Thinking it through: in decisions concerning risk and insurance, it's essential to transcend a firm's limited experience.

Many of us remember from childhood the story of Chicken Little, who was struck by a falling acorn and then alarmed the other chickens by frantically warning them that the sky was falling. Although adults may dismiss this story as merely amusing or even silly, it in fact warns us against some mistakes that can trip up even experienced and sophisticated decision-makers.

One moral of the story is to make sure that the facts and experiences on which you base your actions are not misleading. As business executives well know, information always is limited and decisions must typically be made before all or even most of the facts are known. What's important, though, is to consider whether the partial information one does have might be biased in some important way.

This advice is especially pertinent to decisions concerning risk and insurance. A simple game illustrates this point. Toss five coins. If they all come up heads, you lose $100. Otherwise you lose nothing. Since the probability of tossing five heads is one toss in 32, or about 3%, the expected loss per toss of the five coins is about $3. Now here is the key question: if you could purchase insurance against loss for only $1 per toss--substantially below the breakeven cost--should you do so? Experience would counsel against doing so, since most of the time--31 times out of 32--the cost of insurance would exceed your benefits from purchasing it.

We laugh at Chicken Little's naivete. Yet many firms interpret a series of years with few or no extreme losses as definitive evidence that risk is comfortably manageable.

A second and equally important moral is the need to take qualitative factors into account. Like Chicken Little, who failed to notice that no one else was similarly affected, decision-makers may mistakenly be more heavily influenced by events or considerations that are concrete and quantitative--being hit on the head--than by those that are more subjective and less easily measured, such as the experience or opinions of others.

For example, it is easy to measure how much a firm pays for insurance or reinsurance and how much it benefits in claim payments. But other important benefits of having protection against loss are more difficult to quantify: reduced volatility of cash flow and earnings, an increase in the firm's ability to fund growth and investment opportunities, and a favorable impact on the firm's credit ratings and resulting cost of debt, which varies with the firm's net risk exposure. Most of these qualitative factors are benefits of insurance, but they accrue to the firm as a whole, and not to the person or department making the decision on whether insurance is desirable, so their impact on the decision is consequently diminished.

One way to avoid these potential pitfalls in thinking about insurance is to adopt an explicit comprehensive definition of the cost of risk. As conventionally defined, the cost of risk for a firm consists of the cost of insurance purchased, the cost of claims paid by the firm itself, the cost of loss prevention initiatives and the cost of administration.

By this definition, purchasing insurance inevitably increases the cost of risk in most years, even if, as in the coin-tossing example, it is purchased well below cost. This is because in most years the premiums paid will exceed the losses recovered.

But a comprehensive definition of the cost of risk would include four additional factors: the cost (in market value of the firm) of cash flow and earnings volatility; the cost (also in market value of the firm) of potentially losing growth and investment opportunities in years when losses occur; the increased cost of debt due to the impact of risk on credit ratings; and the cost of risk capital dedicated to absorbing potential losses. This last item represents the fact that a firm retaining risk is acting as its own insurer, and therefore needs capital to absorb potential losses. But this capital is costly, whether to an insurer or to a firm.

Trendy business books in airport bookstores encourage us to behave like Chicken Little: Go with your gut, rapidly respond to concrete events and make one-minute decisions. But in decisions concerning risk and insurance, this is a recipe for disaster. Instead, it is essential to transcend a firm's limited experience and to think comprehensively about the quantitative and qualitative costs and benefits of purchasing protection against loss.

William H. Panning, a Best's Review columnist, is executive vice president and managing director at Willis Re Inc. He can be reached at [e-mail].