Expert Commentary

Event Risk Financing: Thinking Beyond the Transfer versus Retain Paradigm

Do you ever wonder why organizations spend so much time, energy, and expense managing and financing event risk when the most significant risks, collectively known as business risks, receive comparatively little attention?


August 2007

Enterprise risk management (ERM) focuses on some of these risks, e.g., financial and operational, but for the most part, we consider "business risks" as just the costs of doing business. For example, every year a large clothing retailer makes bets on consumer demand and weather expectations. Despite all of the market research, will the new purple fisherman's sweaters sell or languish on the shelves? Will the Northeastern winter be normal or abnormally warm? Some companies use weather insurance or derivatives to hedge against this risk, but can we hedge against the effects of a bad business decision?

The financial consequences of discovering that buying 1,000 carloads of unwanted purple fisherman's sweaters could be quite significant, perhaps even requiring the company to take a hit to its earnings. The company, however, routinely assumes this risk, hoping that next year's sweater bet hits the mark. While the company takes no active measures to hedge against the sweater risk, it nevertheless must finance the loss. It does so through its earnings, supported by its paid-up capital. The company has no choice—it must have the wherewithal to finance this type of loss.

Event Risk

We do not consider event risk in the same way. We usually think in terms of what we should keep and what we should transfer. Ideally, we transfer the catastrophic risk and keep the more frequent, manageable risk. The particulars of this decision are more often than not dictated by the insurance industry. The fact that insurance is available for event risk forces companies to use it at least for catastrophic losses; to do otherwise would be grossly irresponsible.

What if we set aside this "transfer versus retain" mindset and focus on a more basic question: What is the best way to finance the risk? Just because we don't transfer does not mean that we do not have to finance it. Could that large retailer in the above example have found a way to neutralize the risk that purple fisherman's sweaters would not sell? The answer is yes, but instead it chose to finance the loss nonspecifically, with its earnings and capital.

Since the retailer is a public company, its cost of capital includes something called the beta, which is a relative measure of its earnings volatility against the Standard and Poor's 500. Large retailers' earnings are extremely volatile (hence the sweater example). This company's beta is around 1.17. Anything over 1 is considered volatile; a beta below 1 reflects a relative lack of volatility. Betas in excess of 1 are considered "risk premiums" and provide a degree of transparency to investors. The investor receives the risk premium for investing in a company with such volatile earnings. This risk premium increases the company's weighted average cost of capital. From the investor's perspective this means that for the company to grow profitably, every decision involving the use of capital must exceed its cost.

Risk Capital

So, aside from a catastrophic event risk (which we never fail to transfer off the balance sheet), can we take a financial, cost of capital-driven, approach as described above to event risk? More importantly, should we adopt this approach in lieu of the standard transfer/retain assumptions? The answer to both questions is yes, but in the absence of universally accepted metrics such as the beta, we must devise a way to measure event risk's impact on the company's earnings and its cost of capital. The first thing we do is identify that which we consider "risk capital."

Risk capital, like all capital, is divided into sources and uses. The cost of insurance premiums is a use of risk capital, while insurance proceeds (loss payments) are a source of risk capital. Equity represents both a source and a use of risk capital. In the absence of a formal event risk financing arrangement, such as a captive, risk financed on-balance sheet places a burden on the company's equity, the same as that sweater risk in the above example. The components of risk capital are (1) transfer/hedging costs, (2) purchased off-balance sheet risk capacity, and (3) equity.

All three components are inextricably interrelated in that the most efficient combination requires a delicate balancing act. In the transfer/retain mindset the only important variable is the state of the insurance markets. The conventional thinking is that we buy as much (cheap) off-balance sheet protection as we can afford. When the transfer markets harden, we buy less, and so forth. The insurance markets and the availability of affordable transfer products drive our financing (hedging) strategy. However, is this really a strategy, or just a routine exercise that everybody uses and seems like the right thing to do? I suggest it is the latter.

Let us look at each component's function within a financial context, and compare it to the conventional, quite limiting, transfer/retain thinking.

Transfer/Hedging Costs and Purchased Off-Balance Sheet Risk Capacity

The costs to transfer or hedge event risk is rarely, if ever, based on the actual amount of risk transferred; the costs are based on the amount of protection purchased (not received). We do not purchase $100 million of products liability insurance because that matches our actual risk, do we? Of course not. We purchase it because of what our risk might be or could be. Therefore, it is a fallacy, in economic terms, to suggest that the premium for that $100 million of insurance is even close to an efficient use of risk capital. Heresy, you say!

Consider this. If we are sued for a legitimate products liability claim, we could face bankruptcy without all of those insurance limits. Yes, you are correct, but if your company is well run with state-of-the-art quality controls, both physical and legal, then the chances of losing a $100 million products liability lawsuit are very, very small.

Turning back to the large retailer example, your CEO willingly assumes the significant amount of risk associated with your decision to buy the purple fisherman's sweaters (which could be tantamount to a $100 million gamble), but you would never consider not buying enormous amounts of expensive insurance to protect the company against a loss with a likelihood of occurrence equal to a fraction of that represented by the sweater decision. This is one example of how the transfer/retain mindset locks us into a mode of irrational behavior inconsistent with sound economics (not to mention the laws of probability).

Equity

We covered the first two hedging strategy components above, which brings us to the third. Every company uses equity capital to finance event risk in the form of deductibles and self-insured retentions. The question is not whether the company should retain event risk (all do), the question is the impact it has on the company's financial wellbeing.

The transfer/retain paradigm suggests that when transfer markets are hard (expensive), we should simply retain more risk. When the CFO asks about the costs of insurance premiums in such a market, you tell her not to worry, the risk transfer costs are under control; we had to assume a little more risk in our deductible. Unfortunately, neither you nor your CFO has any idea how to measure the impact of that additional retention (or any retention, for that matter). She congratulates you on your cost-containment "strategy." While you and your insurance broker may have worked through one or more "selecting-a-retention" exercises, the decision is usually made on what is considered the optimal attachment point for the insurance, and not the company's tolerance for risk or the effect on its equity.

Continuing with the large retailer example, let us assume that the company has large amounts of cash and unused credit lines. This might suggest that increasing the products liability retention from $2 million to $10 million might be okay. Yes, it might be okay, but it might not. From a financial perspective, this decision places a 5-fold increased burden on the company's equity. The amount of cash on hand and the company's ability to tap credit lines are subject to the company's earnings volatility, which is considerable, as discussed above. By deciding to increase the retention to save money on premiums, you have added volatility to the company's already volatile earnings. What's more, this additional volatility is not reflected in any of the company's cost of capital metrics, resulting in no investor risk premium and decreased transparency.

The primary question, then, is whether the additional volatility is worth the premium savings. Probably not, but you have no way of knowing anyway.

Summary

To summarize, event risk managers (and their brokers and consultants) must find ways to see beyond the narrow world of "transfer or retain." It should begin by gaining a thorough understanding of your company's (or client's) financial management goals. You should strive to find innovative ways to elevate the event risk financing analysis process beyond the gravitational pull of the insurance industry.


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.

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