Risk Financing and Transfer Strategies for AFT Ltd

This report discusses risk financing and transfer strategies suitable for AFT Ltd, a property owner with earthquake-prone buildings. It explores risk retention and transfer options, their pros and cons, and provides recommendations.

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Introduction
AFT ltd is a property owner with 20,000 residential buildings in its portfolio, belonging to the
region of Southern Europe. A certain percentage of the buildings are located in an
earthquake zone and therefore, are prone to earthquake-related damage. Currently, AFT ltd
has insurance coverage in place that is worth around 1.3 billion euros. Over a span of 20
years, the region has experienced a total of 3 earthquakes, with two of which were in the last
five years. AFT ltd has incurred average damage of 2 million euros per earthquake. The
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depreciation or attritional damage that the portfolio had to bear was around 1 million euros,
excluding the earthquake losses.
AFT Ltd is currently seeking a more equitable solution for risk financing since the current
coverage has experienced an increase of 100% in terms of premium payment. This report
highlights available risk financing and risk transfer solutions that are suitable for AFT ltd,
discussing their pros and cons in the context of AFT ltd and its insurance requirement.
Lastly, it will present a risk financing solution for AFT as a combination of transfer and
financing of risk for its portfolio of residential buildings.
Risk Retention Strategies
There are two available options in terms of risk financing for AFT Ltd. Risk financing refers to
funding that is acquired or accumulated to bear the expenses of unexpected losses that may
occur due to an unexpected event. Such events are usually low frequency in nature but have
significantly high financial costs associated with them. In the case of AFT Ltd, it can use risk
financing to fund the costs associated with earthquakes, considering a certain portion of its
portfolio is present in an Earthquake zone. Following are the two available solutions for risk
financing that AFT Ltd can use.
Terminate
One way of risk financing is through termination of risk. As per the four T's of the risk
management framework, termination refers to cutting down or relieving the source of risk in
entirety. It does entail financial costs; however, yet it is meaningful in terms of the fact that
when the risk cannot be mitigated, termination is the only viable option.
For AFT Ltd, with properties spread out across Southern Europe, the termination of risk
would involve ridding of securities that are situated in the earthquake zone. Of the financial
costs involved, earthquake-related damage can be mitigated to a certain extent through
termination of property holdings in that region. Through proper disposal activities, certain
cashflows can be generated that can then be used to purchase residential real estate in
other locations. It would serve as a diversification of the portfolio by purchasing property in
other locations. Furthermore, it would minimise the catastrophic risk associated with
earthquakes. Since earthquakes are low frequency yet have high severity, termination is a
suitable option to mitigate the risk effectively.
Changing the property holdings is not an easy task and may terminate the catastrophic risk
but could accumulate other forms of risks such as property risk, devaluation risk, etc.
However, compared to the earthquake damage, the costs are substantially lower for the
above-mentioned risks. Therefore, the said risks can be tolerated without added financing or
measures required.
Termination would, therefore, prove to be a useful measure for risk financing, allowing AFT
ltd to mitigate the catastrophic risk to a considerable extent. The treat strategy for risk
financing enables the risk manager to securely and effectively reduce the exposure of the
risk, with the intent to reduce the exposure to almost close to none. By moving the
earthquake zone-based investments to elsewhere with minimal catastrophic risk, AFT ltd can
benefit from this risk strategy at a relatively cheaper rate.
Treat
Treatment is a part of the four T's of risk management related framework that is a
standardised process for risk control. Treatment strategy through risk retention involves
creating financing streams within the organisation to pay for the expected losses that are
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incurred due to risk related events. In the case of AFT ltd, there are two major costs
associated with the building. Firstly, the cost of earthquake-related damage and secondly,
the cost related to attritional activities. For the latter, the company can create financing
through cash flow management within its own organisation. It can generate enough funds to
be able to finance these costs on its own. Furthermore, it can reap investment profits by
realisation of gains on the real estate and have liquid funds or sufficient cash reserves to be
able to cater to the majority of the earthquake-related expenses.
This treatment strategy would, therefore, create a steady income stream for the organisation
and a steady and liquid supply of cash and equivalents, that can then be used for financing
losses that are incurred due to either maintenance and operational costs, and due to
catastrophic events.
AFT ltd currently has a sufficiently large portfolio with residential buildings all across
southern Europe. It can offer the property on the rental and leasing basis and reap benefits
of income stream generated. Such a strategy would also allow it to generate sufficient funds
to finance the costs that are incurred due to operational needs. Users and owners of the
residential property can be invoked to bear the expenses of maintenances, allowing AFT ltd
to further expand its profit stream.
The treatment strategy is beneficial for AFT ltd as a risk financing and risk retention
technique. It provides an internal mechanism for managing the risk without having to rely on
any third party. This is particularly useful in the way that it reduces uncertainty and default
risk of the other party, allowing forecastable losses prevention through self-generated funds.
Risk Transfer Strategies
Risk transfer strategies refer to the involvement of a third-party or another entity to bear or
share the risk into consideration. Risk transfer strategies are particularly useful when the
financial cost of exposure is very high. With another party involved, the risk burden is
lowered, allowing the company to reduce its exposure overall to the said risk. The
repercussions of an event that triggers the risk-related costs can either be financial or non-
financial. In either case, the risk transfer mechanism can be put into place to mitigate, or
more accurately, reduce the exposure of the risk to the company in question, in this case,
AFT ltd. The following are the two available options for AFT ltd to use risk transfer as a risk
control strategy.
Transfer with Insurance
One of the most widely used forms of transfer-based risk management technique is
insurance. Insurance provides coverage to the entity or the policyholder to share the
exposure of the risk with another entity, usually an insurance company, that is better
equipped to handle the consequences of the event being hedged against. Usually, the
insurance company has more potential in terms of resources and finances to handle the
repercussions of the said catastrophic event, in this case, an earthquake.
Using insurance is a professional way of tackling risk mitigation. Insurance companies are
skilled with understanding risk exposures and can also offer guidance for future
circumstances. Furthermore, they are capable of bearing the said expenses and are,
therefore, more reliable than using other forms of third-party related risk management
mechanisms. For AFT ltd, using insurance coverage to offset the losses from the likelihood
of an earthquake is a viable option. However, insurance companies price the premiums on
the probability and impact of the exposure to the risk. Considering the buildings existing in
the earthquake zone, the premia for insurance would, therefore, be higher since the
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likelihood and frequency of an earthquake would be high as well. Currently, the package
available to AFT ltd for damage coverage is too high, and it is likely that a similar cost would
be incurred through insurance as well. However, the costs of damage can be broken down
into catastrophic and attrition related. The span of the coverage can be limited to either of
these areas and therefore, can reduce the financial cost of owning insurance coverage.
Furthermore, the financial and non-financial risk of the event can be transferred to the
sharing entity. Hence, lower cost risk transfer mechanism is available for AFT ltd that
encompasses financial as well as non-financial exposure to the above-mentioned risk to the
real estate portfolio.
Transfer Through Derivatives
Another available mechanism for risk transfer is through the use of derivatives. Derivatives
are a secondary form of financial instruments whose pricing structure is based on an
underlying asset. The usage of a derivative allows the parties considerable flexibility in terms
of choosing the terms of the contract. Furthermore, the cash flows of the contract can be
designed synthetically to mimic any available financial product without engaging in the
product itself directly, offering a customised cheaper solution to the entities involved.
AFT Ltd can seek out a combination of financial instruments to build a sort of an insurance
coverage to offset the risk. For instance, it can use options and swaps to fixate the
fluctuations of prices and interest rates respectively at a lower cost and with lower
uncertainty of loss. Similarly, derivatives can be used to create a synthetic cashflow structure
that can charge smaller premium payments and then be available to offer coverage at the
occurrence of an event, similar to an insurance coverage product. The ideology of using
derivatives as a risk transfer mechanism is that it reduces the uncertainty in terms of price
fluctuations specifically, allowing the entity or writer of the contract to utilise the resources to
accurately forecast its losses and potential expenses in the event of a catastrophe. The risk,
however, is not exactly the catastrophic risk that is being shared with the other party, but
rather interest rate risk and housing price risk, therefore, allowing AFT ltd to fix its exposures
to other forms of risk while utilizing the resources to create cash reserves or emergency
funds in case of an unfortunate event, in this case, an earthquake.
AFT ltd can use derivatives as a viable option for their risk transfer mechanism as it offers
substantial flexibility and ability to reserve funds by limiting exposures for other risks
pertinent to the real estate portfolio. It is similar to self-financing in risk retention; however,
while retaining the catastrophic risk, other risks are mitigated or transferred to the involved
parties, giving an effect of a combination of risk retention and risk transfer techniques.
Advantages and Disadvantages of Risk Financing and Risk
Transfer
AFT ltd has in total of four available options for risk management as described in the above
section. However, each of these options has their inherent pros and cons. This section
highlights the benefits and drawbacks of risk retention and risk transfer in the context of the
opportunity cost for AFT ltd, therefore, making the comparison between the available
strategies easier.
Risk Retention Benefits and Drawbacks
Risk retention techniques discussed in this report are termination and treatment. Risk
retention refers to the strategy of using self-generated funds to internally manage the risk
that is pertinent to the organisation.
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Firstly, let's analyse the termination of risk. Terminating risk is not an expense-free option for
mitigating risk. Termination is possible through discarding sources of risk in the investment
holding. AFT ltd would conduct risk termination by letting go of investments in the
earthquake zones and opting for residential buildings in other regions of southern Europe.
The advantage of this approve is that the risk would be reduced considerably, giving AFT ltd,
an expected relief of 2 million euros on average per year. Furthermore, the shifting of
investments from these regions would allow it to expand its investments beyond southern
Europe. Moreover, AFT ltd would be able to generate sufficient funds through the sale of
these residential buildings and can opt for a leasing structure or rental structure for the new
residential buildings acquired.
However, there are disadvantages to this method of risk control. The buildings that are being
sold off may not be sold at a fair price. Moreover, it would require AFT ltd significant efforts
in terms of time and resources to fully dispose of the buildings, let alone at a fair price.
Furthermore, the new buildings acquired in the building portfolio would require due diligence
and therefore, consume exceptional efforts in terms of validation and verification.
Conclusively, the option to opt for termination of risk as a risk control measure would be an
expensive option, that may incur loss before it generates a break-even amount of positive
cash flows.
Second, the option available for risk retention is treatment as per the framework of risk
management. Risk treatment for AFT ltd would require it to self-generate funds and income
streams to pay for the expense of earthquake and attrition related damage. The advantage
of opting for this strategy is that it creates a self-sufficient form of funding and therefore,
guarantees a steady flow of income for the cash reserve generation. Furthermore, it also
reduces the uncertainty of default because the organisation itself is responsible for
generating the funds to be able to pay for damages and repairs incurred due to earthquake
and attrition.
However, the major disadvantage of this risk control mechanism is that it can be costly. The
potential damages incurred can be underestimated, whereas, the funds accumulated could
be insufficient to accommodate for the losses incurred by the organisation. For AFT ltd, the
risk retention through treatment can be fatally expensive if the company is unable to
generate sufficient cash reserves and funds to be considered prepared for the case of an
earthquake.
Risk Transfer Benefits and Drawbacks
Similar to risk retention, risk transfer has its benefits and drawbacks. This section discusses
the pros and cons of each of the suggested solution for risk transfer.
Transfer through insurance is the first feasible option discussed in this report for risk transfer.
The biggest advantage of risk transfer through insurance is that it accommodates for the risk
exposure quite well. The insuring company is capable of offering professional services and
suggestions for risk management. Moreover, the uncertainty for the default on the end of the
other involved party in this contract of insurance coverage is minimal, since insurance
companies are specialised in this area and are capable of withstanding the financial costs
associated with it.
However, there are disadvantages associated with the use of insurance coverage from a
third-party. The major disadvantage is the limitation in the contract. The insurance coverage
may not be as flexible and customised to suit the need of AFT ltd. Furthermore, it might cost
more than what the company is willing to pay despite not providing complete coverage to the
policyholder. Lastly, at the end of the company, AFT ltd, a certain amount of expected lax
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attitude can be anticipated where the company is not committed to performing due diligence
in its investments. Conclusively, it would be a costly option for AFT ltd, that already the
company is currently engaged in.
The second option available for risk transfer is risk transfer through derivatives. Derivatives
have the advantage of offering a considerable amount of flexibility to the contract. It is
capable of allowing you to secure a customised coverage plan for risk transfer mechanism.
Furthermore, it can allow you to transfer more than just the financial risk associated with the
real estate portfolio holdings. The ability to obtain the effect of insurance coverage is also
possible through synthetic instruments created as a combination of derivatives and their
underlying assets.
However, there are disadvantages to using derivatives for risk transfer. The major
disadvantage is that there is a considerable amount of uncertainty involved in using
derivatives. Since most derivatives-based instruments are traded over the counter, they are
not regulated and therefore, are heavily prone to default risk. Furthermore, the derivative
structure can be costly since the premium charged can often sway away from the favourable
conditions of one of the parties involved. Therefore, usage of derivatives requires caution as
it is capable of costing more than necessary under certain circumstances.
Recommendation for AFT Ltd
AFT ltd has four potential options for risk mitigation and management, with half methods
based on risk retention and the other half on risk transfer. The suggested strategy for AFT ltd
is a combination of risk retention and risk transfer strategy. The company should use risk
transfer with derivatives to hedge against the risk of price fluctuations and interest rate
fluctuations in the market. Whereas, utilise risk termination to discard investments that are
prone to earthquake-related damage, thus reducing the catastrophic risk. They should
further utilise the funds generated to opt for residential buildings that are sold on leasing and
rental structure to develop a steady stream of income that makes AFT ltd capable of
withstanding the expenses generated. After termination, the major risk would amount to the
attrition related expenses. Using the self-generated cash reserves, AFT ltd can effectively
account for the costs incurred and be able to internally mitigate the risk.
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References
Books:
Risk Management: A Helicopter View by GARP
ISO 31000 Standards for Risk Management
Websites:
https://www.boltinsurance.com/four-risk-control-strategies/
https://thismatter.com/money/insurance/handling-risk.htm
Journal Articles:
Floros, I., & White, J. T. (2016). Qualified residential mortgages and default risk. Journal of
Banking & Finance, 70, 86-104.
Ashton, P., & Christophers, B. (2018). Remaking mortgage markets by remaking mortgages:
US housing finance after the crisis. Economic Geography, 94(3), 238-258.
Fields, D., & Uffer, S., (2016). The financialisation of rental housing: A comparative analysis
of New York City and Berlin. Urban Studies, 53(7), 1486-1502.
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Glossary of keywords
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Outline
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Recommend with reasons
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