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Taking stock of your risks.

When you look at risk as an investment decision, figuring out how much risk to retain - and when - gets more complicated. But it may save you money in the long run.

Today, many risk managers are trying to cut expenses by retaining more risk. Many large businesses and nonprofit organizations now feel that even very high risk assumptions, if commercially insurable, are also retainable. The rationale is often along these lines: "If it hasn't happened before, let's assume the risk and save the premium."

On the surface, this sounds logical, because risk retention appears to be the inverse of an investment. The organization isn't investing premium dollars in an insured arrangement; it's retaining funds it would otherwise pay out as premiums. In a typical year, this is the least costly way to finance risk, because catastrophic occurrences are rare. The company eliminates risk transfer and, therefore, its frictional costs.

But viewing risk retention as a capital-free investment is an illusion that can expose the organization to ruin merely to save a small amount of premium. In the event of a worst-case loss, your entire capital structure could be considered the potential investment.

That doesn't necessarily mean you shouldn't assume more risk, but you should look at risk retention as an investment like any other. When you do, it's clear that adjusting risk retention up or down (depending on the cost of assumption, transfer or other factors) to match your company's needs is a process that potentially can save the company a fair amount of money.

The test of a good risk-retention decision is whether senior management, the board of directors and, ultimately, the investors still consider it a wise choice after the company has experienced a loss. When you view the entire process as an investment decision with risk and reward components, you're much more likely to get a thumbs-up.

In many respects, risk retention resembles equities options, such as puts or calls. The call buyer pays a premium for the right to buy the stock at a value typically above the current price on the option purchase date. The writer has an income stream without the need to make a cash investment. Thus, if the stock price stays the same until the expiration date, the "rate of return" is substantial, albeit undefined (the premium divided by zero). But the writer isn't risk-free, since the stock price could increase dramatically.

This is a contingent investment of capital. Purchasing coverage is the reverse situation: the contingent use of another's capital for a fee (the insurance premium), much like the buyer of the call option.

You can draw another parallel between a standby credit line arranged with a lending institution (for which there's a charge) and an insurance policy. Both provide funds only if needed, neither provides cash currently and both charge a premium in exchange for the assurance of cash availability.

The main difference between an insurer providing such capital and a lending institution is that you usually don't have to pay back the insurer. Thus, insurance premiums inherently cost more than standby credit lines. However, both are "leased" contingent capital sources.

CHOOSING THE RIGHT YARDSTICK

So how do you measure your rate of return on your added retentions? You can calculate the size of contingent capital impact as the additional loss expectancy on a once-in- 100-years event less the annual premium savings. While an event can be considerably more severe than this, it's a reasonable estimate of an abnormally high result.

To determine the return, calculate the amount you expect to save in a normal year as premium avoided, minus expected additional losses, divided by contingent capital impact. You need to make several adjustments to the premium savings element, such as cash flow and tax timing differences, to accurately calculate returns and compare alternatives.

What rate of return does your company need to get in order to assume additional loss exposure? Arguably, it should be a rate that you could obtain through alternative investments with similar risk and timing uncertainty. The short-term borrowing rate, which is often used to evaluate cash-flow alternatives, implicitly assumes a riskless environment, which isn't the case in risk retention. This is one reason why risk retention more closely resembles an investment decision.

Given that, you might choose the investment hurdle rate as your standard. Yet, the internal rate of return or hurdle rate may not reflect your company's entire capital structure, which could lead to inappropriately low levels of risk assumption. Comparisons based on an organization's cost of capital (the weighted average cost of debt and equity) tend to be more effective than marginal cost approaches, which fall somewhere between marginal borrowing and hurdle rates. While the logic appears counterintuitive, a highly profitable organization with other alternatives for investing its capital may not want to incur the significant opportunity costs of tying up its capital in risk retention.

In addition to the risk-reward consideration in retention decisions, you must evaluate the capacity and materiality of the additional risk your company retains, both insurable and other business risks. To determine the ideal retention, analyze aggregate loss amounts at alternative retention levels, using a loss-forecasting process and aggregate probability distributions. For example, in an organization exposed to a commodity price fluctuation, retaining risk in insurance exposures when combined with commodity price impact may lessen risk retention, because you could have negative results for the insurance exposures and commodity prices in the same year. This would impair both income and the balance sheet.

When analyzing a once-in-100-years event, ask yourself whether the difference is material to your company's financial structure (cash flow, earnings and balance sheet). Does it result in a financially catastrophic event, the breach of a loan covenant or an unacceptable deviation in earnings? Rule-of-thumb ratios are seldom useful in determining how much risk an organization can bear. If the 99-percent confidence interval isn't critical, then you can explore the investment decision further without concern for undue financial impact, assuming your risk management strategy has established structures to deal with aberrations, such as multi-year risk-financing arrangements (see box on page 46 for a guide to the accounting treatment).

IT'S PAYBACK TIME

Another frequently used measurement is to divide the aggregate attachment point by the savings (less related added expected losses and costs), using a payback period method. You can use a similar approach for calculating return on risk.

How many years does it take to pay back a worst-case scenario? If you expect a 20-percent return on new investments, a payback period of five years or less suggests a go-forward decision. This is a more conservative approach, since it doesn't consider the probability of the worst-case event occurring. It also ignores the possibility of a poor result that isn't the worst case but still provides a negative return.

The payback period is calculated only on an unlikely possibility, and this often results in an erroneous decision not to bear added risk. A more accurate, yet more complex, approach is to adjust the payback period calculation based on the probability of occurrence. For example, if the premium to cover a given type of loss is $100,000 and the potential loss is $1 million, the payback period is 10 years. If the probability of the event occurring is 5 percent in any given year, any premium above $50,000 would result in a rational decision to retain the risk, and a 20-year payback may be quite acceptable.

Some of these measurements may differ from traditional risk management, in which risk managers typically develop a risk-retention strategy for stability, increasing it gradually over time as part of the overall risk management plan. This approach presumes the markets for risk transfer always have an overhead and profit margin that you can and should avoid.

But the marketplace isn't perfect, so it's entirely possible that it may not create premium pricing that actually reflects the insurer's overhead and profit margin, because competitive pressures may result in substantial discounting. And if the insurer's cost of capital is lower than yours, transferring your risk to the insurer may be more efficient than diminishing your organization's own resources in the hopes of earning a higher yield.

Viewing retention as an investment decision may mean you'll have to move your risk retentions up and down more frequently, based on your claim results and the cost of risk transfer. While this "yo-yo" approach might run contrary to risk management tradition, it will deliver a lower cost of risk and measurable financial gain in today's drive for peak efficiency. That's why the risk-retention review should be a never-ending process for the risk management professional.

IN SHORT

* Companies with alternatives for investing may not want to tie up capital in risk retention.

* Risk retention isn't a capital-free decision, and approaching it that way to save on premiums can be disastrous for a company.

* Viewing risk as an investment decision means moving your retentions up and down more often, based on your claim results and risk transfer costs.

Spread It Around

Multi-year coverage arrangements that include pure finite elements can let companies spread the earnings impact of a large, unexpected loss over multiple accounting periods. This allows your company to generate enough cash to offset the loss and maintain its original financial position. Since you assume mostly noncorrelated risks, the combined volatility is less, allowing you to retain more risk. Your risk transfer costs may decrease, because you avoid the cost of smoothing year-to-year volatility. These arrangements also eliminate annual renewal negotiations and give companies a way to economically retain miscellaneous smaller exposures.

Despite the advantages, these programs have three major shortcomings. First, they tie up your company's cash at relatively low interest rates. It makes more sense to invest those funds in the company's core functions. Second, according to the Financial Accounting Standards Board, companies may be required to account for these programs as if they've entered into them as deposit arrangements rather than expenses. This position eliminates the ability to accumulate off-balance-sheet assets to pay the loss and spread the earnings impact. Third, you're very unlikely to be successful in defending the premiums for these programs as tax-deductible expenses.

Insurers have developed new multi-year products that blend finite risk and true risk transfer. The insurer's exposure to a payout must be at least 30 percent more than the premium to qualify as adequate risk transfer and obtain favorable accounting and tax treatment.

The American Institute of Certified Public Accountants has issued guidance for auditors on GAAP accounting treatment for finite programs. Emerging Issues Task Force release 93-14 addresses multi-year arrangements and requires companies to disclose the financial effects of the plan in their financial statements, using a "with and without" calculation.

As a result, the multi-year transaction may become a one-year arrangement from an accounting perspective. Depending on incurred losses, the future return premium is a receivable, or else the amounts due to the insurer become payables. Multi-year arrangements can still be very useful vehicles for risk retention, but before embarking on one, be sure you understand the accounting rules thoroughly.

Mr. Sanderson is vice president of J&H Marsh & McLennan in Minneapolis. You can reach him at (612) 349-9782.
COPYRIGHT 1997 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1997, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:includes related article
Author:Sanderson, Scott
Publication:Financial Executive
Date:Jul 1, 1997
Words:1864
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