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The financial impact of risk costs.

THE ASSUMPTION OF RISK IS A BASIC tenet of risk management, whether directly through self-insurance or a captive, or indirectly in the form of a loss sensitive insurance program that uses a formula for final premium based on loss experience. In either case, an organization must make provisions for the reporting of costs to avoid unpleasant surprises in financial results as well as to satisfy financial auditors.

Risk managers have traditionally left accounting issues to the financial people in their organization, who do not always have a complete understanding of risk financing program designs or their intended objectives. When risk management and accounting professionals do not fully understand each other's goals, problems can result and compound from year to year through accounting recognition of costs that are inconsistent with the risk manager's goals. The financial executive may fear that the risk manager will fail to create a "least cost" program design due to underappreciation of the effects of income tax, earnings per share, or cost of capital.

Consequently, risk managers must gain a better understanding of this financial issue, which in turn will allow their organizations to recognize the true cost of risk when losses are being assumed (either directly or indirectly) and therefore to make decisions that will result in the lowest possible cost.

ONE SIGNIFICANT misunderstanding that commonly occurs between risk managers and the accounting department is the always present but little known difference between the totals on loss runs at a fixed point in time and the ultimate cost of claims when completely paid. Claims adjusters have an obligation to set reserves on each claim based on their individual experience and professional judgment. In an ideal world, the sum of all outstanding unpaid claims would equal all future obligations: unfortunately, this is not always the case.

Loss estimates set by an adjuster are referred to as case reserves. Actuaries know from history and personal experience that the ultimate cost of claims will almost always exceed the sum of outstanding reserves because case reserves tend to increase, and unreported incidents develop into additional claims. Case reserves as a whole may be understated due to negative litigation results, economic and social inflation, or any number of unanucipated events that affect ultimate claim cost. Claims are more frequently underreserved than overreserved because, as time passes, new facts about a claim emerge, leading adjusters to fix reserve amounts accordingly. Late reported incidents that turn into claims also increase the amount of loss. The typical result is a creeping increase in total claim amounts long after the exposure period has passed. The total amount that all claims will finally cost when completely closed is the ultimate claim cost.

Claims differ in terms of experience deterioration due to changes in reserves and claim reporting lag. For example, products liability and medical professional loss experience deteriorate significantly over time, while property reserves are relatively static. Risk managers should recognize these differences to ensure that financial reporting is done correctly.


FINANCIAL ACCOUNTING Standards Board (FASB) provides rules that auditors must follow in determining whether an organization has used proper accounting methods. Government Accounting Standards Board (GASB) provides a similar set of rules for governmental entities. FASB 5 are the rules regarding accounting for contingencies. Although they cover numerous types of contingencies, their essential intention is to require an organization to properly account in its financial statements for potential income and expenses that may have an impact on the company's financial condition.

There are two basic aspects to contingency accounting: a reserve account for those items that can be reasonably quantified and are likely to occur, and a footnote to the financial statements that reports a condition that may occur but is either uncertain in amount or is considered by the organization - and the auditor - as being reasonably unlikely to happen. Changes in loss reserves for a given exposure year are likely to arise and are reasonably quantifiable. They should be handled as a charge to income in the exposure year and included as a reserve on the balance sheet. When claims are insured in a program that is loss sensitive, such as in the case of an incurred loss retrospective plan, the same concerns and financial results apply. As annual retro adjustments are made, recognition of increasing claim costs occur in future years, resulting in costs paid in the future to past years. The results are actually compounded due to the variable costs normally included in the retro formula that adds to the claim cost as incurred losses grow. One last point is that FASB rules for financial reporting are not necessarily the same rules as for income tax deductions, especially regarding the deductibility of expenses (including losses) related to a risk financing program.

Income Statement

FINANCIAL MANAGEMENT must post expenses of a given year within that year. Knowing that a future cost increase is likely due to claims cost escalation, current year recognition of that future expense is an appropriate accounting practice and can be properly interpreted as necessary under FASB 5.

Let's consider a hypothetical workers' compensation incurred loss pattern as an example. If at 12 months from inception of an annual exposure period the losses reported are $1,054,53 2, we can reasonably estimate that, over their life, they will grow to $1,586,873, or an increase of over 50 percent. The reported claims will grow 17.8 percent to 24 months, 9.2 percent from 24 months to 36 months, and so on, with the reporting increases each year rising at a smaller percentage in relation to the ultimate value.

Continuing with that example, a simplified income statement might include sales of $100 million, cost of goods sold at $ 70 million and operating expenses of $20 million, resulting in net income of $10 million. These figures assume the company used the total incurred claim amount known at the end of the first year. Included in operating expenses are $1,054,532 in incurred losses, a figure derived from case reserves without recognizing ultimate claim value. If the ultimate value is recognized as the appropriate expense amount, the result would be an increase in the operating expenses by $532,341 and a decrease in the net income by a commensurate amount, or an income decrease of 5.3 percent.

While higher initial income may look better, ignoring actual loss costs and unintentionally forcing them into future years has a detrimental effect on future earnings that will compound as time goes on. In a publicly held company with material levels of self-assumed losses, this can ultimately have negative consequences such as credit losses and negative effects on market value and stock, depending on the amounts involved. Additionally, not recognizing the true loss costs in the proper year conflicts with a basic accounting principle of matching revenues and expenses; loss-related expenses should be matched with the sales that generated them.

Balance Sheet

FAILURE TO RECOGNIZE future claim cost deterioration also results in incorrect balance sheets. Using the same example as in the income statement above and assuming that only case reserves are recognized in the year incurred, a simplified balance sheet might show $110 million in assets and total liabilities of $80 million, resulting in a net worth of $30 million.

This balance sheet has included the overstated income, thus overstating net worth.

Although the total liabilities section would contain an amount for claims incurred but not yet paid, it would be an inadequate amount. If future claim development was properly recognized, the balance sheet would add the $532,341 to liabilities (partially current, but the majority long-term) and decrease net worth by the same amount.

The future obligation for increasing claim costs, as in the income statement, will continue to compound and decrease future net worth; this will result in an unintended erosion of the book value of the enterprise. Note that this is an example in which losses are high in relationship to the size of the company to highlight the impact of the financial statement. In a typical manufacturing business, losses would not normally constitute such a large percentage of sales.

Cost accounting and proper recognition of ultimate claim value is important in regulated industries to justify the cost of producing products or services, which provide the basis for prices they can charge. Take, for example, a regulated public utility. Normally, a public body sets the rates that a utility can charge customers based on the cost of providing services plus a reasonable rate of return on invested capital.

If this business does not recognize the ultimate cost of losses, then loss costs in excess of initial reserved amounts will not be included in their rate base and may not be recovered, depending on the formula and practices of the regulators involved. Recovering past accounting errors in future rates may be difficult, which could result in a loss to stockholders. Even when public approval of rates is not a factor, organizations must know their operating costs to effectively price their products. Therefore, basic cost accounting practices demonstrate the importance of recognizing the future loss costs in the year claims generating these costs occur.

Cash Flow Impact

UNLIKE INCOME STATEMENTS and balance sheets, cash flow statements provide information on how cash flows through a company at a fixed moment in time and, therefore, do not address accruals for future expenses that have not yet been paid. From a cash flow standpoint, the issue of case reserves versus ultimate loss costs is not relevant, and the use of either method in recognizing loss costs will not result in a change to the cash flow statement.

Even though the difference between case reserves and ultimate losses is not recognized in cash flow statements, there is still a need to plan for future cash flows. A cash flow assumption that would match the loss pattern noted previously would result in total claim payments of $317,692 during year one, $602,536 in the first two years, $886,274 the first three years and so on, until all claims were ultimately paid out at the ultimate value over many years.

Although these figures would not appear on the cash flow statement as such, financial management needs to know and understand the likely future cash flow scenario so they can plan the company's cash management strategy. While there may be significant fluctuations from year to year, a pattern will emerge over time that can be helpful in evaluating the cash planning needs of an organization; this will help minimize the need for borrowed funds and related interest expense.

Value Reserves

WHILE A CONSERVATIVE financial approach would follow that reserves should be set and expenses recognized based on ultimate loss expectancy, the methods previously described above (reserve for ultimate loss amounts, less paid claims), a more aggressive and arguably more accurate method of reserving would be to use the present value of expected ultimate loss payments. On a present value-basis, the reserves for future loss payments would be the present value of future cash flows, discounted to the organization's short-term borrowing costs (not internal rate of return).

In the previous balance sheet example, an additional $532,341 was identified as that portion of ultimate cost over and above 12-month case reserves. This was in addition to reserves of $736,840, which was the difference between incurred case reserves and paid claims at 12 months. Thus, when the present value of claims is not considered, a reserve of $1,269,181 is posted to reserves for claims not paid at the end of the first 12 months. When the time value of money is taken into consideration, a smaller amount can be accrued on a reasonably conservative basis and with a more accurate matching of revenues and expenses.

If future cash flow streams were present valued (using the claim payment timing as previously outlined) and assuming a discount rate of 8.5 percent, the amount of needed reserves would decrease by $ 289,3 3 5. However, in this calculation, the first 12 months are not present values because it is a current liability.

Twelve months after inception, on a present value-basis, the reserve would be $979,846, which is the total present value of the ultimate losses ($1,297,538), less the amount paid in the first year. The present value reserve is only slightly higher than the $736,840 amount calculated without recognition of the ultimate claim payout pattern. With higher discount rates, the reserve calculated on a present value-basis could actually be lower.

This example assumes the use of a selfinsured risk financing method. Insured approaches that are cost sensitive also need to be present valued to recognize all costs in the appropriate year. In insured arrangements, the antidpated payment pattern in a loss sensitive plan needs to be present valued, using the ultimate loss amount and taking into account when the premium payments will be made.

Accounting professionals may be concerned about how to book the difference between present value and actual payout amounts. The answer is to book it as an interest expense in each year. While this sounds like a mishmash of expenses and revenues, it permits cash from past years to accrue for the present year, thus eliminating the need for short-term borrowing.

The example provides an accurate picture of accounting needs at the end of an exposure year. But what happens over time? Can the reserve balance be ignored? The answer is no. Each year claims need to be reviewed and reserves reset to take into account two important considerations: actual claim payments and the improving accuracy of the reserves. Case reserves tend to become more accurate as time passes and the inherent divergence between case reserves and ultimate reserves lessens. An annual review should be performed by a qualified actuary to evaluate reserves so they will be both accurate and acceptable to the certified public accountants who perform the financial audit.

Risk managers need to have a basic understanding of financial issues so they can help their organizations develop accurate financial reports. Effective risk management must entail a financial function for the organization served. The harmonious combination of the two disciplines will result in a decrease in risk cost that will benefit an organization immensely.
COPYRIGHT 1992 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

Article Details
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Author:Sanderson, Scott
Publication:Risk Management
Date:Aug 1, 1992
Previous Article:Structured settlements in today's climate.
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