1. Market Volatility and Risk Mitigation Paul G. Turner, CFA May 2008 Presented to IECA

2. The goal of the presentation will be to demonstrate the link between individual credit assessments, the cost of credit and the cost of capital; and how each of these has an affect on capital structure. We will then examine the effect of market volatility on a companys risk management program and finally look at the market in Canada for laying off credit risk.

3. Market Volatility and Risk Mitigation Why do we need to mitigate risk? The easy answer...

4. Market Volatility and Risk Mitigation Why do we need to mitigate risk? (contd) The more appropriate answer is we are challenged more and more to find ways to support increased sales levels with the same number of buyers, and without increasing enterprise risk. This raises three fundamental questions: How to determine the maximum acceptable amount of credit on any one counterparty; Is there a cost to credit and if so, how does one determine it; and, What are the cost of capital issues related to trade credit?

5. Market Volatility and Risk Mitigation Some theoretical background How trade credit replaces working capital loans. Current exposure versus potential exposure. Black Swans. M&M Proposition II and Capital Structure Optimization.

6. Market Volatility and Risk Mitigation How much is too much? If we accept that trade credit is a necessary part of business, what goes into establishing the proper amount for any one counterparty. This has become even more important as firms increasingly need to consider potential exposure as opposed to current exposure. Companies that are targeting increased output, coupled with increasing commodity prices must now actively challenge assumptions with regard to acceptable risk levels – particularly since there is a finite (and small) numbers of buyers for energy supply.

7. Market Volatility and Risk Mitigation How much is too much? (contd) This should not be a mechanical exercise. While modeling can be helpful, the real value of any model is in the testing of assumptions and prevailing thinking. So rather than provide a model, we will focus on the factors that should be considered in establishing the number.

8. Market Volatility and Risk Mitigation Factors to consider – financial analysis Technical Analysis Fundamental Analysis Macro / Micro Analysis

9. Market Volatility and Risk Mitigation Factors to consider – portfolio considerations Investment portfolio theory. Timing – the absolute amount is time dependant; in other words the view will change as events unfold. However, positions are usually static for at least some time horizon. Overall portfolio characteristics. The amount of exposure you can take on in total is limited by your own capital. Correlation of counterparty default. This will have an impact on the overall level or maximum total exposure, and in turn the amount allocated to any one buyer in the portfolio. Is there a difference between the credit maximum for physical exposure as opposed to financial (MtM) exposure. Again this goes to current versus potential exposure.

10. Market Volatility and Risk Mitigation Factors to consider – corporate structure Ownership issues - do you want to have more invested in the company than the owners. Capital structure considerations - what percentage of your working capital is acceptable to invest in any one company.

11. Market Volatility and Risk Mitigation Factors to consider – business relationship Look at it from the customer side as well. How much do they want to be tied to any one supplier: Toyotas philosophy is to ensure that they only represent 40 to 45% of total production from any one supplier. In contrast, the GM - Ford model is to have a much larger share of the suppliers capacity - an issue of control. If that supplier then runs into difficulty, GM must take effective ownership of the supplier (through a bailout or guarantee) to ensure continued supply. Toyotas philosophy is to have healthy suppliers rather than ones they control. Rules of thumb.

12. Market Volatility and Risk Mitigation Cost of credit Broadly speaking, the components of the cost of credit can be broken down into: Administrative Costs: Human resources Information tools Surveillance costs Legal Costs of buyer default Capital Costs: The cost of allocating capital to the risky asset Opportunity costs Companys own default cost

13. Market Volatility and Risk Mitigation Cost of credit (contd) How much capital should be allocated to Accounts Receivable (AR)? It could be the probability of default associated with the AR base to arrive at an expectation of loss. Then the company must allocate a certain amount of capital to this figure, and the cost of credit is the cost of that capital. However, this is the expected default cost, what about the unexpected default cost? Market value approach - assessing the risk premium attached to owning a piece of your buyer.

14. Market Volatility and Risk Mitigation Cost of credit - other issues Wrong way risk - does the price fluctuation of the underlying commodity affect the risk of the exposure? Floating versus fixed costs - do you have the ability to pass on the cost of credit in the price. If not, a deteriorating risk with your buyer will have a direct and negative impact on margins. Bottom line: without understanding your own cost of credit, how can you determine the efficiency of laying off the risk.

15. Market Volatility and Risk Mitigation Cost of capital considerations Basic capital structure dictates a mix of debt, equity and internal funding to support the asset base. The optimal mix is determined by many factors including: Volatility of the asset base; Growth expectations; Tax regime; Timing and market expectations; and, Agency costs. Even with bankruptcy costs, debt is a cheaper form of capital than equity.

16. Market Volatility and Risk Mitigation Cost of capital considerations (contd) Volatility of the asset base is a key determinant. Even in the energy sector, AR is a risky asset. The larger the proportion of AR to the total balance sheet, all things being equal, the greater reliance the firm will place on equity funding. By mitigating the credit risk associated with AR, the firm lowers volatility and can reduce its dependence on equity. Furthermore, stability in cash flows and lower enterprise risk reduces the equity premium demanded by investors.

17. Market Volatility and Risk Mitigation Market volatility The impact of market volatility:

18. Market Volatility and Risk Mitigation Risk mitigation The goal of any mitigation strategy should be to transfer the amount of risk which best improves the capital allocation decision while maximizing stakeholder value. These products are specifically designed to achieve these goals while providing an opportunity for management to protect one of the largest corporate assets. Credit Insurance protects the rm against that which it cannot see, not that which is inevitable.

19. Market Volatility and Risk Mitigation The Canadian market North America is a mature market with respect to Risk Transfer options. Primary options are Credit Insurance, Credit Default Swaps (CDS) and Receivable Put Agreements. The primary mechanism for risk transfer in Canada remains Credit Insurance with all the major global participants having a significant presence in Canada. In the US, CDS outpaces all risk transfer options with a current nominal value in the range of USD62 trillion at YE 2007.

20. Market Volatility and Risk Mitigation Risk transfer options Credit Insurance: Generally the cheapest form of cover. Flexible in portfolio design and degree of risk transfer - both single buyer or multiple buyers acceptable. Aggressive risk appetite. Non-cancelable limits possible with Atradius, AIG, ERIS and some secondary markets. Strong service offering. Ability to syndicate a structure to enhance limit capacity. CDS Market: Very large market - despite its size, signicant liquidity issues of late. Offers long term structures allowing buyers to reduce basis risk of contract tenor. Complex agreements to structure. Not designed for multiple counterparties. Possibility to attain 100% indemnity.

21. Market Volatility and Risk Mitigation Risk transfer options (contd) Receivable Put Market: More closely related to Credit Insurance than CDS market. Not designed for multiple counterparties, strictly one-off transactions. Aggressive risk appetite and pricing from key players such as Credit Suisse and Deutsche Bank. This is tied to their presence in the distressed debt market. Long term structures possible (up to 5 years with most common tenors in the 1 to 3 year range). 100% indemnity, however, insolvency the only risk covered. Much simpler agreements to structure as compared to CDS.

22. Market Volatility and Risk Mitigation Structural Issues Because CDS and Receivable Puts are overlays on one buyer, portfolio structures are not possible. As such, these products are usually considered when Credit Insurance is not viable (for example transferring GM risk in 2005 / 2006) or when term structures are longer than one year. CDS and Receivable Puts are designed to hedge an existing or potential position. Credit Insurance is used as a mechanism to leverage existing positions and increase exposures on counterparties to levels the company is not comfortable with on their own. Credit insurance allows a company to structure a portfolio to meet the specific needs based on buyer risk, exposure size, concentration, financing requirements, etc. Basically any portfolio can be designed as long as the risk presented is not adverse selection.

23. Market Volatility and Risk Mitigation Comments on pricing Credit Insurance is usually the cheapest form of protection. In comparison to LC ʼ s, insurance is generally 30 to 40% their cost. While single buyer transactions are becoming much more common in Credit Insurance, portfolio pricing is generally more competitive. It also allows the Insurer to be more aggressive in their risk appetite. Receivable Puts are more cost effective than a comparable CDS instrument since most CDS products are laid off in another market. CDS pricing is capital market driven and therefore can be subject to severe volatility (as well as liquidity concerns).

24. Market Volatility and Risk Mitigation The Canadian insurance market InsurerRatingPremium Base (YE 2006) Comments AIGAA USD52.7 billion (total premium for all lines) Credit Insurance a small part of their overall Offers non-cancelable limits AtradiusA1.8 billion With the recent merger with CYC in Spain, they are the largest in the world Flexible in tailoring solutions True non-cancelable policy structure CofaceAA-975 million Newest participant to CDN market Lacking service presence in Canada Aggressive pricing EDC AAA (backed by the sovereign) CDN90 million Sovereign rating provides policyholders preferred lending margins Strong risk appetite EulerAA-1.7 billion Largest number of in country risk experts Strong service presence in Canada

25. Market Volatility and Risk Mitigation The product - overview Credit Insurance is designed to protect the seller from non-payment of its buyer. Can be triggered by either the Insolvency of your buyer or Protracted Default due to cash ow problems. Other risks covered include repudiation or the buyers non-acceptance of goods, and political risks. The premise of cover is that the Insurer can step into your shoes once a claim is paid. As such, the underlying contract must be enforceable. Premiums are based on the policyholders usage, either through assessing a rate per dollar of sales, or basis points for credit exposure allocated. Most policies today are losses attaching – meaning the coverage is based on a policy being in force when goods are shipped, not when the loss actually occurs.

26. Market Volatility and Risk Mitigation The product - pricing structure Portfolio / single buyer approach: In most instances the Insurer requires a spread of risk through a portfolio of buyers. The premise is they require is a reasonable spread of risk – taking the good with the bad. They will consider a single buyer portfolio as long as the risk is reasonable. This is most often used when the exposure on a buyer exceeds dened levels of acceptance within the capital structure. Aggressive pricing today: Pricing reects the risk premium required to hold exposures on the basket of buyers – similar to pricing debt instruments. Can tailor risk sharing proportions (through co-insurance and/or deductibles) to maximize the value of premium dollars spent. Despite the recent turmoil in capital markets, Insurers remain aggressive in pricing. This is largely due to the fact they are very familiar with this kind of volatility and do not over-react to a crisis environment. They are not totally reliant upon the capital markets for pricing structures, rather they use them as a guide since the time line is much longer than with other credit instruments.

27. Market Volatility and Risk Mitigation Comments on non-cancelable limits Whenever a non-cancelable policy is issued, the basic premise is that the credit is of sufficient quality that the Insurer can take a longer term outlook on the capacity provided. It offers the Insured greater protection that the Insurer will not withdraw cover due to a risk deterioration. In other words, the Insurer cannot change the conditions of cover to rebalance their own risk profile. It does not relieve the Insured from all obligations related to credit risk management. The Insured must continue to act in a prudent manner as it relates to risk assessment, most importantly in the event of a loss. This is not to say that the limit will be continued irrespective of the credit risk. If there is specific knowledge of imminent failure, cover is halted going forward (it has no effect retroactively on shipments already made). Insolvency and protracted default are covered risks. However, in the energy sector, protracted default is akin to insolvency due to the realities of a delay in payment.