Expert Commentary

# The Importance of Calculating a Capital Charge for Insurable Risk Hedging Strategies

You may recall that my last Expert Commentary article, December 2006, described a method of determining the relative value of competing "hedging strategies," i.e., combinations of retained risk and the cost of purchasing excess insurance.

Risk Financing Info
February 2007

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.

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