Loco Corporation Case Study: Part I

Background Information

Since its formation in 1945, LOCO Corporation has been a leader in the investment banking field. Its largest and best known subsidiary is Loyalty Investment, an investment advisory and management company for a family of one hundred funds. Through a network of thirty-two principal offices in twenty-two countries, LOCO and Loyalty Investment offer a complete range of financial services, including online trading and research assistance to corporations, institutions, and individuals throughout the world. LOCO, through another subsidiary called Loyalty Brokerage Group, engages in sales and trading on a discounted fee basis. It uses the most advanced technologies available in the market. Approximately 50 percent of trades (for both the direct funds and through the brokerage firm) are handled online, another 40 percent are handled over the telephone, and 10 percent are handled in person at sales offices around the world.

LOCO also provides financial underwriting services and advice to corporations and governments around the world regarding their capital structures. Its products and services include corporate finance, real estate, project finance and leasing, debt and equity capital markets, mergers and acquisitions, and restructuring.

Under Loyalty Investment are three subsidiaries:

• The Loyalty Brokerage Group (formerly the Kendu Financial Group acquired in 1994)a stock brokerage firm that handles $4 billion annually in trades for retail and institutional clients on a discounted fee basis.
• The Loyalty Financial Services Groupan insurance, estate planning, and investment advisory organization for high net worth individuals operating only in the United States and the United Kingdom. The nonsupport staff is licensed to sell insurance and securities.
• Loyalwarea financial services software producer.

LOCO has offices in Europe, the Middle East, the Far East, South Africa, Australia, and South America and is expanding into Russia and China. LOCOs financial highlights are shown in Table 23.26 "LOCO Corporation Financial Highlights", which provides information on LOCOs size, liquidity, and debt positions in 1995 and 1996. Although LOCO has been enjoying increased revenues, LOCOs profit margins have decreased from 1995 to 1996. Return on equity has remained stagnant for the last two years.

Table 23.26 LOCO Corporation Financial Highlights

For the Years Ended September 30 (in Millions)	1996	1995
Cash and marketable securities	$ 73,259	$ 93,325
Real estate	$ 45,464	$ 35,217
Other assets	$ 20,000	$ 18,000
Total assets	$138,723	$146,542
Liabilities	$115,050	$116,046
Reserves for losses	$ 300	$ 250
Long-term borrowing	$ 9,114	$ 8,891
Stockholders equity	$ 23,259	$ 21,355
Total liabilities and equity	$138,723	$146,542
Net revenue	$ 4,356	$ 3,480
Net income	$ 696	$ 634
Net profit margin (net income/net revenue)	15.98%	18.2%
Return on equity (net income/stockholders equity)	2.99%	2.97%
Shares outstanding	173,924,100	163,239,829
Number of employees	14,987	14,321

Recently, Dan Button, director of risk management, was appointed director of global risk management, a newly created position to reflect the integration of domestic and international risk management operations. LOCO has a separate operating officer both for its domestic operations and its international operations. Most likely, the separation of operations was the reason that the risk management operations were handled separately as well. Dan and his chief financial officer (CFO), Elaine Matthews, were instrumental in effecting a change. They knew that economies of scale could be realized by consolidating the risk management function on a global basis. Elaine believes in the holistic approach to risk management and involves Dan in the management of all the risks facing the corporation, be they financial, business, or event-type risks that were traditionally under the authority of the risk manager.

LOCO has a rather large amount of reserves on its balance sheet. A considerable portion of the reserves are attributable to the expected E&O losses that were assumed from Kendu Financial Group when it was acquired in 1994. Another big chunk of the reserve amount is attributable to self-insured workers compensation losses. LOCO has self-insured its domestic and international workers compensation risk since the early 1980s. Even though claims were handled by a third-party administrator, two individuals on Dans staff have devoted their full-time work to workers compensation issues. Prompted by soft market conditions, Dan decided to insure the risk. He secured Foreign Voluntary Workers Compensation coverage for U.S. workers abroad and for foreign nationals, as well as workers compensation coverage for the domestic employees. The company has built up fairly significant loss obligations from self-insuring.

LOCOs business has been changing rapidly over the last several years. It has become more global, more dependent on technology, and more diversified in its operations. This changing risk environment, along with the corporations cost-cutting efforts, has compelled Dan to embark on a comprehensive assessment of his risk management department and the corporate risk profile.

Loco Corporation Case Study: Part II

Background Information

The following are some of the actions taken by Dans team:

• Restructuring of all coverages to save money on administration and to provide streamlined and sufficient coverage for all the risks faced by LOCO and its subsidiaries
• Finding ways to take the 1991 losses of the Gulf War off the balance sheet and insure risks that previously were uninsured

The hypothetical LOCO Corporation was created to help you apply the concepts of alternative risk financing that you studied in this chapter. Familiarize yourself with the features of LOCO Corporation, then answer the discussion questions that follow the Key Takeaways section below.

KEY TAKEAWAYS

In this section you studied integrated risk management and finite risk management programs, two types of alternative risk-financing arrangements:

• Alternative risk-financing arrangements are complex arrangements used by large commercial clients that apply to losses above the primary self-insurance retentions or losses above the primary insurance layer.
• Alternative risk-financing arrangements are tailored to clients diverse needs and blend self-insurance, captives, conventional insurance, and excess limits.

• Integrated risk management identifies, measures, and monitors multiple business, financial, and operational risks to satisfy holistic risk management objectives.

  • An integrated risk program combines lines of insurance coverage into an aggregate, multitrigger contract for a multiyear term for improved efficiency and cost savings.
  • A companys loss history, predictability of losses, costs of coverage, and risk tolerance influences the determination of coverages to combine in integrated programs.
  • Integrated programs may be structured with one aggregate deductible for the term of the policy or with separate per occurrence deductibles.
  • Savings from integrated risk programs result from premium decreases, customization, comprehensive coverage, more efficient operations, and reduced administrative costs.

• In a finite risk program, the insured pays for its own losses through premiums placed in an experience fund held by an insurer

  • Finite risk programs allow insureds to share in the underwriting profit and investment income that accrues on premiums, if loss experience is favorable.
  • Finite risk programs are associated with multiyear terms, overall aggregate limits, risk transfer elements, and so forth.
  • The insurer assumes timing risk because losses can exceed funds paid to date by the insured, resulting in liability for the insurer.
  • Finite risk programs can be used in conjunction with integrated risk management.
  • Companies suited for finite programs have high retention levels, unique and/or difficult to insure risks, inadequate availability of traditional coverage, and high liquidity.
  • Finite programs can improve the balance sheet, reduce earnings volatility, secure insurance for previously uninsurable risks, and access new capacity for catastrophic risks.
• Fidelity Investments, Norwest, and Coca-Cola have successfully implemented integrated risk and/or finite risk management programs

DISCUSSION QUESTIONS

1. What is alternative risk financing? How has it evolved over time?
2. What attracts corporations to integrated risk management products?
3. How does integrated risk management improve efficiencies and reduce costs?
4. Why is the cost of coverage in multitrigger contracts less than in single-trigger contracts?
5. What are two reasons that the insurance industry provides large capacity for insurance products designed for integrated risk management?
6. What is the main difference between finite risk programs and traditional insurance coverage?
7. What is meant by timing risk in finite risk programs? How is this like a line of credit for the insured?
9. Assume you are LOCO Corporations major insurance broker. Assist director of global risk management Dan Button in identifying the risks that LOCO faces. Use your knowledge from this chapter as well as the risk-mapping concepts of Chapter 4 "Evolving Risk Management: Fundamental Tools" and Chapter 5 "The Evolution of Risk Management: Enterprise Risk Management".
10. Take each risk that you identified in question 8 and discuss whether you expect aggregate frequency and severity of losses to be low, medium, or high.
12. Current consolidation and diversification in the industry has resulted in an across-the-board corporate mandate to cut costs. Like other department heads, Dan is under pressure to increase efficiency. Dan wants to investigate the feasibility of an integrated risk management approach. What advantages would an integrated program have for LOCO? What characteristics about LOCO make it conducive to starting an integrated program?