ENERGY INSURANCE MUTUAL

1. ENERGY INSURANCE MUTUAL 19th ANNUALRISK MANAGERSINFORMATION MEETING The Westin Innisbrook Golf Resort Tarpon Springs, Florida February 27 - March 1, 2005

2. Neil Doherty Frederick H. Ecker Professor of Insurance and Risk Management at the Wharton School

3. DOCUMENT HOW VOLATILITY AFFECTS COPORATE VALUE 1. Risk increases costs of financial distress (a). Ex ante: the prospect of distress can lead to conflicts of interest and dysfunction decision making (b). Ex post: distress involves transaction costs, loss of business opportunities, increased cost of funding, etc 2. Volatile cash flows prejudice financing of new investments Most firms prefer to fund with cheaper internal cash Shocks to earnings can deprive firm of 3. Risk introduces noise into accounting and economic numbers. Lack of transparency makes monitoring and valuation difficulties Each reason might call for different risk management strategy

4. RISK INCREASES COSTS OF FINANCIAL DISTRESS • Costs of insolvency - Legal cost - Regulatory costs - Liquidation costs • Solutions - Reduce risk (hedge insurance) - Lower leverage - Structured debt – forgivable or reverse convertible debt - Contingent equity capital

5. RISK INCREASES COSTS OF FINANCIAL DISTRESSSTRUCTURED DEBT TO REDUCE CREDIT RISK (FROM CULP JACF)

6. RISK INCREASES COSTS OF FINANCIAL DISTRESSLOWER LEVERAGE LOWERS NEED FOR HEDGES • Many studies (Dionne; Doherty&Klefner/etc) confirm that firms with lower leverage tend to hedge less • After-event studies (Pretty; Doherty-LammTennant-Starks; Gron-Winton; etc.) : show that firms with lower leverage recover more quickly. • However, these studies show that leverage is only a problem when firm value falls • This points to the value of structured debt as a risk management tool. Lowering of firm value triggers derivative which un-levers the firm. - Forgivable debt - Reverse convertible - Warrants - Contingent equity

7. RISK INCREASES COSTS OF FINANCIAL DISTRESSSTRUCTURED DEBT TO REDUCE CREDIT RISK(FROM CULP JACF) • Sonatrach – Algerian state owned oil producer • Problem – Servicing Floating Debt – High Credit Risk – High Interest Charges. The particular credit risk problem is that they may not be able to meet high interest charges when oil revenues fall. • Solution – Issue “Inverse Oil Indexed Bonds” – Raised Credit Quality And Lowered Cost Of Debt. Sonatrach wrote a 2 year call on oil with a strike of $23. Thus they would have to make payment if oil prices rose above the strike. In turn the counterparty (Chase) wrote a spread on oil prices (i.e., wrote a call and put) to the creditors who bought Sonatrach’s debt. Thus the investors had a long position in volatility. - Lowers cost of debt to LIBOR plus 100 basis points - Sonatrach yields some upside on oil to counter party - Investors accept long puts and calls – willing to accept this play on oil prices

8. SONATRACH Credit risk if oil prices fall Floating rate notes @ LIBOR+1 Writes 2 year call on oil – strike $23 INVESTORS- SYNDICATED BANKS Writes 7 year call on oil – strike $22 Writes 7 year put on oil – strike $16 COUNTERPARTY

9. RISK INCREASES COSTS OF FINANCIAL DISTRESSREVERSE CONVERTIBLE DEBT • Convertible debt but conversion option held by firm • Exercised when firm value falls • Advantages - Anticipates workouts in which debt replaced with equity - Avoids bankruptcy costs (which would fall on creditors) - More closely aligns incentives of creditors and shareholders • Shareholders now have more stake in downside • Managers more averse to risky projects (no default option) • This will benefit creditors • User ING. • Form more common in Europe

10. FUNDING POST-LOSS INVESTMENTS • Graph shows the ranking of seven projects - With low cost internal funding - With high cost external funding • With internal funding all seven projects have positive NPV - Total value created = 97 • With external funding projects 1-4 have positive NPV - Total value created = 35

11. FUNDING POST-LOSS INVESTMENTS(CONTINUED) MERCK • Merck was one of the first users of this RM strategy • Research based Pharmaceutical company - Investment in R&D - Bringing new drugs through clinical trials and then to market - Predictable (?) investment budget • Problem – large exposure to FX risk. Worried that sudden FX loss would deplete earnings. Thus Merck would lose cheap funding for R&D, etc., and would have to cut back on new investment • Solution – hedge R&D risk to protect cheap funding - Note transaction costs of FX hedge fairly low - Would this strategy be as attractive for product liability risk where insurance transaction costs are high?

12. FUNDING POST-LOSS INVESTMENTS: SOLUTIONS • Hedging - Secures cheap internal funding source; example see Merck • Contingent equity - Example 1. Insurance firm fearing catastrophe loss sell put option on their own stock to counterparty. Provides cheap post-loss capitalization. CATEPUTS - Example 2. Cephalon drug company is taking drug through clinical trials. If FDA approval, it will need source of funding to develop the drug. Buys call options on its own stock. - Example 3. Michelin keeps high level of capital as war-chest for acquisitions. The cost of this capital is high and it can become a target. Solution contingent equity

13. FUNDING POST-LOSS INVESTMENTS: A RELATED ISSUE • Apache oil (member of EIM) • Problem is that is creates value through acquisitions that are well priced and it has comparative advantage • Hedging oil price risk allows it to lock in profit from acquisition which it gives a comparative advantage in the bidding process • Hedge oil price risk with zero cost collar • Also controls leverage to maintain financial flexibility so that it can fund acquisitions as they arise • Candidate for contingent equity?

14. RISK MANAGEMENT AS SIGNAL • Risk management changes performance of a firm. • Managed numbers can convey more, or less information • Examples where signaling is important - Outside investors rely on accounting numbers to value the firm. Do “hedged” numbers convey more or less information - The profit or share price of a firm depends both on factors under the control of the managers and factors outside their control - Managers of an oil company can control the rate of extraction but not the oil price. - If the firm hedges the factors outside the managers control, then the remaining profit provides a better monitor of managerial performance. - Notice firm may be able to achieve the same goal by paying executives with indexed options

15. RISK MANAGEMENT AS SIGNALCAN WE USE HEDGING MAKE EARNINGS MORE TRANSPARENT INDICATORS OF VALUE? Earnings = Base + Signal + Noise Signal persists but noise transient Investor cannot separate noise from signal. How does investor forecast next period earnings? Bt + (St + Nt)earnings @t (Bt + St) + (St+1 + Nt+1)earnings @t+1 (Bt + St + St+1) + (St+2 + Nt+2) earnings @t+2

16. NOISE HEDGING : FORECASTING EARNINGS FORECASTING WITHOUT NOISE Bt + Stearnings @t (Bt + St) + St+1earnings @t+1 (Bt + St + St+1) + St+2 earnings @t+2

17. RISK MANAGEMENT AS SIGNAL • If purged of noise, then earnings become more transparent signals of underlying value • Some evidence shows that when firms hedge, the responsiveness of the stock price to earnings surprises increases • This leads to the interesting possibility that - Increased transparency can INCREASE the volatility of the stock price - If so, then stock options convey option to make earnings more transparent by encouraging managers to hedge noise

18. WHERE IS THIS ALL LEADING? • ERM starts with fundamentals - How does risk impact firm value? - How can management of risk preserve value? • Three broad themes developed here - Risk affect the costs of financial distress - Risk can impede funding of investments - Risk affect the information conveyed to stakeholders • There may not be one unified risk management strategy that hits all these points • But it does suggest framework for ERM strategy

19. BLENDING COST-OF-RISK THEORIESAND TRANSPARENCY THEORY