Most companies evaluate the purchase of insurance and other risk-transfer solutions one risk at a time. The amount of risk to be retained by the company is most often weighed against the premium or other savings for assuming each risk. It is less common to find companies that make risk transfer-risk retention decisions based on their entire portfolio of insurance and other risk-transfer solutions. Doing so however, could help companies derive the greatest value from their available risk-bearing capacity: its financial capacity and tolerance for taking risk.
This approach is known as intrinsic risk valuation (IRV). IRV is much like intrinsic value investing, in which stock analysts establish an intrinsic value for a stock and then watch the market price rise or fall. If the stock drops significantly below the intrinsic value, they buy. If the price moves significantly above the intrinsic value, they eventually sell and take a profit.
The intrinsic value of each risk, or layer of risk, is defined as the company’s internal cost to retain, or self-insure, the risk at the break-even point over time. The intrinsic value is the sum of the expected (average) cost of a loss or losses to be retained, a risk charge based on the difference between the expected value of losses and a high-confidence interval outcome (the equivalent of 95 percent), a charge for the “surplus” capital needed to support taking the risk, and any other expenses associated with retaining it.
With the intrinsic value established for each risk, companies can evaluate the full range of risk solutions available to them. If a solution is found that’s less costly than the intrinsic risk value, it would add economic value to the business to implement it rather than retaining the risk. If all the solutions are more expensive than the intrinsic value, and the company has risk-bearing capacity to assume the risk, doing so will be the most cost effective-solution.
It may be useful to place such risks in a captive insurance company using the intrinsic value as the captive’s premium for taking the risk. It would then be possible to canvas the reinsurance markets to see if the risk can be laid off for less than the intrinsic value.
The most efficient overall solution can be found by systematically working through the key risks in this fashion: Measure overall efficiency by looking at the IRV ratio, which is defined as the cost of each risk solution divided by the intrinsic value for that risk. By creating a risk index using the IRV ratios, you can see which risks require the highest “premium,” or surcharge, over the intrinsic risk value. Available risk-bearing capacity can then be allocated where it creates the greatest value for the business. Where multiple options are available, they can be compared on the basis of their IRV ratios. The best value is the solution with the lowest IRV ratio.
There can be several good reasons for a company to transfer risks at a ratio greater than one. One is that available risk- bearing capacity has been exhausted and the company is forced to lay the risk off at a premium over what it would cost to retain it. Another is that the risk may not be sufficiently well understood for the company to be comfortable retaining it. But the IRV ratio immediately identifies where value is being created and where the company should work to find a better solution.
For IRV to be effective, a company must have a good sense of its risk-bearing capacity. It’s often helpful for CFOs to evaluate a series of benchmarks (hypothetical amounts of loss experienced in a given timeframe) that would result in well-defined business consequences (for example, a downgrade in credit rating, a breach of lending covenants or a delay in the ability to fund strategic objectives).
With this continuum of benchmarks and clear business consequences, finance chiefs are better able to agree on a level of risk tolerance to effectively manage the business. That should be accompanied by an assessment of the company’s exposure to strategic and other uninsurable risks to determine if there is added risk-bearing capacity available to be used for exposures for which risk transfer or other solutions are available.
Intrinsic risk valuation is a benchmark that keeps a company focused on the relentless pursuit of cost and value. It assures that you’re receiving good value for your money, not just the best quote available in the market. And it makes the most productive use of the company’s risk-bearing capacity.
Rich Michel is the Risk Management National Practice Leader at Wells Fargo Insurance Services USA, Inc.