An Appetite for Risk

A company may have the ability to retain the cost of covering a potential exposure. But does it have the stomach for it?

This is the first of four articles in a special report looking at risk retention. Also included are: Seven Factors in Self-Insuring, which explores the components of retention strategy; If Insurance Costs Too Much, Don’t Buy It, which provides a case study in cost saving; and Taking a Risk on Workers’ Comp, which zeros in on that specific coverage.

Out of the ashes of the financial crisis, corporate approaches to figuring out how much risk to retain and how much to transfer to insurers, banks and the capital markets have been growing by leaps and bounds in sophistication.

From its origins in the insurance industry, corporate risk management calculations of how much a given risk will cost, how much the organization should be protected against that cost and what to pay for that protection have been brought in-house. Chastened by the growing prominence of unpredictable, system-threatening global risks, however, finance and risk executives also grant that gut-level intuitions about a company’s stomach for taking on risk should play an important part in retention decisions. 

Increased awareness of the potential speed, magnitude and unpredictability of risk has brought CFOs into a world they previously relegated to risk managers. If Superstorm Sandy could become so fierce so fast, or Lehman Brothers could collapse in a matter of months, it followed that senior managements needed to prepare for such threats by looking at them in the context of their companies’ entire financial structures. What was predictable? What was not? How do we prepare for the unpredictable ones? How do we budget or plan at all?

More and more, the answers to the question of how much risk to retain and how much to pay a third party to cover are starting from a complex calculation with two basic components: a corporation’s financial wherewithal to absorb uncertainty and its willingness to do so. Call them Risk Tolerance and Risk Appetite. 

Valuing the Volatility
To be sure, for a long time risk managers have  been in the business of deciding whether their companies should insure or retain the expense of  covering their property, casualty and workers’ compensation loss exposures. The profession has evolved its own metrics to help risk managers with such decisions, most notably total cost of risk. (TCOR is defined as the sum of premiums plus retained losses plus administrative expenses associated with risk management.)


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