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Alternative Risk Finance Part 4 – Risk Trading and the Future of Insurance within Treasury
| 07-12-2020 | Mark Roelands | treasuryXL
Intro
This series on alternative risk financing has been about alternatives to traditional insurance, which get are more important role in the current hard insurance environment. How to build the business case is explored in Part 2 and the alternative structure of Cell Companies is explained in Part 3. The last part of the 2020 series is about the future of alternative risk financing, risk trading and the role of treasury in insurance.
In a data driven era, with rapid advancing capabilities there may be more efficient manners to transfer or share risk, insight into risk scan be increased as well as the subsequent possibilities to retain or transfer. Although this is an outlook into the (not too distant) future, it is important to be aware of developments and get into the position to benefit from these developments preparing for 2021 and beyond, the hard market isn’t just a 2020 phenomenon.
Treasury Risk Management
Obviously, risk management is a critical part of Treasury processes. The scope of risks to be managed however within Treasury varies significantly between companies. Common risks in scope include operational risks within payment processes and financial risks like currency risk and interest rate risk. Insurable risks (like property damage and general liability) can be part of Treasury responsibilities, but can be part of legal or enterprise risk as well. Often this relates the the nature of the business as well as the size of the company. For instance, high liability type of businesses often have insurance within a legal function.
With advances in data as well as the analytics capabilities it is possible to expand the scope of insurable risks and thereby the responsibilities of Treasury. As will be explored, with further advances insurance is similar to hedging. This then comes down to matching the risk exposure with the transfer instrument, can this be matched appropriately?
Parametric vs. Indemnity cover
Traditional insurance is well suited to high frequency, low severity events which is covered in the lower part (in terms of limits) of the corporate insurance program. A captive might be part of that area of risk as well, which has a higher degree of predictability. A multitude of small-scale losses are easier to model and manage due to the richness of historic data and the fact that the law of large numbers will enable accurate macro level predictions. Indemnity cover is based on carefully drafted wordings, and a loss has to be established before ultimately (which may take some time) a claim payment is made. The principle of parametric insurance intends to speed this process up to a great degree, as shown below.
This is not intended to declare the end of indemnity cover, this can still be highly efficient. But parametric insurance is increasingly important to complements this traditional approach to improve both the efficiency as well as effectiveness of cover.
Critical is the carefully constructed payout trigger. Traditionally this has been weather related like rainfall or windspeed at a certain weather station. This is increasingly tailor made with on-site weather stations preventing any mismatch in hitting a trigger (“basis risk”). Next to that other perils are increasingly possible, production downtime for instance can be objective measured. Lockdown measures also provide a clear objective trigger, and this is being discussed extensively. With increasing amounts of data and advanced data analytics minimizing a potential mismatch can be done objectively for a large range of perils. Basis Risk in that sense is the equivalent of retained risks in indemnity cover.
Enabling parametric cover does however mean that data should be available as well is a clearly defined model how trigger and potential loss relate. That means that (risk) data needs to be governed and managed, ensuring good quality data available to the treasurer. This may also imply that the treasury or insurance professional needs to tap into more data sources in order to model the trigger and exposure optimally.
Trading
Parametric insurance was initially developed in the form of catastrophe bonds to provide extra reinsurance capital for major disasters. Still very often this is based on large volume transactions. Global capital markets dwarf reinsurance markets in terms of capacity. The Aon Reinsurance report 2020 estimates the global pool of reinsurer capital is $532bn. This is tiny when compared to the global equity market of $75tr, a global bond market of $100tr and a global derivatives market with a notional principal value of $700tr. Insurance provides a very interesting type of risk which is not or limited correlated with traditional investment risks and provides a very interesting new asset class. Being able to transact in smaller volume, while remaining the good trigger-exposure link is a challenge, but this is being resolved with a Risk Trading platform like Ryskex.
Integration into Treasury Processes
An In-house Bank structure is common treasury terminology, the in-house insurance structure is that fors ome treasurers. A Risk Trading hub enables to integrate the best of both worlds and create a shared risk pooling vehicle enabling efficient and effective sharing of risks within the organisation.
A key feature in this approach is Treasury Technology. The Treasury Management Platform or the Trading platform which most (dedicated) treasuries use will inevitably play a key role in the infrastructure of the Risk Trading hub. They provide the centralised point of entry and point of control for trading. Via API or other connectivity the link to a Ryskex platform is possible and allows the treasurer to trade a ‘traditional’ insurance risk as easily as USD risk, hedging any risks that the treasurer isn’t willing to retain.
Conclusion
Whether it is possible to have a parametric trigger or a step further to trade risks is work-in-progress, but as corporate insurance manager, treasurer, captive manager it is critical that initial steps are already being taken. Are you in control of your risk data (which is broader than an historical claims overview)? Which data are you able to utilize and is the data quality being managed? The roadmap for a future proof treasury starts today.
Check my previous blogs of this serie:
Mark Roelands
Risk and Compliance Specialist
Looking for an Interim Treasury Manager (m/f)
04-12-2020 | Treasurer Search | treasuryXL
Our Partner Treasurer Search is looking for an Interim Treasury Manager for a division of a multi-billion global manufacturing company with a large and professional Treasury team.
Tasks Interim Treasury Manager
The treasury manager combines managing the global treasury function, including a small team, with the project of carving this function out of a larger organisation. The emphasis will be on the banking infrastructure, liquidity management and cash forecasting. She is the face of treasury towards external and internal stakeholders and drives the change.
Ideal Interim Treasury Manager
The ideal candidate for this position must have experience in global people management and corporate treasury, at least 7 years. Her track record shows the continuous management of a team and leadership of large projects. Expertise in treasury operations and risk management is a must, in internal and/or external funding a plus. The ideal candidate worked with ERPs, preferably SAP, any other IT experience with TMSs and/or trading platforms is considered a plus.
Our Client
Our client is a division of a multi-billion global manufacturing company. The treasury team is large and very professional. Employees work in different time zones and know how to work with different country cultures.
Remuneration and Process
This project starts in January 2021 and will be at least for a year. What comes after has to be decided in due time. Although it might almost feel like a permanent position, the contract will be a temporary (both detachering (payroll) as well as ZZP (contractor) are options). Working weeks will have 32 hours. The candidate fee will be about €70/hr. For candidates that qualify and are interested, a more elaborate job description is available.
Contact person
Pieter de Kiewit
Location
Home office / Netherlands
APPLY HERE
What is the Interbank exchange rate, and why does it matter?
03-12-2020 | treasuryXL | XE |
Have you sent money overseas with a bank, or are you planning to? Then it’s important that you understand what the interbank exchange rate is and how it might cost you more money.
What is the Interbank exchange rate, and why does it matter?
In a survey earlier this year, 74.8% of you stated that you preferred using banks to send your money overseas (even if you used Xe to check the rates beforehand). Here’s the problem: the rates you see with Xe are not the rates that you’ll get when you choose to use the banks for your money transfers. And while we’ll get deeper into it later, we just want to let you know—the exchange rates the banks use will likely end up costing you more money.
Every foreign exchange and money transfer provider will have their own rates. When banks exchange money with one another, they use what’s called the interbank exchange rate. What is that, why do they use it, and what does that mean for you? Let’s explore that.
What is the interbank exchange?
The interbank exchange market, simply put, is where the banks exchange currencies with one another. It’s the top-level foreign exchange market. The Electronic Broking Service, which is a division of CES Financial, and Thomson Reuters are the two biggest names in the electronic foreign exchange market. This market is largely informal. There is no central trading location and no regulatory oversight body.
Central banks in different countries usually set domestic interbank exchange rates. Since the Federal Reserve is the closest thing to a central bank in the U.S., the Fed determines the exchange rate for transfers which originate in the U.S.
On any given day, the forex (foreign exchange market) handles about $5 trillion USD in transactions, making it the world’s largest financial market.
What about the Interbank exchange rate?
It’s exactly what you’d think it is—it’s the rate that banks use when they exchange large quantities of currency with each other. There’s no singular, universal interbank exchange rate—each bank can and will set their own rate, and the rates will naturally fluctuate in response to fluctuations in currency values.
Who determines the Interbank rate?
This fee, which can also be known as the spot rate, mid-market rate, or real exchange rate, often fluctuates minute by minute. In the United States, the Federal Reserve controls this fee, as well as the interest rate. In 2008, at the beginning of the Great Recession, the Federal reserve slashed the foreign transfer rate to .05 percent, in order to encourage funds transfer and investments. Since then, the prime rate has inched up to about 2.5 percent. But, as with interest rates, the prime foreign transfer rate is hardly ever available to consumers.
In everyday terms, the basic rule is that the Interbank foreign transfer rate is the midpoint between the selling rate and buying rate for a particular form of currency at a particular time. Currency brokers usually determine this rate, which is one reason is so subjective. Other factors which influence the fee amount include:
Bid-ask spread, which is a subset of supply and demand,
Domestic and foreign trade deficit or trade surplus,
Inflation and interest rates in a particular place,
Economic and political stability, or the lack thereof, and
Size of government debt.
Bad news on any of these fronts usually causes transfer rates to increase dramatically. Good news typically reduces the rate, but the effect is not as dramatic. So, based on this knowledge and the current official interbank foreign transfer rate, which a cursory Google search should reveal, you can estimate what the consumer rate should be. Use this estimate when you shop around to find the lowest fee.
In 2019, the Fed stated that it planned to keep the interbank exchange rate at 2.5 percent at least through 2021. The coronavirus outbreak might convince the Fed to reduce the rate. Or, the opposite could happen. The Fed could suddenly decide to raise the rate, largely based on the aforementioned factors.
These factors are important because the interbank exchange rate is not just a supply-and-demand issue. The Fed manipulates the rate to further its monetary policy goals. These goals could change quickly, as the Fed Board of Governors is populated by political appointees.
What this means to you
Technically, a few large international banks, such as Chase, HSBC, and Citibank, can offer their customers the prime interbank exchange rate. But this rate is only available to customers with excellent credit who make gargantuan transfers, like payroll transfers.
The aforementioned interbank transfer rate markup varies, but it is usually between 4 and 6 percent. If you regularly send money overseas, these nickels and dimes quickly add up to quarters and dollars.
Why is the interbank exchange rate marked up?
The rise of PayPal and other FinTechs, along with increased regulatory scrutiny, is expected to decrease banks’ income. Most likely, user fees will make up the difference. Domestic account fees, mostly NSF charges and non-bank ATM charges, make up the bulk of these fees. When it comes to foreign electronic funds transfers, the interbank exchange rate takes center stage.
Foreign electronic transfer fees are a bit like interest rates. The prime interest rate, which is the fee the Federal Reserve charges to loan money to banks, is always lower than the consumer interest rate. Since the Fed also sets the interbank exchange rate in the United States, the procedure is similar. The interbank exchange rate, which is the fee Wall Street bankers charge for huge funds transfers, is always lower than the consumer rate.
Generally, financial institutions raise the interbank exchange rate partially because they can, and partially because they fear the risks of international funds transfers.
The “spread”, and how it impacts what you get from your money transfers
Perhaps the most important interbank exchange rate fee might not appear in your transaction detail proposal or statement. The exchange bank works with currency bid and ask prices.
The bid price is the selling price,
The ask price is the buying price.
The difference between these two prices, which is often substantial, is called the spread. The spread allows currency brokers to buy your currency at a discount and sell it at a profit to a third party in another country.
The spread is like a surcharge which does not appear in the transaction detail. Assume you send $1,000 USD to Russia. The recipient probably expects to receive ₽7,650, minus the transfer fee, which is probably between 6.5 and 10.5 percent. That’s already a pretty hefty fee. However, because of the spread, your friend or colleague in Moscow could receive substantially less.
In many cases, brokers make more money off the spread than they make off the transfer fee. That’s especially true if it is a relatively slow day on the market, as are most Mondays, Tuesdays, and Wednesdays. During these periods, the lower number of buy-sell orders significantly increases the spread, at least in many cases.
Additionally, currency is the most liquid of all traded financial assets. Liquidity, or the lack thereof, is one of the most important spread factors.
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About XE.com
XE can help safeguard your profit margins and improve cashflow through quantifying the FX risk you face and implementing unique strategies to mitigate it. XE Business Solutions provides a comprehensive range of currency services and products to help businesses access competitive rates with greater control.
Deciding when to make an international payment and at what rate can be critical. XE Business Solutions work with businesses to protect bottom-line from exchange rate fluctuations, while the currency experts and risk management specialists act as eyes and ears in the market to protect your profits from the world’s volatile currency markets.
Your company money is safe with XE, their NASDAQ listed parent company, Euronet Worldwide Inc., has a multi billion-dollar market capitalization, and an investment grade credit rating. With offices in the UK, Canada, Europe, APAC and North America they have a truly global coverage.
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