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Using cost-of-risk to measure performance.

For senior managers, fairly measuring risk management performance is a never-ending battle. Given the multimillion-dollar risk management budgets of most large corporations, the lack of accurate and equitable performance techniques can be a top management concern. In any performance measurement system, the available tools are qualitative and quantitative, and balancing them becomes a challenge. While there are many qualitative factors that can be used in measuring risk management performance, such as communication to management, implementation of risk control programs and improvements in professional education, fewer quantitative tools exist.

Currently, quantitative measures tend to focus on control of insurance premiums or direct loss costs. Typical quantitative measures include measurement of insurance costs against budget, average claim size and average age of outstanding claims. Unfortunately, these traditional measures focus only on a part of the organization's total risk cost; they do not take into account the interdependent cost relationships of risk assessment, risk control, risk financing and administration. This lack of a clear and comprehensive quantitative measure of risk management performance can result in short-term risk management "heroes" when insurance premiums drop or when an organization has a lucky year in losses. Conversely, these heroes can become scapegoats when short-term premiums or losses rise regardless of whether risk management is effective in the long-term. There is, however, one quantitative tool, cost-of-risk (COR), that provides a clear and comprehensive indication of long-term risk management performance.

Cost-of-Risk Basics

COR is a concept created to measure the total costs of the risk management function, including losses, risk financing costs, risk control expenditures and administration costs, against a broad indication of an organization's exposures represented by sales, assets, number of employees or other exposure bases. COR was introduced by Douglas Barlow of Canada's Massey Ferguson in 1962. COR surveys have been published under the auspices of the Risk and Insurance Management Society (RIMS) and Tillinghast. Since the last RIMS-Tillinghast survey in 1985, a number of companies and/or industry groups have sponsored their own industry-focused COR surveys in an attempt to maintain access to this valuable cost comparison information. Yet, despite this attention, the concept has not received the full attention it deserves.

The COR concept recognizes that the activities and costs of managing risk includes more than just insurance premiums; it includes the management and responsibility for costs contained in retained losses, risk control expenditures, administration and insurance or risk financing. Normalizing these costs to sales, assets, units sold or man-hours enables management to determine whether total risk management costs are increasing, decreasing or stable compared to a broad measure of the company's exposures or economic activity. This translates the various risk management costs into a measureable factor of production--the risk cost of an organization.

A company's COR can be compared to others within a peer group or industry group to determine if its risk cost "factor of production" is similar to companies with similar exposures and operations. Just as financial officers can generally measure their own cost of funds against others in their peer group, knowledge of peer group risk management costs can be invaluable in measuring risk management performance.

In addition to performance measurement, COR also can be a management and diagnostic tool. Examination of the elements of COR can identify the areas that will have the greatest long-term effect on an organization's total risk management cost. For example, suppose COR as a part of revenue climbs 30 percent over a period of three years. It may be that the culprit behind the increase is not "out-of-control insurance costs," usually the first thought of senior management, but increasing product liability losses. COR forces management to ask such questions as: Why are product losses increasing? Is it a design problem that has not been anticipated or manufacturing defects? Are inadequate quality control procedures driving up losses? What quality improvements should we make, and what will be the cost to correct the problem? By forcing these types of questions, COR shows its worth to all levels of management not only as a measurement tool but also as a diagnostic tool.

Measuring Performance

Sales performance can be measured against the number of units sold, marketing by name recognition, production by defects per 1,000 manufactured, etc., but the measurement of success or failure in risk management is not so clear. How then does one measure the performance of risk management? Through insurance premiums, losses or risk control success? No. Often the risk manager has little control over insurance premiums, which to a large extent are determined by the underwriter's perception of anticipated losses and the vagaries of the insurance cycle. Likewise, losses are only part of the total cost and may be fortuitous and completely out of the risk manager's control to prevent or reduce. Success in risk control efforts is difficult to measure due to the long-term and "soft cost" savings of these activities.

COR includes the cost of each of these essential risk management activities in its measurement. By combining all the elements and comparing them over time to the company's economic activity, the inadequacies of each measurement tool disappears and the direction of total risk management costs is measured. COR recognizes that individual risk management activities influence the cost of other factors. For example, success in preventing employee accidents through a risk control program directly results in an organization's lower workers' compensation insurance costs.

COR Communicates

Often, the greatest challenge to a risk manager is communicating the importance of risk management to top management. The COR concept sidesteps top management's usual impression that risk management is only an insurance buying activity and places it on an equal footing as a function managing a factor of production. Implementing COR as a management tool creates an opportunity to relate risk management costs to the organization's purpose, not the insurance cycle.

For example, in manufacturing industries, raw material costs (a factor of production) increase as sales rise; characteristically, risk management costs also rise because the activity of the organization has increased. Insurance costs rise, losses increase, risk control investments climb and risk management administration requirements increase over the long-term as the economic activity of the organization increases. just as in managing production costs, the important factor in risk management is to keep costs from rising in greater magnitude than the increase in unit production or sales. When a major acquisition takes place or a new production facility starts up and risk management costs increase significantly, relating costs to an indication of economic activity such as total assets, expected sales or units of production can be tremendously valuable to the risk manager's image and senior management's understanding of risk management cost implications. Placing risk management costs on an equal footing with other factors of production is a communication concept top management can understand.

COR for the Long Term

Although COR is an effective management tool, it is not an effective short-term measurement technique. True changes in COR occur over the long term primarily because insurance premiums rise and fall year to year due to the insurance cycle. In addition, it takes time for risk control efforts to show appreciable reduction in losses. By measuring risk management costs over an extended period, the short-term peaks and valleys in individual costs are smoothed out and the long-term risk management efforts, such as loss control improvements, can be recognized. Therefore, any goals for the risk management function to control or reduce COR should be set up with a time frame of at least three to five years.

As with other quantitative measurement techniques, the key to implementation is an efficient information system and effective data collection. In each organization, the cost elements for each category of COR will be defined differently, depending on the risk management program and availability of information. Once the specific elements are defined, consistency on collecting data in future years is the key to a reasonably accurate COR measurement.

Each person responsible for a category of COR data should understand how to collect them and how they relate to the whole COR measurement concept. The best repository of COR information is usually the head of each risk management department. In some organizations, this may be the risk manager, but in others it may include the head of the safety department, or the environmental compliance area. Each year, the senior manager responsible for risk management should collect this information and calculate COR.

Often, the activities of the risk management function, including risk assessment, control and financing, are the responsibility of multiple departments. Security may be responsible for fire safety or preventing crime losses. Human resources may be responsible for preventing employee accidents. The risk management department may only be responsible for insurance. Even though the function may be divided into different areas, it is the coordinated efforts of the different activities working together to fulfill the function of risk management that will have the greatest effect on reducing long-term risk management costs. Managing a company's COR in these organizations is a joint responsibility. By making it a long-term joint objective among the related functional areas, the risk management function can be more effective in controlling overall costs.

Risk management can also be decentralized corporately," through semiautonomous subsidiaries. Where risk management responsibility (and retention of costs) has been "pushed down" to the operating level, COR can be used as a monitoring tool by the parent company. Each subsidiary can prepare its own COR, then transmit the data to "corporate", for preparation of an overall corporate COR. This multiple COR approach may be extremely valuable when a subsidiary operation is distincly different from other subsidiaries in the company.

Barriers to COR

COR is a valuable tool, but there are implementation roadblocks that have stalled its use in many organizations. These barriers generally fall into two areas--people and information.

Examples of people barriers include:

* Risk managers often are unwilling to support COR because they believe too much emphasis will be placed on its quantitative aspects without taking into account other influential factors outside their control.

* Some risk managers resist taking the time to correct the information necessary to perform an adequate COR review, often due to inadequate staffing.

* Senior management may not understand the value of the COR concept as a communication tool.

* "Turf battles" may result if responsibility for components of COR is located outside the risk management domain. However, this barrier can also be an incentive to get different departments to work together. With COR, they will share a common performance measurement, forcing different areas to cooperate on risk management programs that will have the greatest overall effect on COR.

Examples of information barriers include:

* The information for a COR review can be difficult to obtain initially. However, the COR is much easier to measure as the information is updated.

* The information may not be readily identifiable because costs of sprinklers or other property protection measures may not be recorded.

* There may be difficulty in defining the information to go into COR. For example, should a manager include the fun cost of a new risk control investment such as sprinklers or a cost amortized over the life of the improvement? In cost definition, the guiding principle should be consistency over time.

* Comparing COR to peer group companies requires competitors to share information, which may cause concern over antitrust problems or release of competitive information. However, due to the type of information being shared, the risk is minimal. In addition, if a third party is used to collect the peer group information, only the COR results need to be provided to participants, thus negating concern over release of confidential information to competitors.

* Peer group companies have to provide full disclosure of information, which may be difficult for companies that do not currently maintain records of major COR items.

* The information provided by the peer group participants must be put on an "apples-to-apples" basis. Each company has different risk financing programs with different limits, deductibles and coverages. Defining the annual costs to make comparisons requires considerable expertise.

Compilation of peer group information also requires considerable time, patience and expertise, most of which can be provided by a third party. The use of a third party protects confidentiality, eases the work load of the risk managers and provides the expertise to put the information into a comparable format.

Peer Group Information

In the past, the RIMS-Tillinghast Cost-ofRisk Survey was the most commonly used method of obtaining comparative COR information. Last produced in 1985, the survey was a joint venture between RIMS and Tillinghast from 1979 to 1985. In 1986, a COR survey was distributed to the 3,600 RIMS members, yet fewer than 500 returned the completed form. Due to the low response rate and substantial costs involved in reviewing and analyzing the data, RIMS and Tillinghast decided not to tabulate the results and discontinue the annual survey. Both RIMS and Tillinghast are considering reviving the COR survey in a modified, simplified form for 1990.

Since the last survey was published, some companies and industry groups have chosen to sponsor their own peer group COR survey, either using industry contacts or consultants to provide the legwork in gathering data. Such industry specific surveys have included beverage manufacturers, mining companies, financial institutions and hospitals.

COR is a useful measurement tool, but it is not the panacea to performance measurement of risk management. In addition to COR, there are other factors that should be used to supplement performance measurement, including average cost of claims settled, average time to settle claims, achievements on specific projects such as due diligence in acquisitions/divestitures, advances in risk assessment, success in risk control efforts, involvement in and knowledge of other areas and activities of the organization and communication with top management.
COPYRIGHT 1990 Risk Management Society Publishing, Inc.
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Title Annotation:risk management
Author:Duncan, Christopher A.
Publication:Risk Management
Date:Feb 1, 1990
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