Determining the Optimal Combination of Risk Retention and Risk Transfer
December 2006
If you are a risk manager for a large company
or simply purchase the insurance for your firm, chances are you also have deductibles
and/or self-insured retentions (SIRs), also referred to as retained risk. If
you retain significant amounts of risk, your company incurs a capital charge
for retaining such risk, regardless of whether the company recognizes the charge
on its balance sheet.
by Donald
J. Riggin
Albert Risk
Management Consultants
Calculating this charge has proven to be a challenge, even to the most finance-savvy
risk manager. If a capital charge for retained insurance risk is the Holy Grail,
we can construct a methodology that will get us partially there.
Insurance is nothing more than a form of contingent capital—the insurance
company is willing to provide, for a premium cost, access to a considerable
amount of funds in the event you have a loss. Access to the insurance proceeds
is contingent on experiencing an insurable loss. This begs the question: Is
insurance an efficient use of capital? The answer is dependent on several factors,
not the least of which is the cost of the insurance relative to the value of
retaining the risk. Of course, some insurance purchases cannot be avoided; those
for catastrophic loss, for example, but unless a company can identify the actual
cost of retaining risk, the question of whether insurance premiums constitute
an efficient use of capital will remain unanswered.
Up to this point you only know two things: (1) insurance premiums purchase
off-balance sheet risk protection, and risk you retain, either through deductibles
or self-insured retentions, remain on the balance sheet. The eternal question
then becomes what is the optimal combination of risk retention and risk transfer?
Most companies not only do not understand that retaining risk has a capital
impact, but they have no financial metrics for comparing competing retention/transfer
scenarios. They also have no way of determining if the risk transfer premiums
represent economic value.
Many externalities contribute to the confusion surrounding this question.
Pure economic factors do not usually drive the price of excess insurance; the
markets do. This means that in most years, the cost of the protection bears
little resemblance to your individual risk profile. Risk retention conventions
such as the $250,000 per occurrence loss limit is practically institutional
(thousands of companies retain this figure through large deductibles, retroactive
plans or captives, but few actually know whether it is the right one!).
Another factor that contributes to the lack of understanding of the financial
impacts of this decision is the role of insurance companies. When an insurer
promulgates rates for excess risk transfer, it does so at convenient dollar
amount intervals. For example, $100,000, $250,000, and $500,000 are quite popular
retention amounts. In the absence of any economic reason why they should use
any other figure, you get what they offer.
There is a way to calculate the costs of retained risk and risk transfer,
similar to how your company calculates its internal rate of return (IRR), and
the relationship between the IRR associated with your risk management decisions
and your weighted average cost of capital (WACC). It doesn't alleviate the endemic
problems of negotiating the cost of excess insurance, but you will have a better
idea of what the coverage should cost.
The Weighted Average Cost of Capital (WACC)
The WACC is what it costs your firm to maintain its capital base. It is comprised
of the cost of issuing common and preferred stock, the cost of issuing debt,
and in come cases the cost of retained earnings.
Every company has a capital structure—a
general understanding of what percentage of debt comes from common stocks, preferred
stocks, and bonds. By taking a weighted average, we can see how much interest
the company has to pay for every dollar it borrows. This is the weighted average
cost of capital. While most people agree on what the WACC represents, few agree
on a standardized method of calculation. For example, some companies express
a cost for retained earnings, while others do not consider retained earnings
as a source of capital, just funds "left over" after the equity and debt capital
are optimally employed.
The following is a highly simplified example of what constitutes the WACC.
|
|
|
|
|
| Common Stocks |
11% |
X |
10% |
1.10% |
| Preferred Stocks |
9% |
X |
15% |
1.35% |
| Bonds |
6% |
X |
50% |
3.00% |
|
TOTAL |
|
|
|
5.95% |
Internal Rate of Return (IRR)
The internal rate of return (IRR) is the discount rate that makes the net
present value of periodic cash flows equal to zero. It is the return a company
would earn if it invested in itself rather than investing elsewhere. In standard
capital budgeting exercises, the IRR of a venture or project must surpass the
company's WACC. If it falls beneath the WACC, the project has no value to the
company. Theoretically, a company's overall IRR must exceed its WACC or it would
not remain in business very long—its cost of borrowing would exceed its ability
to pay for it.
The internal rate of return formula assumes a series of positive and negative
cash flows, resulting in a positive or negative percentage result. A negative
outcome usually suggests that the project or business is a bad bet. As discussed
above, a result that does not meet or exceed the company's WACC may also qualify
for the trash heap. So the challenge we face is to find a way to mimic the value
of the IRR calculation for the "investment" in risk retention and insurance.
The next question, then, is what combination of retention and insurance produces
the highest internal rate of return? Another way to think of this is what combination
of retention and insurance produces the least opportunity costs? (This analysis does not take into account a potentially positive
reduction in losses though specific risk control activities, which is a capital
budgeting problem.)
While the calculation may be straightforward, estimating the variables is
not. Since each "payment," whether for retained loss or insurance premiums,
is a cash outflow, we need one or more assumed inflows to complete the calculation.
We begin by assuming that we transfer all (hazard) risk to an insurance company
for a premium. This is only true in the smallest of companies, of course, but
it gives us a baseline from which to begin the calculation. We then deconstruct
the insurance premium into its constituent parts based on multiple levels of
risk retention. The following word formula illustrates this concept.
- Pre-tax standard insurance premium without retaining any risk whatsoever,
- Pre-tax premium reduction resulting from retained risk (pick any amount)—once
this figure is subtracted from the standard premium, the result is mostly
insurer expenses—this is the figure used in the IRR calculation
- Tax benefit resulting from purchasing insurance excess of the retention,
- The aggregate, discounted, after-tax cost of the retained risk—(over
the appropriate payout period including investment income)
The following simple numeric example follows the above progression:
Table
1
For simplicity's sake, in this example the premium credit for risk retention
and the expected losses are the same figure. This means that the insurance underwriter
and the actuary agree.
Using the above example, we can then calculate an internal rate of return
for this particular combination of risk retention and transfer, being careful
to enter the cash inflows and outflows in the sequence in which they occur.
The resultant IRR of one scenario has some value as it relates to the company's
cost of capital. But if the IRR does not meet or exceed your company's WACC,
you do not have the option of doing nothing. You must make a choice among competing
alternatives, so performing an IRR calculation on several combinations of risk
retention/transfer reveals the option with the most relative value.
This technique doesn't give us a specific capital charge, but it provides
a financial metric for comparing any combination of retention and transfer.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author's employer or IRMI. Expert Commentary articles
and other IRMI Online content do 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.