Bettering the odds with risk management

This article was adapted from Mr. Jones' “University Day” presentation at this year's annual convention of the American Association of Managing General Agents. The event took place in May in Orlando, Fla.)

MANY businesses have become comfortable with risk. Consequently, they no longer consider insurance to be the answer for everything. They also regard insurance as a significant expense–and unpredictable in its own right. Hard markets, for instance, drive business owners crazy. When premiums go up 400%, the increase comes right off the bottom line–and they don't like it. They want steady, predictable profits and more control–and they are willing to accept more risk to get these things.

In other words, they want alternatives. The proliferation of captives and risk retention groups is the result of buyers who have said, in essence, “You guys in the insurance business didn't give me the answer to my problem, so I'm going to invent my own.”

A paradigm is a habitual way of thinking. A paradigm for most of us is that insurance is always the answer. My hope is that this article will persuade you to shift that paradigm a bit and to start looking for the answer within the more encompassing concept of risk management.

Having been an insurance agent myself, I know that agents often think in the terms of premiums and policies, and have what might be called an “event mentality.” From their perspective, the big event of the year is the renewal date. But such thinking is typically not in sync with the buyer's.

Risk management changes the focus from premiums and policies to exposures and costs. Rather than an event mentality, it promotes a process mentality. The focus is on long-term planning over the next five to 10 years, not on a renewal coming up in 12 months or less.

Just what is risk management? Most buyers can give you a one-word definition for risk: uncertainty. Management, meanwhile, is the wise use of assets. Put them together and you have risk management: the wise use of assets to offset the negative effects of uncertainty.

Risk management is expressed in a plan, one that is sequential and goal-oriented. The objective is that when the worst happens, the client is left in the same financial position as before. In other words, the goal is to protect wealth. If the client's $2 million facility burns down, it is exchanged for $2 million in cash. The form of wealth changes, but the client's net financial position stays the same. Actually, risk management should go a step further and protect not only wealth but also the growth of that wealth, hence the process mentality of now and the future.

Setting objectives

The first step in the risk-management process is setting objectives. Each plan must have three fundamental goals. No. 1 is to reduce losses. Just what is a loss? According to one textbook definition it is “the unintended decline in, or reduction of, value arising from a contingency.” Obviously the loss has to be unintentional, or it would be fraud. But essentially, a loss is a reduction in wealth.

Goal No. 2 is to reduce claims. The difference between a loss and a claim is simply the party that pays. A loss is paid by the client, while a claim is paid entirely or partly by another; e.g., an insurance company.

Goal No. 3 is to spend wisely on steps that can reduce losses and claims. I tell my risk management clients: “It is not the insurance company's responsibility to help you reduce claims and losses. It's your responsibility. After all, it is your business and your wealth.” In that effort, the employers must lead by example. “You want your employees to wear hard hats?” I say. “Then don't let me catch you at a worksite without one. You want them to wear safety glasses and hard-toed shoes? Then you'd better use both every time you step onto the factory floor.”

I will not work for a client who will not agree to those three main goals. If they do agree, they can add whatever other goals they wish: to relocate in the event of a disaster, to prepare to take the company public, etc.

Identifying and classifying exposures

The second step of the risk-management process is to identify, classify and analyze exposures. An exposure is any contingency that can reduce wealth. To discover what a client's exposures are, you have to excel at listening. When I was selling, I had a scripted outline and would do most of the talking. With risk management, I had to turn that around and let clients describe themselves and their business.

Since businesses can vary widely, and since no two clients talk about their businesses in exactly the same way, letting clients talk about their exposures potentially can be quite confusing. I devised a system, however, that keeps everything simple: I list anything and everything the client mentions under one of four categories:

1) Losses to assets: These include real property, personal property, property of others, intellectual property, etc. It's the easiest exposure to identify. A replacement cost value, actual cash value, agreed value or some other value usually can be assigned to each piece of property.

2) Losses to use of assets: This exposure is more difficult to measure. An airline buys a new plane for $30 million. Flying that plane represents a $30 million risk. The airline, like any business, should expect at least a 10-fold return on any asset it buys. But such rules of thumb are only of so much help, because the exposure has to be projected into the future. Who knows what the airline business (or any other business) might be like in five years?

3) Liability: This exposure is even more difficult to measure than use of assets. Who has any idea of what a jury might award these days?

4) The human exposure: This risk has to do with employees and employee benefits. I am not an expert in this area and don't offer consulting services for it, but it is part of a risk management plan.

By using these four categories, I can leave each meeting with a client–regardless of whatever he or she has said–with the information at least somewhat organized. I follow up to clear up any uncertainties.

These conversations, incidentally, offer terrific opportunities to ask for financial statements. Most insurance agents are scared to ask for financials. But using the risk-management approach, you have a good reason to request them: “We're going to project your future earnings,” you might tell the client. “I cannot do that unless you tell me what they are right now. In fact, I need the last five years' worth of financials, so I can project a growth pattern.”

This is another qualifier for me. If I don't get the financials, I bow out. But when I tell clients why I need the information, they usually provide it. Also, I stress that I realize the financials are confidential. I explain my procedures for safeguarding this information. I don't copy it; I keep it in a separate file marked “confidential,” and only people in my office who need to see this information are given access to it. We send this information only to insurance companies that express a sincere interest in quoting on the account. It doesn't go out with the first set of applications, when we survey the markets. We include a cover letter with the financials that says, in essence, “This is the client's confidential information and is to be used only for underwriting purposes. You are not allowed to photocopy this information. If you are not the successful underwriter, you must return this information to us, along with a letter saying you have not copied it and are returning the original copy.” My client gets a copy of the underwriter's letter. You may think this is overkill; but I want to demonstrate to my clients that this matter is important to me, because I know it's important to them.

Analyzing and treating exposures

After identifying and classifying exposures, the next step is to analyze them for frequency and severity. We start, of course, with prior losses, because history usually repeats itself. After determining the average size of losses in the past and converting them into today's dollars, we project the future expected annual loss, using an appropriate multiplier for inflation. (A little familiarity with the fundamental principles of financing can be helpful here, but the calculations are not all that hard.)

Unless I'm dealing with a chief financial officer, I don't review the calculations in great detail. Rather I present a simple graph (or graphs) on which losses are plotted in terms of frequency and severity. We discuss exposures that have low frequency, defined as a loss that is not expected to happen more than once every 10 years. Be aware that a client may object that some low-frequency losses you project will never take place, much less in 10 years. I respond to such objections by saying, “If you do not plan for this contingency and it takes place, what happens to your wealth? It goes down!

“If you plan for this contingency and it takes place, what happens to your wealth? Nothing! If you plan for it and it doesn't take place, what happens to your wealth? It goes up!”

We also discuss exposures with moderate frequency. A loss from such an exposures is probably going to happen once every five years. Then we talk about high-frequency exposures, which are going to cause losses every year. Most will be minor–but they are going to happen.

Then we analyze severity in exactly the same way. Low-severity losses are a nuisance but have little effect on day-to-day operations. A moderate-severity loss may require a client to redirect money that had earmarked for other purposes. Such a loss may alter the client's plans but isn't anything the business can't deal with. Finally, a high severity loss is one that could cause the bankruptcy of the business.

Some exposures have both low frequency and low severity, a few may have high frequency and high severity, and the rest will fall somewhere in between. The next step is to figure out how to treat them. Let's consider the alternatives:

Alternative No. 1: Avoid the risk. This is often the best option for those exposures that have high severity. When a client contemplates entering a new field–manufacturing a particularly hazardous product, for exam-ple–we may need to say there's just too much risk.

Alternative No. 2: Loss prevention. What can the client do to reduce frequency and severity? No alarm system in the building? Put one in! Got one person signing checks? Get two! I tell my clients they must affect frequency and severity. That's part of their job in the risk-management process.

Alternative No. 3: Loss reduction. What's the difference between an alarm system and a sprinkler system? The sprinkler system comes on after the loss and reduces its severity. That's loss reduction. The alarm system, we hope, stops the loss from ever happening. That's loss prevention.

Alternative No. 4: Separation of risks. Suppose a wine maker has plenty of sources for bottles, grapes, labels and everything else he needs–except corks. He uses only the best, and it would take him six months to get resupplied after a loss. A good way to treat the exposure is to keep six months' worth of corks at the winery and another six-month supply at an off-site warehouse.

Alternative No. 5: Finance the loss. For a company with sufficient cash flow, the best way to deal with small, routine losses simply may be to budget for them. Set aside a certain amount each month in a loss fund. If the accumulated funds are not all spent in a given year, the difference falls to the bottom line. (I know insureds would like to carry this over to the next year, but the IRS frowns on that. They have to recognize the unspent balance as profit and start over with the loss fund the next year.)

Losses also can be financed with credit–if you take care to set up the credit in advance. No bank is going to extend a large line of credit to a business after its factory or other potential collateral is destroyed.

Business owners with enough personal wealth to temporarily get by without a salary can even provide the credit themselves. For instance, an owner could finance a loss that exceeded a $25,000 deductible by reducing his or her salary by that amount and lending it to the business. The business would pay it back at an appropriate rate of interest, which would be taxable, of course. But the owner would not have to pay Social Security taxes on the returned loan, because it is not considered to be earned wages.

Alternative No. 6: Non-insurance risk transfer. Such transfers can be achieved via hold-harmless agreements and other contracts. Just make sure the other party has sufficient resources to respond to a loss. Some credit cards issuers agree to assume responsibility for damage to any vehicle rented with their cards. Using such a card is a great way to transfer that risk.

Alternative No. 7: Insurance! When agents talk to prospects, insurance is usually the first thing they discuss. Under the risk-management approach, it's the last. We first go through all these other interesting, less expensive ways to treat exposures.

Insurance is the ideal, although not always the exclusive, way to treat many exposures. When I get around to this alternative, I talk to my clients about three types of insurance:

1) Insurance you must have: It's mandated by law or required by a creditor.

2) Insurance your should have: Commercial general liability insurance would fall into this category. The coverage is not mandated by law, but a business owner would be a fool to not buy it.

3) Insurance you might want to consider–but we're not sure whether it's available or affordable: I consult for a couple of nursing homes. Ideally, they each should have a $10 million umbrella, but the premiums are sky high. They literally don't have the money to buy one.

The next step of the risk management process is to decide which alternatives to use for each exposure. Often I suggest a primary technique and a secondary technique. For example, loss control may be the primary technique for low severity, high frequency exposures, while financing is the secondary technique. For exposures of moderate severity and frequency, insurance may be the primary technique and loss control the secondary.

Implementing and monitoring the plan

Now it's time to implement the plan. This generally calls for the achievement of specific goals in the short term (within six months), intermediate term (within a year) and long term (within five years). A short or intermediate-term goal, for example, might be to build up a cash fund sufficient for the client to accept a $10,000 deductible.

The final step is monitoring the plan. If reducing losses by 10% within a year is one goal, and we don't hit it, we have to determine why the plan isn't working–and what needs to be changed to make it to work. Maybe we'll find employees aren't following safety procedures, or perhaps we'll find that after factoring in a growth in the client's workforce, the plan actually is working.

Obviously, the risk management process is not appropriate for every client. No one buying a BOP policy, for instance, is going to go through all of this. So when should it be used? When I look at the commercial-lines marketplace, I see a triangle. The bottom consists of accounts that are fairly simple, and there are a lot of them. Many agents concentrate on this segment, the idea being that if you knock on enough doors, somebody's going to buy something from you. I don't think that's where independent agents should focus, however, because most people in that market segment don't appreciate what they buy; most buy just because they must.

In the upper portion of the triangle, you have the Fortune 500. They have exceedingly complex needs and often a global presence. This is the realm of the national/international brokers like Aon, Willis and Marsh.

That leaves the middle-market, which I separate into the top and the average. The top businesses are the industry leaders. They may have in-house counsel and accountants, but they also are used to paying fees for services from outside lawyers and CPAs. Individual owners may well pay fees to financial planners. That makes them prime prospects for agencies with fee-based risk-management departments or for individual fee-based consultants. Of course, the risk management process also is of great help to commission-compensated producers working in this market. It provides a framework for treating each exposure a client has in the most efficient manner, creating value for the client and binding the account closer to the agency.

As I mentioned at the start of this article, the marketplace has changed greatly over the past 20 years. Sophisticated middle-market businesses are more comfortable with the notion of assuming risk and less inclined to look at insurance as the answer for every uncertainty. For agents and brokers who want to thrive in this marketplace, risk management is the way to go.

Mike Jones is the owner of Mike Jones & Associates, a firm he founded in 1993 that provides insurance and risk management continuing education services. The firm also provides risk-management consulting services. Mr. Jones entered the insurance business in 1970 as an underwriter for Gulf Insurance Group. For many years, he owned an agency and served as the president of the Independent Insurance Agents of Georgia in 1988. From September 1994 through February 1996, Mr. Jones was American Agent & Broker's first “Strictly Sales” columnist. He can be reached at mdjones4@bellsouth.net.