ENTERPRISE RISK MANAGEMENT
By Michael J. Moody, MBA, ARM
Buffett's comments notwithstanding;
derivatives can be a useful tool
Derivatives have long been used for the effective mitigation of price and supply risks of various commodities.... for more than 100 years, the numerous futures exchanges have been hedging risks associated with currencies, commodities, and interest rates.
The hardening insurance market is requiring corporations of all sizes to consider a wide variety of risk financing options. Most corporate risk management executives have to keep an open mind regarding potential solutions, even those that would have been dismissed outright just a few years ago. These are trying times for risk managers and they can ill-afford to leave any stone unturned.
Such is the case with the use of derivatives. While these financial instruments have been part of the financial landscape for more than 100 years, their potential use by corporate risk managers is still relatively new. However, the convergence of the capital markets and insurance markets, coupled with escalating property/casualty insurance premiums may open the door to further derivatives utilization.
Derivatives have long been used for the effective mitigation of price and supply risks of various commodities. In fact, for more than 100 years the numerous futures exchanges have been hedging risks associated with currencies, commodities, and interest rates. And since the 1970s, derivatives have become a financial mainstay of most corporate treasury departments.
The use of derivatives over the past few years has literally exploded, and one of the largest users today has become the insurance industry. Following several major natural catastrophes, the industry realized that capacity shortages could clearly damage the long-term viability of the industry. As a result, insurers and reinsurers turned to the near inexhaustible capacity of the global capital markets.
In addition to the additional capacity that the capital markets bring, other advantages include low transaction costs as well as greater leverage from these transactions. The industry also found that derivatives have a high degree of flexibility in both form and design and make an ideal instrument for hedging.
The basic concept of derivatives has remained the same over the years. In essence, derivatives are defined as financial instruments that do not constitute ownership, but rather a promise to convey ownership in the future. Simple examples of derivatives are options and futures. All derivatives are based on some underlying cash product.
Risk management departments
As corporate risk management has expanded over the past 10 years or so, risk managers have struggled to determine where derivates fit into enterprise-wide risk management programs. As the barriers to integrated risk management began to disappear, initially it was the insurance companies that began to fill the need for integrated products. Several major insurance carriers began to offer innovative products, which incorporated property/casualty coverages with a variety of financial risks. However, as the enterprise risk management (ERM) concept has developed, the hard market has caused most insurers to back away from the integrated model.
Once again, the risk management community is looking to the capital markets for potential solutions. At this point, while derivatives have traditionally been associated with hedging just price risks, many risk management professionals believe that appropriately structured derivatives may be used in diverse ERM programs. Significant movement in this direction had occurred by the start of the new millennium.
A number of progressive risk management departments had taken up the banner for derivative use and had developed sophisticated ERM programs to support their position. For a period of time, one could not attend any ERM conference without hearing presentations by some of these proponents. Unfortunately, one of these cutting edge companies was Enron.
As a result of these examples of "progressive" derivative use, most risk management professionals began to back away from their use. The problem, however, as with Barrings Bank and others before them, was not so much an issue of the derivative trading itself, but rather its uncontrolled, undisciplined use and a lack of proper monitoring. And in the case of Enron, management took this to a new level of abuse.
"Financial weapons of mass destruction"
Then, like a shot out of the blue came warnings from the Oracle of Omaha regarding derivative use. In a letter to Berkshire Hathaway's shareholders in early March 2003, Warren Buffett decried the use of derivatives and derivative trading. Buffett and Charlie Munger, the vice chairman of the investment and insurance company operations, characterized derivatives as "time bombs." They warned that derivatives were "financial weapons of mass destructions," and they were "potentially lethal" to the economic system.
Among Buffett's concerns was "the parties to derivatives ... have enormous incentives to cheat in accounting for them." And despite the Financial Accounting Standards Board taking action in June 1998, via the issuance of FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, according to Buffett, significant risks remain. While FASB No. 133 did provide a comprehensive standard for the recognition and measurement of derivatives and related hedging activities, its complexity is well known in accounting circles.
The major problem occurs when accounting for these financial instruments, companies are allowed to use "market-to-market" rules that often permit them to establish their own fair market value of the contracts. And as with Enron, this could lead to using derivative contracts to hide volatile assets and to inflate the value of new businesses.
An additional concern noted by Buffet was that large amounts of market risks have become concentrated in the hands of relatively few derivatives dealers. These dealers have already been exposed in the gas and electricity business where derivative activities have significantly diminished. But, he goes on to say other derivatives businesses continue to go on unchecked.
Whether or not derivates will ultimately be the "financial weapons of mass destruction" that Warren Buffett warned of or will become a staple in many progressive companies' ERM program, only time will tell. One thing is certain, however: Successful financial strategies that incorporate derivatives have been in use since long before Enron, and the future use will likely continue despite Buffett's dire warnings. The real question is whether we stop using an instrument that has proven useful because it can be abused rather than work to eliminate the potential for abuse.
Good risk management would dictate that this alternative, like any other, be fully explored prior to use to make certain this approach is consistent with a company's overall corporate and risk management objectives. Only when a company has assured itself that it fully understands the risks and rewards of using derivatives and it has developed appropriate mitigation precautions, should derivatives be incorporated into an ERM program. But given today's current business climate, proper utilization of derivative instruments may well be a key component in ERM's expanding role. *