The Value of Risk Transfer

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Roxanne Fields
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1 White Paper The Value of Risk Transfer By Richard Michel, Risk Management THE USI NE ADVANTAGE

2 Can buying an insurance policy add economic value to your business, even if it never pays a claim? Yes, if you follow the right strategy. We have conducted research with a select group of key executives and risk managers at companies within the Russell 2500 Index to learn more about their risk management practices and perspectives. We found that 83% of study participants generally believe that their company s risk and insurance programs fit extremely well or generally well with business priorities and objectives. While 69% of participants said that their company s insurance portfolio has a positive impact on financial performance, it was concerning that 31% of participants feel that there is no impact or negative impact. Risk and insurance program fit with business priorities and objectives 67% Impact of insurance portfolio on financial performance 47% 16% 2 16% 2 Marginally well Extremely well Generally well Somewhat positive None Very positive Negative There has long been a perception that insurance is a necessary expense to avoid a catastrophic impact to a business, but there is no financial upside to its purchase, i.e. there is no financial gain possible. Companies with adverse loss experience and loss ratios over 100% may consider insurance to have a positive return on investment, but this isn t sustainable and misses the real value risk transfer can bring to an organization. Opportunity and risk are positive and negative value judgments applied to the uncertain outcomes of specific goals and objectives of value to an organization. Without opportunity, there is no risk and vice versa. They are two sides of the same coin. Taking risk is an essential need of every organization seeking to profit or achieve some objective of value. Companies have finite financial capacity to take risk. For every company, there is an amount of financial loss that would cause them to become insolvent. Entrepreneurial startup companies may use their full risk bearing capacity and more, but mature companies generally operate within much more conservative parameters (see our white paper, The role of risk bearing capacity and risk appetite in value creation, for additional information). An organization s financial capacity to take risk, or risk bearing capacity (RBC), must first be reserved to support strategic and other uninsurable risks for which no risk transfer solutions exist. The remaining, or surplus, RBC can then be used to support the risks associated with other opportunities that have the highest potential return to the organization. Surplus RBC has an opportunity cost to the organization in that the assets used to support RBC cannot be consumed by the business to buy plant, equipment, raw materials, etc. Surplus RBC must be available when needed to respond to an unexpected event. The decision to use RBC to retain risk should take into account the organization s ability to recover the associated opportunity cost. 7% USI Insurance Services white paper: The Value of Risk Transfer Page 2

3 Determining the Economic Value of Risk Transfer This can be evaluated by adapting the Economic Value Added (EVA ) 1 formula to the decision to retain versus transfer risk. In the adjusted formula, a risk adjusted capital charge is included in the cost of retaining risk and net operating profit is replaced by the difference between the cost of risk retention and risk transfer after taxes. Standard EVA Formula Net operating profit after tax - Risk adjusted capital charge Economic Value Added The Role of Risk Advisors It is critical that risk advisors ensure their clients have both the data and effective methods with which to weigh the risk/ reward tradeoffs necessary to measure the value risk transfer creates. While the vast majority of study respondents judge the level of information provided by external advisors to be generally sufficient with respect to making insurance-based purchase decisions (73%) and risk-adjusted business decisions (7), there is room for improvement. A significant group (21%) felt that the level of information provided by advisors is marginally or not at all sufficient in making business decisions and 1 feel this about the advice they receive when buying insurance. Adjusted EVA Formula Cost of risk retention after tax* - Cost of risk transfer after tax Economic Value Added *including risk adjusted capital charge External advisor information for risk and insurancebased purchase decisions Extremely sufficient 1 Generally sufficient 73% If transferring risk is less expensive than retaining the risk, such risks can be transferred in order to preserve RBC for other high value opportunities. In addition, such risk transfer adds economic value to the business directly per the equation above. In this context, the purchase of insurance does contribute to financial performance both by preserving RBC for higher return opportunities that the organization could not take advantage of otherwise and transferring risk at a cost lower than the organization s intrinsic cost to retain it. Otherwise, it would be more cost effective to retain the risk if there is sufficient surplus RBC available. We call this strategic method of evaluation Intrinsic Risk Valuation. In this way, risk transfer, or the purchase of insurance, creates economic value in the business even when it is not called upon to pay actual losses. Marginally sufficient Not at all/not very sufficient External advisor information on risk-adjusted business decisions Extremely sufficient 6% Generally sufficient Marginally sufficient 10% 17% 7 Not at all/not very sufficient 1 Economic Value Added (EVA ) is a registered trademark of Stern Stewart & Company. Details on the Stern Stewart & Company EVA can be found in J. M. Stern, G. B. Stewart, and D. A. Chew, The EVA Financial Management System, Journal of Applied Corporate Finance (Summer 1999). USI Insurance Services white paper: The Value of Risk Transfer Page 3

4 Risk and insurance advisors have a great opportunity to improve their performance in this area. This was supported when we asked what insurance purchasing process respondents would most like to see improved. The top two responses were: use of data and related analysis to support purchasing decision framework and understanding of the company and persuasive use of data by external providers in developing a marketing approach. There is clearly a desire to see better use of data and analytics to support both the marketing of risks and the decision making process in respect to risk transfer. There are many things external advisors can do to improve the quality of their advice, such as: Collecting better, more actionable data in the risk identification and assessment process Bring this data into the marketing process to provide the underwriting community with a better understanding of the client s risks, the actions being taken to control those risks, and expected results Help clients develop a framework to evaluate their financial capacity to take risk and weigh risk/reward trade-offs Leverage data for enhanced decision making Use data to measure the impact of a client s risk management programs on broader performance goals, and demonstrate the contribution and relevance of risk management to senior leaders and other stakeholders The Availability of and Value of Insurance A disturbing research finding is that the vast majority of study participants (77%) do not think their companies need insurance for their top uninsured business risks identified. Business Risks Not Covered by Insurance Regulatory change/ scrutiny 9% Cyber threats 6% Privacy and information security Damage to reputation Supply chain Political risk Organic growth Commodity price risk I don t think my company needs insurance for any of these risks 7 This is a concern because there often are risk transfer solutions available, on an affordable basis, for many of these risks. There are a wide range of insurance products that can address cyber threats, privacy and information security, damage to reputation, supply chain, and political risk. There is a very sophisticated, robust futures market to address commodity risks. Yet, the belief that most companies don t need these products suggests that their availability or value has not been adequately demonstrated. This is further supported by the finding that 36% of respondents either believe that insurance is generally not available or do not know whether insurance is available to address their companies most significant risks. This is a serious communication failure on the part of the insurance industry in general. USI Insurance Services white paper: The Value of Risk Transfer Page 4

5 Insurance Availability for Company s Most Significant Risks 26% 28% Insurance is available to address our most meaningful risks and generally can be purchased for a reasonable cost such that insurance is highly valuable to our organization Insurance is generally available to address our most meaningful risks though the associated costs sometimes make the value to our organization questionable 10% Insurance is available for our most meaningful organizational risks in concept but the actual limitations associated with such insurance and its costs make purchasing such insurance a poor value for our organization 3 Insurance is generally not available to address our most meaningful organizational risks Summary The long-held perception that the cost of insurance or risk transfer is a necessary expense to avoid catastrophic loss, but does nothing to add economic value to the organization is incorrect. An organization s financial capacity to take risk is finite and must be preserved to enable the organization to take the risks with the greatest possible potential reward within that finite capacity. Using Intrinsic Risk Valuation to evaluate the decision to transfer versus retain risk can help preserve RBC and directly add economic value to the organization even if a loss is never experienced. Risk advisors must do a better job of helping their clients collect the data and apply the methods of analysis necessary to make effective risk management decisions when considering risk transfer. Don t know whether insurance is available to address our most significant organizational risks By and large, organizations that are aware of the existence of these products seem to believe they represent a fair value. If some of those products are overpriced, market competition will eventually lead to more attractive price levels. Risk advisors must do a much better job of making the existence of the full range of risk solutions known and helping companies evaluate the associated cost/benefit or risk/ reward versus the cost of self-insurance. This will provide the market with the right signals to get pricing on track with demand and value. How Can We Help? For more information, please contact your USI Consultant, or Richard Michel richard.michel@usi.com This material is for informational purposes and is not intended to be exhaustive nor should any discussions or opinions be construed as legal advice. Contact your broker for insurance advice, tax professional for tax advice, or legal counsel for legal advice regarding your particular situation. USI does not accept any responsibility for the content of the information provided or for consequences of any actions taken on the basis of the information provided USI Insurance Services. All rights reserved.

Putting a value on your company s financial capacity to take risk

Putting a value on your company s financial capacity to take risk Session: SRM009 Price Tag This! Day/Date: Tuesday, April 12, 2016 Speakers: Graeme Harper, Senior Vice President - Global Insurance, FIS