Christopher L. Culp - Structured Finance and Insurance

Contents

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Copyright 2006 by Christopher L. Culp. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Culp, Christopher L.

Structured finance and insurance : the ART of managing capital and risk / by Christopher L. Culp [et al.].

p. cm.(Wiley finance series)

Includes bibliographical references and index.

ISBN-13: 978-0-471-70631-1 (cloth)

ISBN-10: 0-471-70631-0 (cloth)

1. Asset-backed financing. 2. Securities. 3. Risk management. 4. Risk (Insurance). I. Title. II. Series.

HG4028.A84C85 2006

658.155dc22

2005019905

Foreword

Wherefore ART Thou? The Importance of Principle-Based Structured Finance

Whenever I get a chance to speak to one of Chriss MBA classes at the University of Chicago, I enjoy the look on his students faces when I start spouting Shakespeares views on risk management and corporate finance. For practitioners of structured finance and alternative risk transfer (ART), many of his quotes are quite instructive. For example:

Eye of newt, and toe of frog,

Wool of bat, and tongue of dog,

Adders fork, and blind-worms sting,

Lizards leg, and howlets wing,

For a charm of powerful trouble,

Like a hell-broth boil and bubble.

Macbeths witches truly appear to be our first structured finance specialists. At least that is what some may conclude when reading about the efforts of managers and their financial advisers to practice structured finance and ART as a sort of alchemyturning debt into insurance, taking liabilities off balance sheet, or accelerating earnings to cover known losses. We cant bid farewell to magic ( Tempest, Act V, Scene I), but we can establish the fundamentals on which the proper solutions are structured to address fundamental capital and risk management issues.

In Parts One and Two of this book, Chris lays out the building blocks of finance and risk management drawing on corporate finance theory and applied research that has been developed over the past 30 years. These tools are then sharpened in Parts Three and Four as we move from theory to applications involving project finance, securitization, and the convergence between insurance and capital markets solutions such as catastrophe bonds and committed capital. Chris brings together two different worldsthe world of corporate finance and the world of insuranceand explains how the tools, while they may look different, are based on the same fundamentals.

These worlds are complicated on their own. When practitioners bring them together they often create Byzantine structures to address accounting, regulatory, tax, and corporate finance drivers that might lead even the most astute shareholder or analyst to proclaim:

Sir, I am vexed;

Bear with my weakness; my old brain is troubled.

(Tempest, Act IV, Scene I)

This is why simple principles are important. Shakespeares entreaty To thine own self be true ( Hamlet, Act I, Scene III) can be used by any manager to question whether the structured transaction is a means for obscuring or addressing underlying risks. Structured transactionswhether they securitize assets, cover difficult-to-insure risks, or access capital markets investors more efficientlyare of questionable value if management cannot explain clearly why considerable time and resources were spent to structure such solutions.

Often, the decision to structure a solution is a type of To be or not to be question. Does management of an airline company believe its shareholders wish it to be in the transportation business or the fuel speculation business? To what degree should the future oil price be hedged, for how long, and at what cost? Chris explains the fundamental principles to answer these questions and goes one step further by explaining the confusion shareholders face if they do not know or understand managements risk management strategy.

Of course, it is because companies can never be secure from worldly chances and mishaps (Titus Andronicus) that risk management has a role. It is equally important that risk managers understand that shareholders expect management to take risks. Without taking risk, management cannot create value. It is the balancing act between risk and ruin that Chris concentrates on in such detail by keeping our attention focus on both capital and risk management.