Just imagine: Neither rain nor sleet nor collapsing sales could keep your company from delivering its projected earnings on time. No more investors outraged by nasty surprises. The results are guaranteed because your company simply bought an insurance policy that pays out when earnings fall short.
What sounds like a pipe dream is fast becoming reality, as insurers rush to design bold new policies that protect companies against bad financial results. On Jan. 28, New York's Reliance Group, for one, launched a radical product called Enterprise Earnings Protection Insurance that covers any operating earnings shortfall due to events beyond management's control. Let's say a company wanted a guaranteed $40 million in annual profits. If it posted a $10 million loss, Reliance could make up the difference, after a deductible. No need to debate whether the poor results stemmed from blizzards or Brazil's economic woes. Except for situations over which management has control, Reliance would pay out up to $50 million.
And that's just a start. Reliance plans to expand coverage levels and sell the policy to European companies within six months. "Chief financial officers are looking for ways to deliver to expectations," says Mario Vitale, president of Reliance's casualty risk services division. "And investors love the idea because it means less surprises."
OFF THE SEESAW. With the property/casualty business in a serious slump, insurers are racing to take on risks that few would have thought insurable. Industry giants like American International Group Inc. and broker Marsh & McLennan Cos. have covered dozens of clients for everything from future movie receipts to a general business downturn. "We're seeing a lot more deals where companies want a financial guarantee, not just a hedge on earnings risks," says Bob Partridge, a director at Standard & Poor's Corp.
Reliance and its competitors are going further, aiming to insure a big chunk of actual cash flow. That, say proponents, could revolutionize corporate strategy by making seesaw sales and earnings a thing of the past. "If you live in a volatile world, it might be worth spending some money to take out the peaks and the valleys," reasons Tobey Russ, president of AIG Risk Finance. Buying into a company could become like buying a Treasury bond with guarantees of safe returns. "You might even insure share price," says Leslie Rahl, a principal of Capital Market Risk Advisors Inc. in New York.
Would this mean the end of volatility as we know it? Not likely. Insurers themselves could get burned on bad bets. Regulators also fret that policies might hide a company's true health or be less than transparent in what they actually protect.
And predictability has a price. Insurance that aims to smooth out revenue lows will likely cut into the highs. And while investors hate unpleasant earnings surprises, they may also balk at paying a hefty fee--or giving up potential profits--to guarantee steady results. Further, an insurer will keep providing coverage only if it keeps making a profit--which means the company may come out on the losing end of the stick. As Harris Chorney, national director of KPMG Peat Marwick's insurance practice, puts it: "If management needs insurance to get the right earnings per share, I think you need to question management."
SNOW JOB. Many companies, though, seem to like the idea of removing clouds of uncertainty that linger over the bottom line. British Aerospace PLC recently bought a special policy that guarantees its aircraft-leasing business will generate $3.7 billion in revenue over the next 15 years. Essentially taking a volatile business off the books, says spokesman Jeremy Barnes, sent the company's share price soaring. Toro Co. of Bloomington, Minn., tried to pump up snow-blower sales this winter by offering refunds based on inches of snow. Rather than risk the big payout that warm weather could bring, the manufacturer estimated its sales and bought a $400,000 insurance policy to fund up to $9.5 million in refunds.
Honeywell Inc. in Minneapolis is taking a broader approach. It is bundling much of its foreign-exchange exposure with other risks under a blanket insurance policy with one deductible arranged by AIG. By blending a broad range of risks together, the company gets a cheaper overall premium and the flexibility to include perils that might be hard to insure on their own. Honeywell's director of global insurance risk management, Tom Seuntjens, says the controls-technology manufacturer is now looking at insuring against weather disruptions, interest-rate bumps, and poor sales of new products under the same scheme. "We're trying to make our earnings more predictable," says Seuntjens. "We look at this as a great opportunity to smooth out other areas of risk.... It's a plus for everyone."
Yet Honeywell isn't ready to insure its entire balance sheet. It insured nearly all of its foreign sales income last year but still handled another $1.1 billion more through traditional capital-market instruments. Bill Kelly, a managing director at J.P. Morgan & Co. in New York, argues that banks have a long history of helping companies cope with such financial risks, adding that "the question of whether an insurance product does that more efficiently remains to be seen."
That's not all that remains to be seen. Securities & Exchange Commission officials ask how companies would disclose the terms of an insurance deal that aims to manage earnings. "We're concerned about anything that tries to hide the true financial state of a company," says one SEC official.
While clients may be happy to hand over risk to Reliance and other insurers, what about Reliance's risks? Under its new policy, the only revenue risks not covered are accounting changes, employee strikes, or other perils that fall within management control. What constitutes "management control," of course, is a fuzzy area in itself.
Also fuzzy is trying to predict the volatility of a client's earnings. Myles L. Strohl, CEO of Strohl Systems Group Inc. in King of Prussia, Pa., says the firm is using its expertise to "hopefully expose the [company's] business risks," that determine policy price. Reliance's own exposure is hedged through a policy with Swiss Reinsurance America Corp. The least risky Reliance candidates can pay as little as 5% of estimates to guard against a 20% fluctuation in operating earnings. "The bigger the risk, the bigger the retention" or money a company pays on claims, says Vitale. He even plans a product aimed at companies setting up an IPO to "convince potential shareholders that they will meet certain earnings projections."
In the end, though, the biggest gamblers may be the insurers themselves. Michael Smith, an analyst with Bear, Stearns & Co., argues that, with the industry in a slump, insurers are racing to expand the definition of what's insurable and "that usually leads to underwriting disasters." That could also lead to messy lawsuits that ultimately put risk back in the hands of investors.