Rethinking Retention.

Rules of thumb for determining the risk a company should retain may be outmoded and misleading.

My first boss emphatically warned me to "always be part of a profit center, not a cost center. You want to be viewed as adding to the bottom line, not subtracting from it." Sound advice, but sometimes difficult to follow, especially for buyers of insurance and reinsurance.

The problem is that insurance decisions pit premium costs that are clear and precise against benefits that often seem vague and indefinite. The most direct and obvious benefit is the transfer of claim costs from insured to insurer. In years when catastrophes are plentiful or severe, this benefit is obvious and unchallenged. On average, though, claims will necessarily be less than premium costs, since insurers must make a profit to survive.

The fact that insurance is, on average, a net cost creates an incentive for firms to reduce this cost by increasing their retention of risk. When firms are under severe pressure to maintain or grow earnings, risk managers and reinsurance buyers may acquiesce or even initiate such decisions to demonstrate their value to the firm.

Another important benefit of insurance is a reduction in the volatility of an insured firm's cash flow and earnings. Reducing cash flow and earnings volatility benefits a firm by lowering its probability of financial distress, increasing its ability to internally plan and fund current and future investments, reducing its cost of borrowing from external sources, and enhancing its ability to minimize tax costs. Reduced earnings volatility also is widely regarded as increasing a firm's stock price. The trouble with these benefits is that they are difficult to quantify. Moreover, they affect the firm as a whole, rather than being clearly attributable to the efforts of insurance decision-makers. Consequently, the costs of insurance again seem to outweigh the benefits.

Lacking quantitative measures for comparing the benefits of insurance against its costs, firms understandably develop and rely upon simple rules of thumb for determining how much risk they should retain. Unfortunately, these rules of thumb may be outmoded and misleading.

For example, a risk manager of a large industrial firm said his company set its retention at a half-billion dollars. The company was comfortable with this number, the risk manager said, because it was about half the company's projected annual cash flow, a criterion that had been developed some years earlier. As we talked, however, it became clear that this rule was no longer appropriate. Although the annual cash flow was indeed substantial, the firm had recently embarked on a high-growth strategy and was using all its cash flow, along with additional new debt, to make large acquisitions.

Moreover, senior management acknowledged that the firm's high growth rate was responsible for its lofty stock price. A loss equal to half a year's cash flow, therefore, could impose substantial costs upon the firm's shareholders. In addition, the retention decision assumed that the firm's cash flow would remain constant. But, in fact, a disaster of this magnitude would curtail production and would substantially reduce the firm's cash flow, potentially jeopardizing its credit ratings and its ability to fund its debt.

Fortunately, new tools are available that enhance retention decisions by improving the ability to quantify the benefits of insurance protection. A key insight here is that insurance reduces a firm's need for capital. Besides working capital, which is needed to purchase assets and fund operations, firms need risk capital to absorb potential fluctuations in earnings and cash flow. By offsetting some significant sources of these fluctuations, insurance reduces the firm's need for risk capital. Insurance, therefore, increases a firm's return on equity--ROE--not by raising the R but by lowering the E.

A new, valuable tool for quantifying this contribution of insurance to a firm's ROE is value at risk, or VaR, a measure of the amount of capital a firm needs to survive an extreme loss. (See, "The Virtues of Value at Risk," Best's Review, September 2001.) The effect of insurance can be determined by first calculating a firm's VaR without insurance, then recalculating VaR with insurance and subtracting this second number from the first one. The result is the amount of capital saved by buying insurance. Multiplying this number by the firm's cost of capital produces a measure, in dollars, of the capital-reduction benefit of insurance, a measure that should be taken into account in program design and purchasing decisions.

This approach to thinking about insurance and reinsurance decisions not only enables us to better quantify the benefits, but it convincingly demonstrates to chief executive officers and chief financial officers that managing risk is managing capital.

William H. Panning, a Best's Review columnist, is senior vice president of Willis Re Inc.