Corporate Risk Finance and the "Internal Economy" of a Company
June 2000
Despite the theoretical view that corporations
should retain more risk, the reality is that they try to avoid unexpected expenses
that result in significant loss of profit in a given accounting period. This
article examines the internal economies that affect this reality and how insurance
and risk transfer vehicles fit into the picture.
by Brent
Clark
Strategic Risk Solutions
As discussed in the first article of this series, corporations have become
increasingly comfortable with the notion of retaining risk that traditionally
would have been insured. The practical view is that insurers tend to recapture
the cost of losses over time plus expenses, so that insurance mainly provides
smoothing of loss costs over multiple time periods. The value of this smoothing
has to be compared to the frictional costs of using insurance over the long
term.
The classic academic view is that a corporation faces a variety of risks
and that this essentially constitutes a diversified portfolio of risk for the
company. If the company is large, its capital probably is sufficient to fund
the volatility of the combined risk portfolio. It is therefore inefficient to
spend money to transfer individual risks to outside parties (assuming a fair
market price would be paid for the risk transfer).
Moreover, when viewed from the shareholder perspective, the corporation should
not waste money on insurance because he should own stock in a portfolio of companies
rather than a single company. The idea is that if all of the companies in his
portfolio stopped buying insurance, the investor’s overall wealth would be increased
by the total premium savings, while occasionally one of the companies would
suffer an occasional uninsured loss. The key assumption is that the total savings
on premiums for all of the companies in the portfolio would exceed the total
uninsured losses.
However, there are at least some practical (if not also theoretical) problems
with this view, which brings us to a discussion of some of the issues companies
face when designing risk financing programs.
The “Internal Economy”
The idea that a large corporation such as General Motors or General Electric
can retain large amounts of risk because of the size of their balance sheets
is not too hard to understand. Yet there are a few “real world” issues that
seem to stop even the largest companies from doing away with insurance and other
hedging instruments.
One of these considerations is stock price volatility. Given the levels to
which earnings multiples have risen, stock prices are in a sense highly leveraged
to earnings. As can be commonly observed, companies that fail to meet earning
expectations by even relatively small amounts can see dramatic reductions in
their stock prices. Again the academic view (and in fact the view of long-term
value-oriented investing) is that such short-term volatility does not matter
too much, especially if it is caused by an event that does not really impact
the company’s long-term earnings capacity. However, such drops in stock prices
can be highly disconcerting to managers and employees holding stock or stock
options. The question that is raised from a shareholder and corporate governance
perspective is, “Does it matter if the managers and employees are affected?”
The academics describe the issue of managers’ personal interests differing
from the interests of the corporations they work for as “agency costs.” The
use of the term “agency” is from the legal concept that a corporation can act
only through its agents, i.e., its employees, since the corporation itself is
only a legal construct. Here the idea is that employees (including managers)
are paid a wage that fairly represents the market value of their services but
that once paid, they should act solely and completely in advancing the interests
of the corporation as opposed to any personal interest.
This raises at least one theory problem and one practical problem. The theory
problem relates to the growing belief that employees should be given a direct
stake in the profitability and value creation of the business, and that by aligning
the self-interests of the employees with the interests of the shareholders,
the shareholders’ wealth will be increased. This employee ownership model seems
to be correlated with the success of the technology industry generally in recent
years, as well as such other notable cases like General Electric. The theoretical
question is whether “agency costs” are a problem or whether they are in a sense
part of the solution.
The practical issue from all of this has to do with the way that large companies
actually operate. Most large companies are a collection of smaller business
units. Some of these business units may be divisions or departments; some may
be subsidiaries. The problem from a risk finance perspective is that while the
overall corporation may be able to retain a large uninsured loss, that loss
normally will be charged to the business unit from which it arose. The problem
for senior management is similar to that faced by shareholders; a loss that
eliminates a substantial portion of the profits of a component business can
damage the business if it results in a loss of bonus compensation for the managers
and employees of the unit. While it is easy to say, “That’s too bad; better
luck next year,” it creates the risk of loss of morale generally and loss of
key employees specifically.
Risk Finance in the “Internal Economy”
The fact that the risk retention capacity of the overall corporation exceeds
the risk retention capacity of the individual business units comprising the
corporation creates some opportunities in the area of risk finance. These opportunities
arise from the question of whether the company should try to do anything to
manage the financial impact of risk on the company’s internal economy.
The first set of opportunities relate to how mangers within the firm can
organize a program to manage risk in a proactive fashion that helps to both
identify and control risk. A common approach is to create a framework of internal
transfer pricing that permits risk exposures of a business unit to be transferred,
for a price, to a central risk financing unit. It is also common for the company
to use a captive insurance company to act as the vehicle for administering such
a program. The captive retains risk at a level that is appropriate for the corporation
and which may be too high for an individual business unit. The captive then
essentially sells insurance to the business unit to cover the difference between
the captive’s per-loss retention and the per-loss retention that is comfortable
for the business unit.
Some companies forgo the use a captive, and simply use management accounting
to “charge” a premium to a business unit in exchange for “coverage” of all or
part of losses that are retained by the company under its corporate insurance
programs. The advantage of this approach is that it is simpler and cheaper than
a captive. There are some disadvantages and other issues created by this approach,
however, as discussed below.
The first issue is that the accounting approach has less formality than the
captive approach. This is an intangible issue that may or may not be important
in a given situation. Utilization of a captive means that risk costs are accounted
for using the detailed set of financial accounting standards applicable to insurance
companies. This can help to assure that proper accounting methods are used,
and this in turn can facilitate transactions with the commercial insurance industry.
While the value of formalized accounting may be difficult to fully articulate,
the answer lies in recognizing that well-organized information always has a
value in managing an enterprise. Consider how much most large companies spend
simply to have accurate and detailed management and financial information systems.
As companies deal with multiple risk exposures over multiple years, formalized
accounting has clear advantages.
There is a further issue if a company operates through divisions rather than
subsidiaries. Under segment accounting rules, it is considered proper for self-insured
losses arising from a business unit to be ascribed to that unit. In theory,
this gives investors a more accurate picture of the actual financial position
of the segment. Transferring loss costs to an account not connected with a principal
business activity can be viewed as creating a distorted picture of the business
units that comprise the corporation.
The accounting approach also does not provide a vehicle for funding losses.
Some companies have a view that it is preferable to actually set aside funds
to pay for self-insured loss costs. In addition, many companies actually record
a transfer of cash when they process intercompany accounting transactions.
On the other hand, there are some disadvantages or other issues involved
with using a captive. One is that the captive itself is a much smaller entity
than the corporate parent. The problem is that if the captive takes a larger
per-loss retention than its capital base can handle, the captive could be exposed
to a technical bankruptcy risk. Bearing in mind that since the captive is typically
a wholly owned subsidiary whose obligations are guaranteed by the parent, it
is consolidated with the parent for financial reporting purposes. Thus some
would say that it does not matter if the captive takes on too much risk, because
the parent will simply provide additional capital injection. In reality, captives
that experience losses that exceed their financial resources cause problems
for the managers responsible for them.
Captives have so far mainly been used as vehicles for traditional insurable
risk exposures like workers compensation or property insurance. Since excess
insurance can be purchased cheaply over relatively small retentions, most captives
do not deal with risk levels that are beyond their own financial capacities.
However, captives occasionally do take retentions that are too large for their
balance sheets. In addition as companies look to employ captives to finance
nontraditional operating or strategic risk exposures, the risk of taking on
too much risk becomes more relevant.
Opportunities for Insurance Providers
Despite the theoretical view that corporations should retain more risk and
that shareholders should ignore short-term volatility in earnings, the reality
seems to be that corporations, and the individual business units that make up
corporations, do not like unexpected expenses that result in significant loss
of profit in a given accounting period. The unique aspect of insurance is that
from an accounting perspective, the actual cost of insured events is ignored
in exchange for recognition of the cost of the insurance. Even if it is true
that over time the cost of insurance adjusts to reflect the cost of insured
losses over time (assuming the adjustment process is not contractually guaranteed),
the company can exchange a series of volatile cash flows (uninsured losses)
for a series of predictable and budgetable cash flows (insurance premiums).
For large risk exposures, insurers sell insurance for large loss events in
excess of substantial retentions. Insurers that adjust to this model will see
growing opportunities, while those that seek to insure lower levels of risk
will see their market continue to erode.
In addition, those insurance organizations that recognize and understand
the need to help companies deal with the risk financing issues of the companies’
“internal economies” will also find opportunities beyond traditional insurance
products.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does not purport
to provide legal, accounting, or other professional advice or opinion. If such advice
is needed, consult with your attorney, accountant, or other qualified adviser.