Risk managers have significantly lower risk tolerance than their CEOs and CFOs. In fact, they are the most risk-averse professionals within organizations, according to an IBM study on risk tolerance. To understand this wide gap in risk tolerance, one has to consider the incentives that each party has.
Minimizing risk and maximizing bottom loss results are goals common to all professionals in the organization, but these goals require a tradeoff when it comes to insurance purchasing decisions, as insurance can be costly. There are clear benefits for nearly all organizations to assume some level of property and casualty risk as lower insurance costs will more than offset the increase in expected retained losses.
Consider three reasons why risk managers may not act to bring about these benefits.
First, the risk manager’s role in some companies may be more tactical than strategic: ensuring that policy wordings are appropriate, certificates are readily available, and that the catalog of enterprise risks is exhaustive. A second driver is that brokers and insurers are in the business of selling risk protection�there is often a disincentive for a broker to recommend that an organization not purchase a certain policy or an insurer to offer competitive pricing on a higher deductible. Even risk consultants who are compensated irrespective of risk transfer purchase may have a motive to overstate the need to address certain risks.
Probably the most significant reason is the career and reputational concern of the risk manager who chooses to retain more and transfer less risk. A marginally lower insurance spend might not be recognized by a CFO or might be mistakenly attributed to movements in the market price of insurance rather than a savvy risk management decision. But a risk manager is more likely to be held accountable for a high-profile property loss that goes uninsured. The resulting paradox is that there is a net benefit for the organization to retain the risk but not for the risk manager to make the decision to retain the risk.
One way to address this paradox is by measuring an organization’s Total Cost Of Risk (TCOR). The TCOR is a way for buyers of insurance to think about how much they should devote annually to insurable risks. To calculate the TCOR, we add:
- a) the annual insurance premium
- b) an estimate of the amount of retained claims
- c) the costs of managing claims (e.g. third party administrator or TPA expenses).
The TCOR statistic is helpful in calculating the cost and benefits of risk management decisions. For example, if an organization were to select a higher deductible policy, it is likely that the premium would decrease, and be only partially offset by an increase in expected retained claims. By making decisions that decrease the TCOR, a risk manager can provide transparency to senior management about their success in reducing total insurance spend.
But this won’t tell the whole story. Because insurers usually charge a higher premium than the expected claims that they assume, the TCOR statistic will decrease in response to any reduction in premium spend. It quickly becomes clear when evaluating alternative insurance programs that an organization can minimize its TCOR by simply not buying any insurance at all. Our common understanding of property and casualty risk management is that there is little value in this strategy of total self-insurance, so perhaps the TCOR metric needs to be rethought.
Consider an organization with volatile annual results. In Table A the net assets increase in most years and decreases in some years. This organization would be prudent to hold additional assets as a buffer to ensure that one bad year or one large insurance claim does not wipe out the organization.
But for the organization to hold these assets, it would first have to convince and reward investors to use their capital. This estimate of the additional cost of capital required to act as a buffer against the uncertainty of retained claims can be considered as an important element of the Total Cost of Risk.
As an alternative, the organization might have purchased insurance that would smooth its annual results, making it unnecessary to hold as much additional capital. This would have increased its premium, but be offset by a reduction in both retained claims and the cost of capital. This modified definition of TCOR addresses the concern about retaining too much risk. Organizations with significant self-insurance will also have higher costs of capital, and so TCOR will not always reward higher-retentions and more self-insurance.
The TCOR can be difficult to calculate, as it requires an actuarial estimate of the expected retained losses, as well as an understanding of how much additional capital is required to protect against severe losses. The estimate of expected retained losses is often provided by a broker or an actuary hired by the organization, but for risk managers without access to these services, it can be estimated based on historical claims amounts adjusted for changes in exposure, incurred but not reported (IBNR), and uplift factors to account for increases in the average cost and frequency of claims.
Organizations that fund property and casualty risks through a captive insurance company will usually have a broker or actuary perform an annual funding calculation along with an appropriate capitalization level to ensure that it will remain solvent for the foreseeable future. Companies without captives can perform a similar exercise to assist in calculating the total cost of risk. But there is no industry standard for determining the amount of capital to be held within a captive or at an organization to manage retained claims. It requires an understanding of not only the organization’s claims volatility, but also the risk tolerance of the organization.
It can be difficult to clearly define an organization’s tolerance for property and casualty risks. One starting point is to categorize whether a claim, if it were self-insured, would have a material impact on the organization’s annual results. If it would, the claim can be further categorized as to whether it would impact the organization’s future profits. For example, if a claim were so large that the company’s borrowing costs would increase in the future, we can say that it would have a material impact in the current period as well as in the future. These are franchise risks.
One way of determining the amount of additional capital required is to consider how much capital would need to be held to ensure that all foreseeable “franchise risks” would be reduced to “material risks.”
Defining Performance Measures
Risk managers and their organizations will benefit from aligning their tolerance of risk with those of senior managers of the organization. This alignment can be demonstrated and verified through calculating the Total Cost of Risk, including a consideration for the cost of capital. By including an actuary in the process, the statistic can be given more credibility within the organization and can be tracked over time against internal and external benchmarks.
Colin Mitchell is a principal in Integro Insurance Broker’s Toronto office. For over 20 years, he has provided brokerage and advisory services to clients with complex risks, with a focus on captive insurance options.
Patrick Gallagher is a managing principal and chief actuary of Integro Insurance Brokers. He has served the insurance industry as an actuary, broker, banker, and consultant for over 15 years.