reverse put option, one would need to contemplate the following issues (Neftci, 2000). First, the specifications of the trigger must be well defined and its probability distribution must be determined. This requires identifying the risk that the buyer wants to be hedged against using this option, then collecting statistical data on the occurrence of the loss event to form probabilistic expectations. The difficulty here is that the risks to be hedged by contingent capital option tend to have very low probability of occurrence, limiting the amount of available statistical data and the accuracy of probability expectation. Secondly, the way the trigger will affect the underlying price must also be determined. This requires studying the volatility of the underlying price and the impact of past events with similar loss magnitude. What is more, as discussed in the construction of contingent capital option, the impact of trigger on the underlying is complicated by either moral hazard if the trigger is tied to a loss directly influencing option buyer, or basis risk if the trigger is tied to a loss proxy outside the buyers immediate control. In the first case, the impact of trigger is easier to predict, but if it is known with relative certainty to the 43

buyer, pricing contingent capital option will be very difficult since the buyer will change their capital structure according to the imminence of the event that they can foresee. In the latter case, the impact is less visible and requires approximation of the correlation between the proxy and the loss incurred. For example, a capital provider issuing a contingent debt capital option using an insurance index as proxy for trigger has to identify the correlation between the index and the buyers credit spreads. This still leaves some possibility of pricing the facility too high or too low since correlation is only known with limited certainty. These above-mentioned issues make pricing contingent capital option a complicated task that should be dealt with using sophisticated actuarial skills and thorough understanding of the buyers risks. Given the limit of words, this paper will not go in greater length to discuss pricing issues and will instead explore contingent capital from a corporate financing view.

Contingent Capital as a Component of Corporate Capital Structure

The development of contingent capital as a method to help firms structure their balance sheet and manage risks has spurred discussion on the convergence of capital management and risk management, two areas which have been treated separately in the area of finance. The idea of convergence was first advocated by Prakash Shimpi, President and CEO of Swiss Re Financial Services Corporation, who illustrated this view in a new model of capital structure called the Insurative Model. Essentially the Insurative Model incorporates risk management instruments into the capital structure in addition to the capital sources which have been recognised in conventional corporate finance. Corporate capital structure has normally been thought of as comprising a mix of capital sources used by a firm to finance its assets (Brealey, Myers, and Allen, 2006). These sources include internal fund retained from operations, debt and equity securities issued to outside investors. Shimpi (2001) suggests that there are other sources of capital which do not appear on the balance sheet but a firm can draw on to finance its activities. These are called off-balancesheet capital, which can come to a firm in two ways. First, the firm can pre-arrange access 44

to capital which would be available when needed. This contingent capital source is cost effective since it delays putting capital on the firms balance sheet although the cost of such arrangement should be taken into account. Alternatively, a firm can engage in insurance or hedging contracts to transfer risks partly or entirely to other firms and let the counterparty bear the losses incurred. In the first case, risks are still retained by the firm and access to the contingent capital source is considered a support for the firm in difficult time. In the latter case, the firm transfers risks and receives compensation for the losses incurred. The following diagram illustrates the traditional view of capital structure as comprising of debt, mezzanine financing, and equity, whose order shows an increasing exposure to risk exposure and decreasing priority of claims. In other words, the traditional view of capital structure focuses exclusively on on-balance-sheet capital sources which are used to cover retained risks, i.e. risks that the firm remains primary responsibility in financing loss if occurred, while other off-balance-sheet capital sources which could be used for the same purpose are ignored. This exclusion is argued to overlook the risk-reducing effect of using off-balance-sheet capital and distort the view of capital cost and return on equity (Shimpi, 2001).

Traditional view
Decreasing Priority of claims

Debt Mezzanine Financing Equity

Increasing Exposure to risk

Retained Risks of Corporation Figure 15: Traditional view of corporate capital structure (Shimpi, 2001). On the other hand, the Insurative Model incorporates off-balance-sheet and on balance sheet capital sources used to cover both retained risks and transferred risks of a firm.

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The Insurative Model

Off-Balance-Sheet On-Balance-Sheet

Debt Contingent Capital

Insurance-linked securities

Insurance and Derivatives

Mezzanine Financing Equity

Increasing Exposure to Risk

Transferred risks

Retained risks

Transferred risks

Figure 16: The Insurative Model (Shimpi, 2001). This model arranges capital sources in terms of their presence on the balance sheet and the types of risks they cover. On-balance-sheet sources include those used to cover retained risks such as equity and debt, and those that cover risks transferred away from the firm such as insurance-linked securities, e.g. catastrophe bonds. Off-balance-sheet capital sources are illustrated as Insurance & Derivatives and Contingent Capital representing the risk transfer and risk retaining approaches respectively. The term insurative is therefore coined to refer to any source of corporate capital that is used to finance the firms activities and cover its risks. By incorporating off-balance-sheet (OBS) capital sources, Shimpi (2001) argues that calculation of cost of capital will include both off and on-balance-sheet components as follows: Total average cost of capital = + cost of debt x debt value firm value cost of equity x equity value + cost of OBS capital x OBS value firm value firm value

where firm value = debt value + equity value + OBS value 46

While the traditional view calculates a firms cost of capital as: Weighted average cost of capital2 = risk adjusted-cost of debt x debt value firm value + risk adjusted-cost of equity x equity value firm value

The fundamental difference between the two models is that under the conventional approach, the capital stock used to manage risk is provided from conventional funding sources such as equity, debt or hybrid securities, and the cost is reflected in the capital charge of those sources, whereas in Shimpis model, that required capital stock is a separate source of capital. This is also the basis of the criticism given by Doherty (2005) who argues that the formula of the total average cost of capital (TACC) is flawed in a fundamental way. The amount of OBS capital could be seen as the capital released from the balance-sheet as a result of undertaking the firms risk management strategy, therefore the capital base in the TACC formula is the total amount of capital required had the firm not undertaking the risk management strategy. In other words, the TACC formula measures the cost of a capital for a firm with an efficient risk management strategy using the capital base the firm would require for an inefficient and rejected risk management strategy (Doherty, 2005). In contrast, the use of onbalance-sheet capital in the WACC formula reflects the efficient and adopted risk management strategy, consistent with the risk-adjusted cost of capital used in the numerator. Effectively, once the hedge decision is made and executed, the released capital ceases to be relevant for calculating the firms cost of capital because the firm then needs only the amount of risk capital necessary to implement the hedging strategy (Doherty, 2005).

In short, the Insurative model is an interesting illustration of the convergence of capital management and risk management. Shimpi establishes a framework to incorporate considerations for the use of risk management instruments into capital structure decisions, suggesting that a firms debt-equity mix should only be determined after all risks, including those to be transferred and retained, have been identified, and the amount of offbalance-sheet and on-balance-sheet capital has also been determined. However the inclusion of off-balance-sheet capital sources, of which contingent capital is an example,
2

The component of hybrid securities should be converted to either equity or debt before entering the cost of capital formula. See Shimpi (2001).

47

into the capital structure does not convincingly illustrate that the overall cost of capital can be reduced by undertaking risk management. Other interesting insights gained from the model include the idea that hedging can release capital set aside to cover risks from being idle on the balance sheet and that the hedging decision can be evaluated by comparing the cost of the hedge and the cost of the released capital (Doherty, 2005). These insights illustrate the benefits and costs of undertaking risk management as discussed in the literature. They will be further explored in the next chapter where the value-enhancing effect of contingent capital option will be analysed.

Market and Participants

Overview of the Contingent Capital Market
The market for contingent capital is relatively small as compared to other traditional insurance and risk management products. Originally the market was created by insurers and reinsurers who arranged capital deals to provide capital support during hard time such as natural catastrophes and loss of equity and comply with regulatory capital requirements (Swiss Re, 1999). These capital arrangements allow insurers to transfer and finance insurance risks via the capital markets, with the total volume of transactions reaching US$13 billion in 1994 (Munich Re, 2001). Such activities were part of a so-called securitisation of insurance risk trend beginning in the early 1990s with the development of a range of Alternative Risk Transfer solutions such as catastrophe bonds and insurance derivatives (Punter, 2002). The risk transfer effects of these solutions gradually gained popularity and contingent capital deals were standardised as a product offered to both financial and non-financial corporations. The first deal was conducted in 1996 between RLI Corp, a US insurance company with major exposures to California earthquakes, and Centre Re in conjunction with Aon Re with a three year Catastrophe Equity Put, which gave RLI option to issue $50m convertible preferred shares in case of a Californian earthquake that exhausts RLIs reinsurance programme. The transaction was termed CatEPut which later became a brand name of Aon. 48

Since then the market has grown steadily over the years with major participation of large corporations. The table below summarises contingent capital deals archived in the ART Deal Directory of ARTEMIS a website dedicated to studies and information in the field of Alternative Risk Transfer and weather derivatives. Time 1996 Provider Client Capacity Details $50m 3 year CatEPut covering various

Centre Re and RLI Aon Re Corp.

catastrophe exposures $100m 3 year CatEPut covering various

Mar 1997 Aug 1997

Centre Re and Horace Aon Corp. European reinsurance, Allianz, Re, Securities Corporation Aon Aon Mann

catastrophe exposures CatEPut giving coverage for various cat exposures, allowing issuance of shares at predetermined rates in the event of a major loss

La Salle $100m Re

2000

Swiss Re New Michelin $1 Markets led a syndication banks insurers of and billion

Michelin was granted a five-year put option to issue subordinated debt maturing in 2012

Jan 2001

Swiss Re New Royal Markets Bank of Canada

C$200m

Swiss Re New Markets agreed to purchase up to C$200m in Royal Bank of Canadas preference shares should the banks loan portfolio suffer extraordinary losses.

Sep 2002

Swiss Re

Horace Mann

$75m

Three year option agreement gives Horace Mann the right to issue up to $75m of cumulative convertible preferred securities to Swiss Re Financial Products Corp if Horace Mann incurs catastrophe losses exceeding a pre-determined level.

Table 2: Directory of Contingent Capital Deals (Adapted from ART Deal Directory, ARTEMIS) 49

Participants
The table shows that the market is largely dominated by insurers and reinsurers. This dominance is explained by both the origination of contingent capital and the advantage of insurers in providing the solution. Firstly, developing contingent capital was an initiative of the insurance industry aiming at providing capital support for insurers to comply with capital requirements, then diversifying product range and taping into the capital markets to cater to corporate client needs (Sawyer, 2002). Secondly, writing contingent capital deals require significant experience in determining a qualified loss making event and in measuring probabilities of its occurrence. Credit evaluation and structuring expertise are also requisite skills necessary for administering contingent capital arrangements (Neftci, 2000). As venerable specialist in providing post-loss indemnification services, the insurance industry has apparent advantages in capitalising on their experience and moving on operating in this newly expanded field (Tobey Russ, CEO of Chubb Financial Solutions, cited in Risk, 2000). Moreover, insurance companies also have experience in buying structured paper and take part in private placements, evidenced by fast growth of insurance-link securities and structured notes in the Alternative Risk Transfer market. This competence enables them design flexible customisation for contingent capital deals (Sawyer, 2002).

In organising contingent capital deals, there are typically one or two lead capital providers who act as agents and a group of institutional investors who would purchase the securities if issued. Such syndicate together shares the risk and returns of providing the facility, thereby lowering the asymmetric information costs that could make the facility too costly to be viable (Schenk, 2000).

In the spotlight, Aon Re and Swiss Re are two leading capital providers and have established their own branded products, Catastrophe Equity Put (CatEPut) and Committed Long Term Capital Solutions (CLOCS) respectively. Since most option writing parties involved in contingent capital deals to date have been large financial institutions, credit risk has not been a big issue (Sawyer, 2002). However, the issue of liquidity has been a concern for capital providers since they would prefer to receive tradable securities rather 50

than illiquid ones which would prove very risky in case the option holder defaults on securities issued under contingent capital arrangements (Shimpi, 2001). The buyers of contingent capital options have been mostly financial institutions as well, although non-financial firms also found multiple benefits from using the instrument. For example, financial institutions like banks and insurers might use this facility to replenish capital in the event of unexpectedly large losses (Culp, 2006). Non-financial companies, on the other hand, might want to arrange borrowing at pre-determined rates to avoid credit downgrade in difficult economic times (Sawyer, 2002). Therefore, contingent capital can be shown to serve different financial plans with the same aim to serve both capital management and risk management objectives.

Featured Case
The following case study has been discussed widely as setting the standard for the use of contingent capital:

Compagnie Financire Michelin integration of bank and insurance markets3

In 2000, Compagnie Financire Michelin (CFM), the Switzerland-based financial and holding arm of the French tyre maker Michelin, was looking for a capital facility of a similar credit volume to replace a 15-year $1 billion subordinated loan which it took up in 1990. When considering remarketing the loan at the time it was five years away from maturity, the group decided that its limited time to maturity made it not suitable for the groups strategic investment plans. The aim of looking for a new source of capital was to allow CFM take advantage of business opportunities such as acquisitions and partnerships, and conduct restructuring if required.

This featured case is based on Culp (2002b), Schenk (2000) and Banham (2001).

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At that time, Michelins debt to equity ratio stood at 1:1 and its business risk was relatively low with value-at-risk at 20-25%. Michelin therefore needed some debt to maximise the value for the shareholders, and was approached by Swiss Re New Markets which teamed up with Socit Gnrale (SocGen) to arrange a $1 billion 12-year committed subordinated loan facility. This deal actually involved both bank debt from SocGen and Committed Long-term Capital Solutions (CLOCS) from Swiss Re. Under the bank portion of the deal, CFM has guaranteed access to a bank credit facility from SocGen for five years, i.e. up to 2005, in return for a commitment fee of 35 basis points per annum. This part of the deal is essentially a committed line of credit and did not involve a second trigger.

Under the CLOCS portion, Michelin was granted a five-year put option on subordinated debt maturing in 2012, i.e. if drawn, the debt will be outstanding until 2012. The second trigger embedded in the option is a fall in the combined average annual GDP growth rate in the euro zone and the US below a certain level. This trigger threshold, calculated using scenario tests executed with a stochastic model bought by CFM and Swiss Re New Markets for this particular deal, was set at 1.5% in the first three years and 2% in the last two years of the option. The deal, which CFM agreed to pay an annual fee of 30 basis points, involved a Swiss Re-led syndication of European banks including BNP-Paribas, Crdit Lyonnais, Crdit Mutuel Banque Populaire and insurers including Winterthur of Credit Suisse. If the trigger is activated and CFM decided to exercise the option, it will have access to capital at a borrowing cost of between 70 basis points and 110 basis points over LIBOR, depending on the specifications of the granted loan. Swiss Re New Markets contributed itself an initial $100m commitment. This CLOCS deal vividly illustrates the use of contingent capital option at a non-financial firm in several ways. Firstly, the embedded second trigger is tied to a macro variable highly correlated with Michelins revenues since the tyre maker makes the bulk of its 16 billion sales in Europe and North America, with 49% and 36% of total sales respectively (How, 2006). Such high correlation helped to limit basis risk which is a potential problem for any proxy trigger used in contingent capital option. Moreover, the fact that the trigger was out of CFMs discretion helped to limit potential moral hazard

52

issue. If GDP fell in these major markets, the facility would inject capital and allow restructuring at CFM.

Another illustrating point was the availability of capital from a syndication of financial institutions which allowed an attractive overall cost of the deal for CFM. Compared to the SocGen bank debt portion of the integrated deal, this CLOCS deal has a commitment fee of five basis points per annum lower, a significant discount given the credit volume involved. In addition, while traditional bank syndication and Eurobond markets would allow most corporate debt maturing up to ten years only, this CLOCS deal allows up to 12-year debt issued following an exercise of the facility.

To CFM, this contingent debt deal fitted its capital structure strategy which was in favour of debt since the French economy was not bullish enough for issuance of equity and Michelins share price was trading at only 110% book value. While avoiding issuing equity and its expensive costs, CFM could still maintain a natural hedge against economic downturn by reserving a financial source in advance. This gives shareholders the confidence that the group can weather risks as well as take up any expansion or acquisition opportunities that arise. To the financial institutions involved in the deal, this was a ticket to form partnership with Michelin in the future, a promising opportunity given the strong growth of the worlds number-one tyre maker. The integrated deal also proved a successful combination of banks and insurers to satisfy both the short term credit needs and the long term capital option of the client.

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Chapter 4
Value?

How Might Contingent Capital Add

Although the literature and study evidence have praised risk management for enhancing firm value, this value-increasing effect varies across different strategies. The academic literature, however, has largely ignored the variety of approaches to manage risk and the rapid development of new solutions, especially alternative risk transfer methods, and focus instead on two most popular approaches to date: insurance and derivative hedging. This lack of interest in non-traditional risk management approaches can be explained by an impression of opacity of the new solutions and the actual paucity of empirical data. These issues, however, should not hinder an analytical investigation into the use of an evolving risk management approach to bring some light into the discussion and generate further interest in digging empirical information. After reviewing the literature underpinning the development of risk management instruments and introducing contingent capital the convergence product of risk management and corporate finance, we will take on the proposed idea to explore the value-increasing effect of this approach by following the framework used in studying risk management activities to examine whether using contingent capital results in similar effects. As reviewed in chapter 2, risk management can add value when it affects expected future cash flows, cost of capital, and the organisational efficiency in generating firm value. Specifically, the use of risk management can be valuable in reducing expected tax liabilities, bankruptcy costs, and mitigating organisational conflicts. The discussion below will explore the use of contingent capital in each aspect and use numerical examples to illustrate and summarise the arguments. Finally, some practical problems entailed in using contingent capital will be highlighted.

Impact on Tax Liabilities

As the literature review in chapter 2 reveals, the use of risk management activities is considered having a negative effect on tax liabilities by reducing volatility of after-tax earnings in progressive tax systems. This is a general statement which has been tested 54

primarily on the use of hedging using derivative contracts (see Smithson, 1998; Smith, 2006). Using contingent capital has both similar and dissimilar effects on tax liabilities compared to other risk management approaches. First, contingent option premiums paid to capital provider are also treated as business expenses (Culp, 2002a) like insurance premiums and financial option premiums; hence paying for contingent capital option also reduces taxable income and the resulting tax liabilities. However, unlike other hedging instruments such as derivatives securities, contingent capital acts to smooth cash flows (Shimpi, 2001) instead of earnings as capital injected will enter the statement of cash flows but not the profit and loss accounts. Effectively exercising contingent capital option to issue equity or debt results in increased financing cash flows and net cash flows, while the effect on net income will only start to appear from the first payment of dividend or coupon on the securities issued. On the other hand, receiving payout from other hedging contracts will increase cash flows less the tax levied on the amount received (Harrington and Niehaus, 2003). Consider the following numerical example which compares contingent capital with a typical risk management approach - the insurance contract, in terms of effect on tax liabilities. Firm A is looking for an infusion of capital next year to finance new investment opportunities just sought from overseas. However, the firm is concerned of possible losses from a market downturn at the end of the year making profit decline and affecting the cost of issuing capital. The firm has a choice between purchasing an insurance contract with a limit of $15,000,000 at a premium of $500,000; and purchasing a loss equity put from a capital provider at the same premium to issue up to $15,000,000 in convertible preference shares in case the market goes down.

Suppose that firm A is subject to tax rate of 34% for taxable earnings above $10,000,000 and 20% for taxable earnings below $10,000,000. If the market does not go down, it can expect to earn $20,000,000 in taxable earnings. Market research says that there is a 20% possibility that the market will go down, which will make its earnings drop to $5,000,000. Therefore, there is a 20% chance that firm A will suffer from a loss of $15,000,000 compared to normal earnings. 55

The option purchased by firm A can only be triggered in case of a defined loss, which is similar to the payout from insurance or a derivative hedging contract. Assume that the payout from either the insurance contract or the contingent option will pay for the full loss if occurs, therefore post-loss balance sheet of firm A will receive $15,000,000 which will attract tax in the insurance case but not in the contingent capital case. The table below compares firm As after-tax taxable earnings and changes in cash flows in three scenarios: without risk management, with insurance, and with contingent capital. Taxable earnings ($000,000) Without risk management No downturn (80%) 20 20 x (1 - 0.34) = 13.2 Operating CF: +20 - 0.34x20 = +13.2 Downturn (20%) 5 5 x (1-0.2) = 4 Operation CF: +5 - 0.2 x 5 = +4 Expected after-tax earnings = 13.2 x 0.80 + 4.0 x 0.20 = 11.36 After-tax earnings ($000,000) Change in cash flows ($000,000)

Expected increase in cash flows = 13.2 x 0.80 + 4.0 x 0.20 = 11.36 Insurance No downturn (80%) 20 - 0.5 = 19.5 19.5 x (1- 0.34) = 12.87 Downturn (20%) insurance pays out Expected after-tax earnings = 5 + 15 0.5 = 19.5 19.5 x (1- 0.34) = 12.87 Operating CF: +19.5 0.34x19.5 = 12.87 Operating CF: +19.5 0.34x19.5 = 12.87 12.87

12.87 x 0.80 + 12.87 x 0.20 =

Expected increase in cash flows = 12.87 x 0.80 + 12.87 x 0.20 = 12.87 Contingent capital No downturn (80%) 20 - 0.5 = 19.5 19.5 x (1- 0.34) = 12.87 Downturn (20%) issue shares 5 0.5 = 4.5 4.5 x (1-0.2) = 3.6 Operating CF: +19.5 0.34x19.5 = 12.87 Operating CF: +4.5 4.5 x 0.2 = + 3.6 Financing CF: +15 Expected-after tax earnings = 12.87 x 0.80 + 3.6 x 0.20 = 11.016

Expected increase in cash flows = 12.87 x 0.80 + 18.6 x 0.20 = 14.016 Table 3: Impact on tax liabilities of using contingent capital 56

As the table shows, the one-off capital injection from exercising the loss equity put does not help to smooth after-tax earnings as the payoff from insurance does, and even results in reported earnings lower than when not using risk management due to the commitment fee paid regardless of whether the option is exercised. On the other hand, using contingent capital will result in higher expected cash flows which might be more appealing to shareholders than the reported earnings figures.

The difference in expected after tax earnings between insurance and contingent capital arises from the difference in their loss financing approach. Based on the principle of indemnification, insurance policies only provide payout to help the insured recover up to the point where it would have been without the loss (Billings and OBrien, 2006). In contrast, when contingent capital option is triggered, the option buyer can demand the writer to infuse capital into the buyers balance sheet in exchange for some proportion of financial claims. The capital provider will then become a stakeholder of the buyer and will receive income distribution (for shareholders) or coupon payments (for debtholders) while the insured in an insurance contract has no obligation to make further payments after the claim is settled. This suggests that the use of contingent capital should aim at strategic objectives of financing new investments to maximise shareholders wealth rather than at regular savings on tax liabilities.

Impact on Financial Distress Costs

Academic studies have found that decreasing costs of financial distress and increasing debt capacity are major incentives for firms to implement risk management in various types including using derivative securities and insurance contracts (Smith and Stulz, 1985; Mayers and Smith, 1990; Judge, 2006). Viewed as a source of capital to support firms activities as illustrated in the Insurative model, contingent capital helps to reduce pressure put on cash flows by the existing leverage, thereby reducing the costs involved in liquidating the firm when it fails to service all its debt. However, a closer look at the design of contingent capital option reveals that it does not serve as a means to prevent bankruptcy. First, funding from contingent capital contract is only granted when the option buyer meets a set of conditions 57

which are designed to protect the option writer and their investment in the loss-stricken firm. Intuitively an investor only pours capital into a firm if she knows that her money would come back manifold which implies that the capital receiver should possess some growth potential. Moreover, covenants are often in place to protect capital providers from stepping into a distressed firm. Restrictive conditions such as material adverse clauses reduce the possibility of exercise of contingent capital option but not the possibility of adverse situations. Therefore, contingent capital is not designed to prevent firms from going bankrupt; instead it stands ready as a funding source for firms with substantial growth potential but are exposed to risk of financial loss that may deter them from taking up their investment opportunities. In addition, unlike other risk management approaches which result in cash payoffs to bail out a firm in financial trouble, contingent capital option when triggered will provide additional capital into the firms balance sheet and create a new capital structure with different leverage scenario, hence the costs of financial distress also change. Therefore the implications of contingent capital turning into on-balance-sheet capital depend on the state of the capital structure right before the triggers are pulled, i.e. after the firm has suffered some loss up to the amount specified in the contract. For example, a contingent equity capital contract which will reduce leverage and thus probability of financial distress will be a valuable option for a firm which has stacked up too much debt in its balance sheet, but will cause undesirable dilution for a growth firm which has been financed mostly by equity capital. On the other hand, a contingent debt capital contract may make a loss-stricken firms financial health even worse if the exercise of the option brings in new creditors when the firm is already having problems with servicing its existing debt. This option however could be worthwhile for other firms which are still making debt payments but already reaching their debt capacity. Issuing contingent capital option on hybrid securities like preferred shares can avoid changing leverage as well as dilution effect and still provide loss financing like other options on equity and debt capital. Consider the following examples:

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Firm B is a high-tech firm producing corporate accounting software. It has been financed mostly by equity and has the following capital structure.

Assets Debt Equity

$3,000,000 $500,000 $2,500,000

The firm has reached maturity stage and would like to issue debt to increase its leverage ratio. Management anticipates possible tightening monetary policies resulting in higher interest rates and would like to purchase a contingent capital option maturing in 3 years to lock in the cost of issuing debt. In year 2, one of its clients reported loss of corporate information and the firms major profit-making software was sued for failing to protect client privacy, leading to a total ban from being sold in the market. Moreover, it was found that the privacy platform used in this particular software was the firms core technology being used in a range of other applications it offered. As a result, share value dropped to $300,000, stalling all projects in pipeline and pushing the firm to the verge of bankruptcy. In such situation, the contingent debt option could be made void if the attached covenants require a lower leverage ratio for the option to be exercised. If it is still exercised, the increased leverage will be a large burden for the firm as it starts investing in research to rebuild its technology platform. In another example, firm C is a heavily indebted company producing replicas of fighting aircrafts for entertainment and collection purposes. Firm C currently has the following capital structure: Asset Debt Equity $2,500,000 $2,300,000 $200,000

The market for physical toys, especially those aiming at male consumers, has increasingly been cannibalised by internet entertainment such as online games. The firm has several models in development and has purchased a contingent equity capital option maturing in 4 years to lock in the cost of issuing equity against such bearish market. In year 3, the firm won a contract to produce a large amount of aircraft replicas for the Society of War Museums which promoted the use of these replicas for educational purposes at all of its 59

member museums. Share price of firm C rose to a record high, making the option out-ofthe-money as the firm walked out from the edge of bankruptcy on its own. These simplified examples show that the use of contingent capital could be ineffective in mitigating financial distress costs as the leverage structure of the firm holding the option could change before exercise, creating unexpected effects of exercising the option on probability and costs of financial distress. Therefore, when considering purchasing and using contingent capital options, financial managers will have to take into account contingencies that could change the state of the balance sheet at the time of exercise.

Impact on Shareholder Manager Relationship

As reviewed in chapter 2, academic theories suggest that risk management can reduce managers risk aversion and encourage optimal investments, and empirical evidence also gives support to the argument. As a risk management solution, contingent capital also acts to mitigate shareholder-manager conflict but its nature as a pre-arranged financing mechanism could potentially exacerbate the agency problem as explained below. On the upside, contingent capital designed as part of a corporate risk management program might reduce the costs of agency conflict by reducing managers risk aversion in undertaking investment projects. Using contingent capital increases financing flexibility for corporate managers by giving access to capital in case of difficulty without having to use critical financial resources set aside to fund operations (Sawyer, 2002). Most financial management plans include working capital facilities and bank credit lines to inject regular capital into a firms growth machine but using them comes at a cost of forgoing other opportunities. For example, a swimsuit manufacturer is considering a large order for the new season but is concerned of a possible fire that could require a substantial fund to restore and carry on production. If it draws funds from a bank credit line it can be short of cash to purchase materials for the next season which expects higher demand. Alternatively, if the firm has a contingent capital option to issue capital at favourable terms, this can be a supplementary financing source that supports the firms cash flows under difficulty without using up its vital sources for continuous operations, thereby increasing managers confidence with their decision. 60

However, using contingent capital does not entirely wipe out agency costs which result from information asymmetry between managers and shareholders. By laying out access to fund in advance, contingent capital might exacerbate the agency conflict by eliminating the supervision of external market investors which helps shareholders scrutinise managers effort in putting forward investment projects. When a firm introduces an investment opportunity and calls for funding, investors in the market would take into account firms investment needs and potential of the project to give evaluation and ongoing monitoring throughout the course of investment. This helps to prevent managers from choosing unprofitable projects and taking advantage of excess free cash flows brought about from investment returns. When contingent capital is brought in, managers are assured of pre-arranged financing and freed from such external supervision. Therefore they might be tempted to benefit themselves by siphoning off shareholders value. This argument is developed by Tufano (1996) who reports anecdote evidence that some managers are actually inclined to undertake risk management for their own good rather than according to shareholders interest. Consider the following example which is developed from Tufanos example. Firm D and E are both oil firms of similar size. Managers of firm D are aligned with shareholders and trusted to act in shareholders best interest, whereas managers of firm E look to siphon off benefit from investment returns to maximise their own wealth. Assume that managers of firm D will transfer total returns from investment to stakeholders whereas managers of firm E attempt to consume 20% of returns before distributing to others. The two firms have similar current earnings which could end at $180 or $20 with equal probabilities. At the beginning of next year, they will both be offered an investment opportunity requiring an outlay of $100 which earns a rate of return of 5%. If the firms earnings end at $180, they will not need to seek extra funding to finance the investment and will invest the $80 excess earnings zero-rate-of-return account. Total earnings from their investments will be $100 x 1.05 + $80 = $185. However if they are short of funding, they will have to raise money in the market at a rate of 8%. The capital market would typically investigate if the firm has sufficient cash flows at disposal to service the debt issued. Alternatively the two firms can purchase an option to raise money for the shortfall at a pre-agreed rate of 6%. In either case, returns from 61

investment project will be distributed by managers who arrange payment for themselves, then the market investors (if no option is purchased in advance) or the capital provider (if contingent capital option is exercised) and the shareholders. The following table shows the payoffs to shareholders and managers in the two scenarios: Firm D Cash flows Shareholder No option CC 100x1.05+ Borrow 80 = 185 (185+18.6) 185 105x0.2 164 No = borrowing allowed. 0 (164+0)/2 = 82 High Low Expected High Firm E Low Expected

$80 at 8%: /2 = 101.8 100x1.0580x1.08 = 18.6

With option

CC 100x1.05+ 100x1.0580 = 185

(185+20.2)

185 105x0.2 164

20.2

(164-0.8)/2

80x1.06 = /2 = 102.6 20.2

= 105x0.2 = = 81.6 -0.8

Decision

Buy Contingent Capital Option

Do not buy Contingent Capital Option

Manager No option With option Decision Buy Contingent Capital Option CC Act in shareholders interest CC Act in shareholders interest 105x0.2= 21 105x0.2= 21 Buy Contingent Capital Option 21 21 0 10.5

Table 4: Impact on manager-shareholder conflict of using contingent capital option For firm D, all returns will be distributed to stakeholders and managers always act in shareholders best interest. o If firm D does not purchase contingent capital option, it will have to borrow $80 at 8% when cash flow is low at $20. Returns from the investment will be paid first toward this borrowing account. Shareholders are left with the remainder.

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o If firm D purchases contingent capital option, it will exercise the option to borrow $80 at 6% when cash flow is low. Returns from the investment will also be paid for this amount first, leaving shareholders the remainder. For firm E, when the firm invests in the new project, managers will siphon off 20% of the returns which is $105 x 20% = $21. o If cash flows end at $180, the firm can fund the new investment without borrowing and shareholders will enjoy $185 $21 = $164. o If cash flows end at $20, without a contingent capital option on hand, the firm cannot approach a bank to ask for external financing because the bank would ask for return of $80x1.08 = $86.4 while shareholders would be left with only $105 - $21 = $84. Therefore there is no borrowing and the managers cannot siphon off value from the investment. o If firm E purchases contingent capital option, it can exercise the option to borrow at 6% when cash flow is low. The return will be consumed by managers, option writer, and the shareholders will be left a negative return. Therefore, the shareholders of firm E are better off not buying the contingent capital option, while the managers are shown to have incentive to buy this option so that they can secure financing for the investment project which would otherwise be refused by the capital markets. The intuition from this example is that if agency conflict is severe, using contingent capital option may lead to managers undertaking projects without taking into account shareholders value maximisation objective. Interestingly this is metaphorically analogous to the risk thermostat problem discussed in chapter 2 in which managers having undertaken risk management feel unconstrained to take risks to the level they feel comfortable with. As Tufano (1996) reflects from his experiences with managers, in some occasions managers put forward risk management programs to protect their pet projects, i.e. those with critical importance to shareholders and potential for managers to siphon off value for their own benefit. Therefore, although using contingent capital can help to reduce managers risk aversion in undertaking investment decisions, it has the downside as managers can take advantage of the assurance it provides and diverge from shareholders interest. 63

Impact on Underinvestment Problem

Apart the above agency conflict between shareholders and managers, underinvestment which results from the conflict between shareholders and debtholders also affects the efficiency of investments. Debtholders are concerned that because of the existing leverage structure shareholders would pass up positive NPV projects to avoid wealth transfer to debtholders (Smith and Stulz, 1985). To mitigate this conflict, shareholders have to assure debtholders that the firm has sufficient cash flows to undertake investment opportunities when arise so that the shareholders can choose optimal levels of investment and financing (Froot et al, 1993). This is one of the objectives that using contingent capital aims to achieve, i.e. providing cash flows to firms to take up investment opportunities after suffering from loss. Although the fund is generated externally, it comes at pre-agreed terms which allow firms minimising the cost of fund raising while also avoiding the cost of keeping capital on the balance sheet (Shimpi, 2001). Consider the following example to see the effect of having a contingent capital option in place can induce firms to take up profitable investment. Firm F is contemplating an investment opportunity which requires $55 million outlay. The investment has a probability of 90% to generate $60 million in value at the end of the year and 10% to be worth only $20 million following a fire. Assume that if the fire occurs, firm D could put in an additional $20 million and restore the investment to $60 million. Firm F wants to borrow from the bank and promises to repay $45 million at the end of the year. Assume for simplicity that the discount rate is zero. The bank is not sure whether firm F will reinvest if a fire occurs and hence could be left with only $20 million if firm F does not put in the additional investment to restore the project. Therefore, the bank can expect payment of $45 million with probability of 90% and $20 million with probability of 10%. The amount of loan can be given to firm F is therefore $42.5 million ($45 mil x 90% + $20 mil x 10%). To undertake the $55 million project, firm F therefore will have to put in $12.5 million outlay.

64

If there is no fire, the investment will be worth $65 million o The bank gets paid: $42.5 mil o Firm Fs payoff from investment: $65 - $42.5 - $12.5 = $7.5 million

If there is fire, firm F will consider whether to reinvest: o If reinvests: firm F pays an additional $20 million, the investment will be worth $65 million. The bank gets paid: $42.5 million Firm Ds payoff from investment: $65 - $42.5 - $20 - $12.5 = -$12.5 million o If not reinvest: the investment will be worth only $20 million The bank gets all what is left: $20 million Firm Ds payoff from investment: -$12.5 million

As shown from the payoffs in case of a fire, firm E will have an incentive to abandon the project if a fire occurs because further investment will result in larger loss. This is because most of the investment return will be distributed to debtholders instead of the firms existing shareholders. With an anticipation to abandon the project if a fire occurs, firm Es expected payoff from investing in this project is $7.5 x 90% - $12.5 x 10% = $5.5 Now consider the case when the firm has already purchased a contingent capital option to finance the additional investment required in case a fire occurs. In this case, assume that firm F pays $500,000 to get a right to issue $20 million in equity which is only triggered after the fire. The bank will be assured that firm E will reinvest if a fire occurs and therefore will give a loan of $45 million and the firm needs only $10 million outlay to advance. If there is no fire, the investment will be worth $65 million o The bank gets paid: $45 million o Firm Fs payoff from investment: $65 - $45 - $10 - $0.5 = $9.5 million If there is fire,: the contingent equity option will be triggered, giving $20 million, the investment will be worth $65 million. The bank gets paid: $45 million Firm Fs payoff from investment: $65 - $45 - $10 - $0.5 = $9.5 million. 65

Therefore, purchasing contingent capital option can secure a financing source for losses which could deter the firm from taking a profitable investment. The firm will no longer be concerned about wealth transfer to the bank and the bank is also assured that the firm will not forgo post-loss investment and leave the loan not serviced.

Impact on Costs of Issuing Capital

Raising external capital is an important mission that most corporations have to spend substantial financial and human resources to arrive at a decision which is both costeffective and gives a strategically correct signal to the market. Literature in corporate capital structure proposes that information asymmetry between issuers and investors in an imperfect capital market makes raising external capital costly (Brealey, Myers and Allen, 2006). Effectively investors with less knowledge than managers about the firms investments are likely to assume that managers seek external funding only when they feel that the firm value is overpriced. As a result, investors always depress the price they pay for the securities issued to balance with managers expectation (Smithson, 1998). This conclusion is the basis of pecking-order theory which ranks financing choices in terms of the information gap between the issuer and investors (Froot et al., 1993). Therefore, a firm with cash flow shortfall and would like to raise new fund will be constrained by the costs of issuing securities at the terms suitable for their capital structure and investment policies.

Since risk management activities work to safeguard earnings against adverse scenarios, they are suggested to reduce the need to call on new capital (Froot et al, 1993; Stulz, 1996), hence reducing the expensive costs involved. Moreover, the use of contingent capital has a greater effect in helping firms mitigate the cost of issuing capital than other instruments in several ways. First, pricing of contingent capital is structured with anticipation of capital issuance following a specific loss of significant severity, which typically has lower probability of occurring than probability of default used in pricing debt capital (Neftci, 2000). Therefore, contingent capital contract has lower risk to the capital provider than debt securities (Shimpi, 2001); hence the former should be less expensive than the latter. In addition, any company suffering a severe loss will be at a great disadvantage when entering the market for additional equity as the market would doubt its potential to resume and sustain growth. Securing a source of capital in advance would 66

place securities with a small group of investors with sufficient information and avoid such disadvantage. Moreover, contingent capital option created with a large capital provider also has positive signalling effect which helps reduce the market discount typically applied for new capital issues. This effect comes from the fact that the potential issuer has cleared due diligence process and has capital issues subscribed to by an established institution when things go wrong (Sawyer, 2002). However, issuing capital under contingent capital option also incurs underwriting cost which should be taken into account together with other commitment fees and weighed against the issuing cost at normal rate (Banks, 2004). Now lets consider another example to see the impact of purchasing contingent capital option in issuing new capital. Firm G is assumed to operate over a two-year horizon. Assume that firm G is facing possible losses from a pending lawsuit at the end of the year making its cash flows uncertain. If the firm does not face the lawsuit, which is estimated to have a possibility of 80%, it will have cash flows of $20,000,000 otherwise cash flows will be -$5,000,000. Therefore, the firm has 80% chance of suffering a $25,000,000 loss relative to its normal cash flows. The second year cash flow is assumed to be $35,000,000. Firm G has been heavily financed by equity and wants to finance the loss by debt capital to raise the debt equity ratio to industry-wide level. As a result, the firm has two options to consider. First, it can issue debt at end of year 1 equal to the loss amount. The infusion of debt capital in the case of loss will eliminate the possibility of having negative cash flows and fix expected end-of-year-1 cash flows at $20,000,000. This approach tends to be very costly in practice because of underwriting cost and administration fees. Assume that the rate of return required by existing shareholders is 10%, but new debt issued after a loss occurs would raise the cost of capital to 15%. The second year cash flow will be used to repay new debt and the remaining will be distributed to existing shareholders in year 1. Therefore if firm B issues new debt, at end of year 2 the debtholders will receive $25,000,000 x 1.15 = $28,750,000; and original shareholders will receive the remaining of $35,000,000 $28,750,000 = $6,250,000. Alternatively, firm G can purchase a contingent capital option for a premium of $500,000 which gives it a right to issue $25,000,000 debt to finance the loss at end of year 1. Assume the new cost of capital is agreed to remain at 10%. The infusion of capital will 67

eliminate the negative cash flow possibility and fix end-of-year-1 cash flows at $20,000,000 - $500,000 = $19,500,000. The second year cash flows will be used to repay new debt issued and the remaining will be distributed to existing shareholders in year 1. Therefore, at end of year 1, new debtholders will be paid $25,000,000 x 1.10 = $27,500,000; and original shareholders will be left with $35,000,000 - $27,500,000 = $7,500,000. The table below summarises the expected cash flows for the two options above: Cash flows available First year cash flow (in millions) Second year cash flow (in millions) for shareholders at end of year 2 (in millions) Issuing debt capital after loss No lawsuit (90%) Lawsuit (10%) $20 $20 $35 $35 $35 $6.25

Firm value at beginning of year 1 = 0.9 x [ Purchasing contingent debt option No lawsuit (80%) Lawsuit (20%) $19.5 $19.5

20 35 20 6.25 + 2 ] + 0.1 x [ + ] = $44.69 1.1 1.1 1.1 1.15 2

$35 $35

$35 $7.5

Firm value at beginning of year 1 = 0.9 x [

19.5 35 19.5 7.5 + ] + 0.1 x [ + ] = $49.34 1.1 1.1 1.1 1.12

Table 5: Impact on cost of issuing capital by using contingent capital option.

The illustration above shows that by paying an advance commitment fee of $500,000 firm B can lock in the cost of issuing debt capital and effectively increase firm value against anticipation of a major loss occurring. This example however does not reflect the dilution effect which could occur if equity is issued in the contingent capital case. Dilution occurs when new shares are issued without a proportionate increase in firms assets, making the value of each existing share lower. This is a common result of exercising company-issued options such as warrants and executive stock options. Therefore, when considering purchasing contingent capital option, financial managers have to take into account not only total firm value but also the value distributed to each shareholder as this may result in adverse shareholder judgment.
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What Make Using Contingent Capital Difficult?

The analyses above present some theoretical predictions that contingent capital can be a useful tool for firms to manage risks. Despite much expectation the facility has not been very popular since its introduction due to a number of practical difficulties in implementation. The numbers of deals completed every year as well as the number of participants remain small. The discussion below will highlight some of these issues.

Pricing
As discussed in the previous chapter, contingent capital is a relatively new facility and its pricing has not been studied thoroughly. The analogy with reverse knock-in put option does not perfectly align contingent capital pricing with put option pricing as the former still requires probabilistic expectation of a triggering event which is not based on the underlying value and modelling the relationship between those two unrelated variables. In other words, pricing contingent capital requires a combination of risk assessment and actuarial skills to be applied with option pricing methodology. The difficulty lies in that there is little data available to estimate the probability of the trigger and its impact on underlying value. Data insufficiency gives way to erroneous pricing which might considerably affect the transaction given a large amount of capital involved.

Moreover this mathematical challenge must be done with precision and objectivity. To resolve this, Aon Re contracted a third-party risk-modelling firm whose role is retrieving data from the solution buyer and preparing a model to produce estimations (Callahan, 2001). Other providers such as Swiss Re cooperate with clients in selecting third-party software to assist accurate and fair pricing (Schenk, 2000). Such procedure increases transaction costs and the perceived complexity of the facility which limits its popularity in the market. These transaction costs already have to cover stringent due diligence process to minimise asymmetric information between the two parties. In addition, the price of contingent capital can only be appealing to the market if all the costs involved are outweighed by the resulting benefits, which only appear after the option is exercised. Therefore the question whether these efforts in making fair pricing are worthwhile can only be answered with time.

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Marketability
In a contingent capital transaction, the solution provider is typically an intermediary between the issuer of the contingent securities and the capital markets where the securities will be issued. Therefore whether the transaction will be successful or not depends critically on the ability of the intermediary in assembling a group of interested investors who are willing to assume the risks transferred from the issuer. In the case of Michelin, Swiss Re was the deal maker who called upon a syndication of banks and insurers to share the $1 billion contingent subordinated debt deal of which Swiss Re contributed $100 million. Other providers such as Aon Re and Centre Re also team up with investment banks to leverage upon their extensive client relationship. This shows that making contingent capital deals requires a lot more than just technical skills to give accurate pricing. While information about contingent capital remains limited, the marketability of each deal depends crucially on reputation of the issuer and the deal maker. Therefore in the meantime market participants will remain limited among large financial institutions with sufficient capacity and large corporations with adequate credibility.

In addition, getting corporations interested in this new solution given a range of risk management solutions currently available also requires marketing effort of the suppliers. Many companies would prefer sticking to the more popular risk management channels such as insurance or derivative securities, rather than trying a new integrated product with limited popularity and requiring more resources to conduct long term strategic planning than those used for dealing with short term market volatility. The challenge to the solution providers is to approach potential individual clients and customise contingent capital solution to each specific situation. This was the case of Michelin which was approached by Swiss Re and Societ Gnrale to negotiate and set up the CLOCS deal. As the number of deals is still limited, subsequent potential users are restricted from gaining experience from previous users and may have to rely on the solution providers for instructions and cautions of using contingent capital, which might create concerns of informational disadvantage and hence further limit the appeal of the solution.

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Communication with stakeholders

While financial institutions have difficulties in marketing contingent capital solutions to potential corporate users, corporate managers have their own challenge when deciding to use contingent capital in explaining their intentions to the stakeholders. Theories suggest that risk management helps increase firm value but to arrange a contingent capital deal which could result in changes in capital structure such as increasing the number of shares outstanding or increasing debt would need thorough explanation before it could be approved.

Effectively shareholders of public corporations can diversify their portfolios and achieve their desired risk level. Therefore, while the benefits of using contingent capital have not been verified by practical evidence, potential problems such as managerial opportunistic behavious as discussed previously might create some sense of hesitation. In addition, potential dilution is also an important concern to shareholders if additional equity is issued following the exercise of contingent capital option. For debtholders, potential change in leverage structure leading to increased probability of insolvency has the same weight of concern as dilution to shareholders. Not only will the terms of the transaction but also the credentials of potential investors in the to-be-issued securities need to be well articulated to the stakeholders. Such concerns have been reflected in the popularity of non-dilutive and subordinated securities in the contingent capital deals known to date. For example, Michelin issued $1 billion subordinated debt under its CLOCS deal and RLI Corp. issued 50 million convertible preferred shares under its CatEPut deal 4.

Moreover, to present thoughtful justification for the use of contingent capital, managers also need to underline the imperative of catching potential strategic opportunities and the imminence of loss which could push those opportunities out of hand. In the case of Michelin, the CLOCS deal was grounded on managements aim to be able to grasp acquisitions and partnerships opportunities, as well as to respond to the need for restructuring. These challenges for managers need a clear and well directed strategy together with managerial bravery to put forward such an integrated capital managementrisk management initiative.
The issue of convertible preference shares is not dilutive until conversion, which occurs three years after issuance (Nieman, 1999).
4

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Chapter 5

Conclusions

Does contingent capital add value?

The financial theories underpinning risk management studies suggest that risk management does not add value under the conditions of perfect capital markets, but does so once those conditions are relaxed. Studies also provide evidence for the value of risk management in reducing expected tax liabilities, reducing probability and costs of financial distress, and supporting optimal financing and investment decisions by mitigating organisational conflicts. Based on this framework used in analysing the value of risk management, the analyses in the previous chapter suggest that the significance of contingent capital depends on the aspect of value-increasing being discussed. Specifically it is shown that contingent capital brings in benefits in reducing cost of issuing capital and minimising the effect of the conflict between shareholders and debtholders, i.e. the underinvestment problem. However, using contingent capital does not seem to work that well in reducing tax liabilities, costs of bankruptcy and the effect of manager-shareholder conflict.

As these theoretical predictions are not yet verified by empirical evidence, they might not be taken as material by managers until proven as factual matters. However, the current lack of popularity of contingent capital will delay such effort and will make this approach remain unclear to potential users for the time being. What this paper has shown is an analytical account from the view of a possibility theorem to give different insights into the scenario of initiating an integrated capital management-risk management strategy. Like the Insurative model discussed in chapter 3, these insights are developed to catch up with the rapid evolution in the field of risk management, but theoretical debate and empirical evidence are needed to verify and refine these ideas.

To the risk management practice, this paper reminds that to value any risk management strategy, there should be specific considerations of its impact on cash flows, capital structure, and organisational relationships influencing the effectiveness to the value creation process. The value of contingent capital as discussed in various aspects in this paper also needs to be put into specific context of each firm. At the most fundamental 72

level, critical questions such as those regarding capital structure strategy, expectations of imminent losses, managers commitment, current cash flows and cash flows if a loss happens should be raised in planning. Only until firms have thoroughly taken into account these strategic considerations can a selected risk management strategy bring about the expected value.

Is it here to stay?
The previous section discusses the value of contingent capital on the demand side and suggests that this approach might be beneficial in some specific circumstances. The prospect of contingent capital, however, relies on its perceived value to both the demand and supply sides. To the supplier, its value comes from premiums paid by clients and a new channel to diversify pooled risks. From a value-based viewpoint, these are the core benefits that will make contingent capital a marketable product. Therefore, theoretically contingent capital solution should have a market for itself as there are potential benefits for both clients and providers.

As highlighted in chapter 4, there are certain practical difficulties which could deter effort of companies and financial institutions in making contingent capital deals. The current challenge is to increase its popularity by developing pricing framework, improving marketing and exposure to the corporate community so that the implications of using contingent capital are widely known to managers as well as board members. Without these operational platforms established for use, the practical application of contingent capital will remain opaque, limiting efforts to expand its popularity beyond the existing client base.

Moreover, in a rapidly developing market for risk management where innovative solutions are continuously introduced to serve more and more demanding clients needs, the positive effects of using contingent capital can be replicated in other services, e.g. insurance services offered for capital issuance. Such replication can reduce the comparative advantage of contingent capital and make it even less recognised than currently. This issue is again down to firms understanding of their risks and decision to 73

choose appropriate solutions. The essence of contingent capital is a standby source of capital to serve long term strategic opportunities; hence it is more in line with long term strategic planning rather than day-to-day operating issues. As a result, the use of contingent capital can thrive as soon as risk management become more recognised as a strategic function and taken into account in long term decision making. When managers spend resources to apply risk management thinking in planning their long term objectives such as mergers and acquisitions, restructuring, and international expansion, the strategic value of contingent capital such as mitigating shareholder-stakeholder conflict and reducing cost of issuing capital will be compelling reasons to undertake this new integrated risk management approach.

In conclusion, the benefits of contingent capital are available to both the demand and supply sides, suggesting a promising prospect for this risk management solution. However, whether contingent capital will grow more in popularity or not depends very much on the efforts of not only providers in developing operational platforms such as pricing framework and marketing channels, but also potential users in enhancing understanding of the value of risk management, especially in their specific business context. By understanding more of what each risk management solutions can bring to their business, firms can improve the effectiveness of the solution they choose, for them to play safe and for the risk management market to grow.

Limitations
Although featuring a rather lengthy discussion on the theoretical underpinnings and the use of contingent capital, this study does not present empirical evidence to support the arguments presented. In addition, the authors effort in contacting institutions involved in contingent capital operation to collect information was not successful, resulting in the dissertation relying in large part on information from secondary sources. This limitation, even though was moderated by the use of illustrative examples, reduces the persuasiveness of the analyses. Moreover, the examples are constructed in generalised contexts which might not be applicable in other situations. As a result, the analyses might suffer from calculation biases making the conclusions prone to subjectivity. Such 74

limitation results from the actual lack of empirical information on the relatively few contingent capital deals made to date. This problem is understandable as the use of contingent capital is not yet a popular trend hence the deals are not yet covered in great depth in academic and business literature.

However, as commented in the methodology section of the paper, the use of illustrative examples to generalise the issue avoids the diverging influences of various case details on the argument being put forward. It is hoped that these arguments on value enhancement will be verified in further work which can approach users of contingent capital and obtain direct information. Further study should also delve on the issues of pricing, marketability, and corporate governance to propose solutions for the practical difficulties suggested.

75

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