A key business premise is that companies take risks to take advantage of opportunities (reward). In the case of risk retention, insurance premium savings are the reward. But how can one be sure that this reward justifies the increased risk?
Most risk managers agree that small, inconsequential risks should be retained, and large ones should be transferred. The difficulty is how to determine what is small and what is large. In other words, how much risk is too much? What is the organisation's risk-bearing capacity?
Within this risk-bearing capacity, how can the risk retention programme be structured to achieve the most attractive balance of risk and reward?
More specifically, how can you select the appropriate retentions for each of the risk classes, so that the total cost of risk is minimised and the volatility stays within acceptable bounds? Should these retentions be paid out of operating cash flows, or be funded via a specialised risk-financing vehicle, such as a captive insurance subsidiary or a finite (re)insurance programme?
Economics of risk retention
Never has risk management had a higher profile. Sarbanes-Oxley, COSO, the combined code and other corporate governance regulations have forced companies to adopt more rigorous risk management processes and procedures.
Under the new enterprise-risk paradigm, organisations are trying to determine how various financial, hazard, liability and even core business risks contribute to the total portfolio of risk-related costs. Optimising this risk portfolio is a key concern.
Businesses rely on financial planning and cash budgeting to project their future retained risk costs. Barring catastrophic events, these projections tend to be accurate, making it possible to pay most of the losses out of the operating cash flows.
However, the retained losses may significantly exceed the cash budget, forcing the business either to use up or sell off some of its assets, raise new debt, divert funds from other planned expenditures, get a capital injection from shareholders or even declare bankruptcy. These measures may well lead to market value erosion, financial distress, and severe opportunity costs.
Market value erosion
A large loss, and management's failure to decisively respond to it may be interpreted by the markets as a recurring problem, thus eroding the share price(1). However, if a risk is seen as remote and unlikely to happen, in theory the shareholders should encourage retaining it. In fact, the shareholders already carry most of the risk, but have it diversified within a broad investment portfolio. From their point of view, transferring the risk to a third party would only lead to unnecessary frictional costs.
Arguably, not all of the transferable risks can be diversified. However, investors are carrying these risks anyway via insurance companies' stocks.
Therefore, as long as the risks, and the losses they cause, are outside the management's control, risk retention creates shareholder value. In other words, the shareholders' formula for risk retention should be: Implement the best risk management practices, and then retain all risk. However, retaining all risk may be unacceptable to other stakeholders - creditors in particular - especially if it seems to escalate the likelihood of financial distress.
Financial distress
Impaired competitiveness, severe credit downgrading, increased cost of capital, fire sale of assets, and downsizing are just a few items from the long list of financial distress symptoms. A firm in risk of financial distress is particularly sensitive to retained losses. Even a relatively small loss may exacerbate its financial troubles. A large retained loss may bring even a financially strong organisation to the brink of financial distress.
The risk of financial distress is greater, the more leveraged the company is. Debt and other obligations may leave little room for cash-flow volatility.
To deal with the volatility, businesses can either rely on their credit facilities to provide financing in the event of a loss, carry large amounts of cash, or transfer some risks and thus mitigate the volatility.
In some circumstances, risk transfer may be the most attractive of these alternatives. Indeed, a large loss or a financial downturn may prompt the creditors to withdraw attractive financing terms. At the same time, carrying too much cash as a volatility buffer may signal poor capital utilisation. Only risk transfer offers a reliable, normally tax-deductible, means of offsetting large losses.
These observations suggest that the value of risk transfer is greater for volatile, highly leveraged, and financially weak organisations. Therefore, to determine what risk retention positions a company could bear, one should evaluate the volatility of its cash flows, analyse the constraints of its capital structure, and assess the impact of losses on its credit terms.
Retained risks are said to stay within the company's risk-bearing capacity, if a probabilistic analysis indicates that they do not materially aggravate the threat of financial distress.
Opportunity cost
Many firms possess risk-bearing capacity far exceeding their actual risk retention. Why do they not just increase the retention, and save on risk transfer (premium and hedging) costs?
Even before a loss is incurred, the awareness of high risk exposure may make decision makers adopt a more timid business strategy - the phenomenon known as 'underinvestment'. The reverse may also be true: knowing that a large portion of non-core risks is transferred, senior management may be encouraged to adopt a more aggressive strategy.
A company experiencing large losses and forced to abandon some of its planned investments incurs an opportunity cost. Similarly, a firm raising new debt to offset a large loss has to divert funds from profit-generating opportunities in order to absorb increased debt-servicing costs.
Businesses that embark on aggressive and capital-intensive strategies are particularly sensitive to risk-related opportunity costs, and may benefit the most from risk transfer. By analysing and quantifying scenarios leading to excessive opportunity costs, one can explicitly measure the risk against the cost of risk transfer.
Programme (in)efficiency
There is another opportunity often foregone by risk managers. By failing to optimise their risk retention programmes, firms lose an opportunity to cut their cost of risk by 3% to 15% (2). For large organisations, the cost of risk may run to tens and even hundreds of millions per year, putting a hefty price tag on the cost of programme inefficiency.
In practice, there are multiple examples of such inefficiencies. To name just a few:
- buying limits of cover far exceeding maximum probable loss
- transferring small inconsequential risks while taking multi-million retentions on other risk classes
- retaining risk in excess of the firm's risk-bearing capacity.
To maximise programme efficiency, one has to treat all risk-related costs, from all risk classes, as a single portfolio. It often happens within a risk portfolio that by buying more insurance coverage on some of the risk classes and less on the others, the cost of risk is reduced without increasing the volatility of retained losses. For that to happen, one has to analyse a very large number of programme alternatives.
Consider, for example, a risk portfolio consisting of multiple risks insured in excess of deductibles and up to the limits of cover (obviously, losses exceeding the limits are retained). Changing the programme would trigger a change in the cost of retained losses and in the cost of risk transfer. For instance, raising the deductible on one of the risk classes would increase the retained risk, but would also lower the insurance premium.
For example, if we were to consider five risk classes, each one with five alternative deductible levels, then we would have to stochastically quantify and compare 55 = 3,125 programme structures. If additionally we were to consider five different limits of cover for each risk class, then the number of programme alternatives would grow to 510 = 9,765,625.
Real-life programme optimisation involves comparing millions of programme alternatives.
To demonstrate this process, we can map all possible programme structures as dots on a chart with the retained-risk volatility, for example measured by the standard deviation of the aggregate retained loss, plotted along the X-axis, and the expected cost of risk, consisting mainly of the premiums and expected losses, plotted along the Y-axis (see Figure 1). Then the plotted dots' lower boundary, often called the efficiency frontier, would represent the most cost-efficient programmes at any given level of volatility (red line on the chart).
In this example, the current programme structure is represented by a green dot. Relative to it, any point below and to the left would be an improvement, offering both a lower expected cost of risk and reduced volatility.
Moving along the efficiency frontier to the right of the current programme would create additional cost-of-risk savings, but ones which are attended by increased volatility, and should be exercised only if the risk does not exceed the organisation's risk-bearing capacity.
The following steps should be taken to optimise risk retention:
- QUANTIFICATION OF RETAINED RISK
- Derive statistical probability distributions for each retained risk from the company's own data and from external databases
- Combine all retained risks into one probability distribution.
- RISK-TRANSFER PRICING ANALYSIS
- Evaluate risk-transfer costs relative to retention levels (deductibles, limits of cover, etc) based on actual market quotes and expert opinion
- Mathematically model the cost of risk transfer as a function of retention levels.
- RISK/REWARD ANALYSIS
Model the total cost of risk as a function of retention levels. Select and run an optimisation algorithm to minimise the cost of risk relative to the retained-risk volatility (for example minimising the expected cost of risk relative to the standard deviation of the aggregate retained loss)
- For the identified cost-efficient programme structures (underlying the efficiency frontier), verify that they stay within the firm's risk-bearing capacity.
Alternative risk transfer
With the advent of alternative risk transfer (ART), the dividing line between risk retention and risk transfer started to blur. In fact, various ART arrangements, such as captive insurance subsidiaries, risk pooling, finite risk programmes etc, can be viewed as risk retention vehicles with some elements of risk transfer.
Few companies see ART as a way to enhance tax benefits. Instead, it is being used to manage higher retentions, cut (re)insurance premiums, and spread the risk across multiple periods, or between the firm's divisions or pool participants.
For practical purposes, there is always a gap between the size of the losses a firm knows it does not want to bear and losses it can easily absorb. This grey area can be identified by a risk-bearing capacity analysis as described. It is this area that best lends itself to ART solutions.
Risk retention principles
Large organisations will continue to maintain sizeable retention positions, regardless of risk-transfer market cycles. To add economic value, risk retention should be based on the following principles.
- ENTERPRISE RISK MANAGEMENT
Risk should be managed as one large enterprise risk portfolio. Focusing on the core business risks, enterprise risk officers must create a uniform value-creation framework to manage the organisation's financial, hazard and liability risks.
- VALUE CREATION
The economics of risk retention are based on three main tenets: (a) coupled with risk prevention and control, it helps create shareholder value; (b) it should not escalate the risk of financial distress, and (c) it should not lead to excessive opportunity costs.
References: 1) See for example, 'Risk Financing Strategies - the Impact on Shareholder Value', by Deborah J Pretty, (Risk & Insurance Research Group 1999) 2) Based on IRMG retention optimisation projects
Ken MacDonald is chief operations officer, Aon Captive Services Group - Europe/Asia and managing director, IRMG, Tel: 01932 837 400, E-mail: ken.macdonald @irmg.com, and Vladimir Uhmylenko is head of analytical services, IRMG, Tel: +1 201 225 3633, E-mail: vladimir.uhmylenko@irmg.com
RETAINING MORE RISK
In a recent Aon survey, over 70% of companies responded that they would continue to retain more risk - even under more favourable risk transfer pricing. Another poll was conducted in October 2003 at Aon Captive Services Group's annual conference attended by over 100 Fortune-1000-sized companies; 74% of these representatives felt that increased risk retention was truly a long-term strategy and unlikely to be reversed.
