The focus on risk management has intensified as crises have roiled through markets, such as the collapse of major corporations due to mismanagement and daily developments on Wall Street arising from poor management of credit risk–including the federal bailout of the world’s largest insurer, American International Group, and other financial institutions.
Over the last few decades, hazard risk management has developed from its roots in insurance purchasing to become a core part of a company’s capital management strategy, similar to financial risk management. In short, risk managers now view risk management as financial management, and are making insurance purchasing decisions accordingly.
Those with an understanding of risk-transfer vehicles–who can accurately judge the relative cost and value of each under different scenarios–stand to improve their company’s financial and governance profiles.
Corporate governance initiatives such as Sarbanes-Oxley–and, more recently, rating agency scrutiny of company enterprise risk management capabilities–have forced risk managers to become literate across a broad range of corporate functions, not the least of which is financial management.
One consequence of this has been the realization that the purchase of insurance is a corporate finance decision. Viewed from the perspective of a financial manager, insurance is simply the purchase of a particular kind of capital whose receipt is contingent on particular events occurring–a fire, for instance, or a product liability claim.
When an organization pays an insurance premium, it is using the insurance company’s balance sheet to provide contingent capital under certain circumstances. The decision to buy insurance is based on whether the cost of this contingent capital is cheaper than the cost of other capital resources.
If the company has access to a cheaper source of capital, financial reason says it should use it.
The question for many risk managers is how to determine the embedded cost of capital in the insurance premium, and where to set retentions and limits. At what point does self-insurance become more expensive than taking out a policy? At what limit does the “marginal cost of insurance capital” become greater than the company’s cost of its own, or alternative sources of capital?
Managing insurance through the prism of corporate finance sounds complex, but in reality, decisions should be made on the basis of a very simple criterion: If the cost of buying an extra unit of insurance, relative to the extra cost of risk capital, is greater than your before-tax cost of capital, don’t buy the insurance.
The theory is simple, but the analysis itself can be complicated.
Many firms spend tens of millions of dollars on liability premiums (for general, products, auto, directors and officers, etc.) and property premiums. For these companies, increasing or decreasing coverage levels by just a few percentage points at both the top and bottom of the insured levels can result in increases or decreases in premium and retained claim levels in the millions of dollars.
Knowing exactly where to set these retentions and limits is a science that draws on an in-depth understanding of the financial structure of both the client company and the insurance product. Getting it right requires a sophisticated financial and actuarial analysis that can help risk managers compare and contrast alternative risk-financing programs.
This complex work requires knowledge of corporate finance, actuarial science, risk assessment and insurance strategy. But for those who persevere, the rewards are significant–both from a financial and corporate governance standpoint.
Approaching insurance from a corporate finance perspective allows risk managers to determine an appropriate retention and limit across all classes of risk, based on the cost of insurance compared with the cost of alternative sources of capital. They are able to save on insurance costs through the innovative use of traditional and nontraditional sources of contingent capital.
Treating an insurance-buying decision as a capital-financing decision rather than a premium-expense decision elevates the risk manager’s role within the organization.
Further, corporations that undertake a rigorous retention optimization exercise are able to produce a formal Risk Financing Policy Statement, which provides both quantitative and qualitative justification for risk transfer and optimization decisions.
The statement can be used as a communication tool to explain risk-transfer decisions across many different classes of hazard risks. In fact, these same tools are used to assess other risk-transfer programs for exposures related to employee benefit programs and traditional financial derivatives.
But to make the right decision, risk managers must understand the opportunity cost of different forms of risk capital, recognizing the value at risk, tolerance for risk and capital structure of the firm, while considering insurance as a form of contingent capital.
In other words, they need to see risk management through the prism of financial management, and recognize that insurance is just one of several risk-transfer vehicles available to them.