This is the third of four articles in a special report looking at risk retention. Also included are: An Appetite for Risk, which explores the metrics and thought processes of the new ways of thinking about risk; Seven Factors in Self-Insuring, which analyzes the components of retention strategy;and Taking a Risk on Workers’ Comp, which zeros in on that specific coverage.
Every profit-making organization assumes certain business risks every day it is in operation. Many CFOs and risk managers have begun to realize, however, that their companies can profitably assume some of the risks that in the past they have transferred to an insurance company.
The reasons risk retention can benefit an organization include:
1) Eliminating the charge for risk transfer to an insurance company. That’s generally 40 percent to 50 percent more than will be paid out in losses, depending on the type of coverage and the amount of premium involved.
2) It’s inordinately expensive to document and settle relatively small losses with an insurance company, particularly when management’s time is considered.
3) The collection of payment for small losses can frequently have an adverse effect on future insurance costs.
The decision about the types of insurance to buy and the amount of risk to retain is as important to an organization as the decisions about how much debt and equity a firm needs to issue.
The choice of whether to buy coverage or retain risk should thus be based on a rigorous corporate finance framework that determines the trade-offs between buying an added unit of insurance and adding to the firm’s cost of capital.
Managing insurance through the prism of corporate finance might sound complex, but it comes down to this basic principle: If the cost of buying an extra unit of insurance is greater than the cost of the extra risk capital used to retain the risk, don’t buy that insurance coverage.
One thing to consider when determining your organization’s best risk-retention level is to figure out its Total Cost of Risk. The traditional formula for calculating TCOR is expected self-insured losses plus expenses to run the company’s risk management program plus insurance premiums.
Yet what’s been missing in that definition of TCOR is the cost of capital. If an organization wants to assume more risk, it should also hold more capital than it would otherwise.