That methodology entailed the use of a modified version of the internal rate
of return (IRR) calculation in concert with the various risk-related financing
components. This article bridges the gap between being able to determine an
optimal hedging strategy among a number of options, and the importance of
converting that strategy into a capital charge. For our purposes, we
distinguish insurable risk from financial and operational risks, which we do
not contemplate in this article.
Weighted Average Cost of Capital (WACC)
Why is the ability to calculate a capital charge for insurable risk
important? Its importance is directly related to a firm's economic value
added (EVA). EVA is a corporate performance measure that stresses the ability
to achieve returns above the firm's cost of capital. We express EVA as
after-tax net operating income, less the product of required capital times the
firm's weighted average cost of capital (WACC). The higher the firm's
weighted average cost of capital, the lower the firm's EVA. Another way to
express EVA is the degree to which a firm's IRR exceeds its WACC.
For example, Company A is considering an acquisition that produces an IRR of
15 percent. It determined that after the acquisition, the combined
companies' WACC would be 10 percent, so the transaction makes economic
sense. We can express the 5 percent spread between the IRR and the WACC as its
EVA. In this case, 5 percent happens to be an acceptable spread, but a lower
spread, say 3.5 percent, might cause the company to question the long-term
value of the transaction. If Company A did not incorporate a risk capital
charge in its WACC, the actual difference between its after-transaction WACC
and the deal's IRR, could be closer to 3.5 percent than 5 percent.
Before we discuss the concept of a capital charge for risk, we will review
the WACC. The weighted average cost of capital is the company's cost of
maintaining capital, of owning capital. Capital exists in two forms—equity and
debt. The baseline cost of equity capital, for example, is the share price
times the share count, divided by the market value of the company. The WACC may
include two additional factors: (1) a risk premium for non-insurable risks,
e.g., interest rate risk, etc., and for publicly traded companies, (2) the
company's beta. The beta (β) is a statistical measure of market risk on a
portfolio. Put another way, we use the beta as an index of the systematic risk
due to general market conditions. We cannot diversify this risk away in the
company's portfolio.
For example, a beta of 0.5 means the total return of the security is likely
to move up or down 50 percent of the market change; 1.2 means total
return is likely to move up or down 20 percent more than the market.
So, the beta in the WACC measures how equity market volatility affects the cost
of a company's capital. Usually, however, companies' capital structures
comprise both equity and debt. In these cases, the beta is expressed as being
leveraged, i.e., adjusted to the degree of leverage (debt) in the
company's capital structure. If a company's capital structure comprised
only debt, it would have no beta. While entire companies cannot survive solely
on debt, specific transactions can and do, especially when moved off of the
balance sheet into special purpose entities.
Thus far we have discussed each of the standard components in the typical
weighted average cost of capital calculation. We also discussed how the
economic value added (EVA) of the company as a whole or of specific capital
allocation decisions (an acquisition, for example), depends on the accuracy of
the WACC. We will now discuss how (insurable) risk hedging strategies draw
capital away from economic production, (usually) undetected by the
company's financial management.
Risk Hedging Strategies
Every significant economic pursuit requires capital. The notion of risk
capital, i.e., capital devoted to hedging the company's risk, is not a
complicated concept, but until recently companies only thought of it as an
expense and not a significant draw on the company's capital. For many
years, the dominant component of the cost-of-risk formula (also known as risk
capital) was insurance premiums.
Insurance provides two types of economic value: direct and indirect. Direct
value refers to the actual amount of insurance consumed by losses as compared
to its cost (premium). The indirect economic value of insurance is the
company's ability to pursue its business without establishing a financial
contingency equal to the ultimate value of its risks, assuming it could
calculate such a thing. Because insurance premiums are usually a fraction of
the amount of transferred risk, the transaction works in principle. Moreover,
efficiently accessing an insurer's capital can be less expensive than
owning risk capital. An example later in this article illustrates this
concept.
Another way to think of insurance is contingent capital: nonowned
capital at the ready in the event of a loss. Its direct economic value to the
company depends on two variables: (1) the state of the insurance and
reinsurance markets (an uncontrollable cost driver), and (2) the amount of
insurance purchased (a controllable cost driver). Here is where we introduce
how the concept of marginal utility reveals how any risk hedging
strategy may prove to be more expensive and inefficient than originally
thought, and how, if those inefficiencies are not discovered, the true cost of
insurable risk for any company can prove to be very expensive.
Every company experiences some maximum yet unknowable amount of insurable
loss each year. For the long-tail lines, such as workers compensation, that
maximum amount is more predictable than others. But for many lines of
insurance, historical losses have no bearing on our ability to predict future
losses. For example, directors and officers (D&O) liability has a
potentially very long tail, but losses are not predictable based on any
actuarial methodology.
Because loss mitigation and the root causes of loss vary widely among the
various lines of insurance, a company's ability to accurately predict its
combined maximum annual amount of insurable risk is virtually impossible. Even
when we consider a multiyear horizon, i.e., we determine that a certain type of
significant loss event occurs, on average, every 5 years, we don't know in
which of the 5-year time periods the loss will occur. The standard reaction to
this problem is to purchase enormous amounts of insurance limits.
Consider Company A. It is an article of faith that regardless of the state
of the insurance markets, it must purchase as much products liability insurance
as it can find, up to $500 million in some years. In extremely hard markets,
only the size of the premiums derails this annual mandate. Historically, the
company's product liability losses are very low; just one $25,000 loss in
the past 5 years, but the company manufactures a product considered by the
federal regulatory watchdogs (and the plaintiff's bar) to be potentially
quite dangerous. So while a major catastrophic loss has not yet occurred, the
potential is real. Moreover, as a public company, Wall Street (and the
company's shareholders) fully expect the company to purchase insurance for
catastrophic loss events; to do otherwise would be considered irresponsible in
the extreme.
In this example, actual losses are minimal so the downstream marginal
utility of all of that unused insurance is zero. Marginal utility refers to the
relative value of a good or service over time. At some point in the future,
that $500 million of products liability insurance the company bought 5 years
ago, (and every year thereafter) after the solitary $25,000 loss is finally
settled, will have no marginal utility. Put another way, in direct economic
terms, the premium spent to purchase insurance limits excess of $25,000 was
unnecessary. We do not, of course, measure the value of insurance solely in
direct economic terms. After all, just the fact that the company had access to
as much as $500 million (the indirect economic benefit) in the event of a loss
allowed it to grow the business unfettered by the financial consequences of a
major loss. However, would perhaps $200 million offer the same benefit? How
about $100 million? Might $50 million also satisfy this need?
How Much Insurance Is Too Much?
The question is not whether the company purchases excess insurance;
the question is how much is enough, and more importantly, how much is too
much. There exist several compelling arguments for lowering the point at
which the marginal utility of your insurance expenditure reaches zero.
First, that potential catastrophic loss you purchase excess insurance to
cover will doubtless have significant implications for the company's future
prospects regardless of how much insurance you have. No major loss in any line
of coverage is 100 percent covered by insurance. In fact, some estimate the
so-called indirect costs of any loss to equal as much as six times the dollar
value of the loss itself. This means that while you might have a lot of
insurance, much of it will not apply to the actual costs of the loss.
Second, you cannot build $100 million of insurance capacity with one
insurer. Multiples of risk layers mean multiple coverage forms and exposure to
significant credit risk.
Third, regardless of how willing the insurers were to sell you the
insurance, none of them will cut claims checks without extensive and exhaustive
time-consuming investigations.
The object of this argument is not to convince you to foreswear excess
insurance, it is to get you to think about the direct economic costs of a
product with questionable marginal utility potential, and how the amount of
insurance you purchase, along with other factors, affects your company's
WACC—and the EVA of every capital allocation decision. The goal here is to
maximize the indirect economic value of the insurance purchase while minimizing
the direct economic costs.
Capital Charge for Insurable Risk
The amount of the capital charge for insurable risk depends on the
relationships between three variable factors: premiums, retentions, and
limits—and one constant: the percentage of insurance limits likely to be
consumed when every loss is settled and closed. If you retain your workers
compensation expected losses, the percentage of workers compensation insurance
limits likely to be consumed approaches 100 percent, assuming your
actuary's predictions prove correct. Conversely, if you purchase $100
million of D&O limits and assume a $1 million deductible, you might assign
a 5 percent likelihood, meaning that you expect to consume $4 million of
purchased limits plus the deductible.
The difference between the purchased limits and the estimated percentage of
limits likely to be consumed is the difference between cost and
value. You purchase insurance limits for a set cost, but you measure
the direct economic value of that purchase based on its marginal utility—how
much did we actually use? (This is one of the primary arguments for either
forming or joining a captive where instead of paying premiums to an insurer for
little marginal utility, you pay it to yourself and eventually get some of it
back.)
Now consider the relationships between the three variables. If you reduce
the amount of limits purchased, and/or increase the retained limit, the
insurance premium goes down. The opposite is also true. However, since the
variables are not perfectly aligned, the relationship between them is not
linear. For example, assume Company A, flush with cash from a recent
divestiture, decides to double its property retentions (deductibles) to reduce
its insurance premiums. It does not understand the concept of risk capital, and
views insurance premiums as simply an expense.
The company has had no catastrophic property losses, so it assumes that
doubling its retentions will not materially affect the balance sheet. What it
does not understand is that its insurance is a form of contingent capital, the
cost of which is determined, in part, by the amount of limits purchased, and
insurance premiums are tantamount to a tax deductible form of risk capital.
By doubling its retentions, it may have increased its risk capital
and decreased the amount of contingent capital available for large
losses. Why? Assuming the company's total purchased property insurance
limits remain unchanged, it perhaps traded a comparatively inexpensive form of
risk capital—insurance premiums—for a potentially expensive form of risk
capital—its own equity. Of course, without knowing the company's financial
condition and the materiality associated with doubling its property risk
retentions, it is impossible to make an accurate assessment, but you get the
idea.
Let us assume that the above example is accurate and that the company did,
in fact, increase its equity risk capital and decrease the cost of its
contingent risk capital. Further, let us assume that it continued to purchase
the same amount of property insurance limits, except that the attachment point
is far higher than prior to the change. What impact could this have on the
company's equity capital? This, dear reader, is the core of the argument
for calculating a capital charge for insurable risk.
If we accept that the company's action, on its face, appeared to
increase its cost of risk by replacing a less expensive form of risk capital
(insurance premium) with a more expensive form of risk capital (its own
equity), the only thing left to do is determine the cost of that strategy,
ideally against the costs of other possible risk hedging strategies. Another
way of expressing this cost is … a capital charge.