Determining the Optimal Combination of Risk Retention and Risk

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					Determining the Optimal Combination of Risk
Retention and Risk Transfer
December 2006

If you are a risk manager for a large company or simply purchase the
insurance for your firm, chances are you also have deductibles and/or
self-insured retentions (SIRs), also referred to as retained risk. If you
retain significant amounts of risk, your company incurs a capital charge
for retaining such risk, regardless of whether the company recognizes
the charge on its balance sheet.
by Donald J. Riggin
Albert Risk Management Consultants

Calculating this charge has proven to be a challenge, even to the most finance-savvy
risk manager. If a capital charge for retained insurance risk is the Holy Grail, we can
construct a methodology that will get us partially there.
Insurance is nothing more than a form of contingent capital—the insurance company
is willing to provide, for a premium cost, access to a considerable amount of funds in
the event you have a loss. Access to the insurance proceeds is contingent on
experiencing an insurable loss. This begs the question: Is insurance an efficient use
of capital? The answer is dependent on several factors, not the least of which is the
cost of the insurance relative to the value of retaining the risk. Of course, some
insurance purchases cannot be avoided; those for catastrophic loss, for example, but
unless a company can identify the actual cost of retaining risk, the question of
whether insurance premiums constitute an efficient use of capital will remain
Up to this point you only know two things: (1) insurance premiums purchase off-
balance sheet risk protection, and risk you retain, either through deductibles or self-
insured retentions, remain on the balance sheet. The eternal question then becomes
what is the optimal combination of risk retention and risk transfer? Most companies
not only do not understand that retaining risk has a capital impact, but they have no
financial metrics for comparing competing retention/transfer scenarios. They also
have no way of determining if the risk transfer premiums represent economic value.
Many externalities contribute to the confusion surrounding this question. Pure
economic factors do not usually drive the price of excess insurance; the markets do.
This means that in most years, the cost of the protection bears little resemblance to
your individual risk profile. Risk retention conventions such as the $250,000 per
occurrence loss limit is practically institutional (thousands of companies retain this
figure through large deductibles, retroactive plans or captives, but few actually know
whether it is the right one!).
Another factor that contributes to the lack of understanding of the financial impacts
of this decision is the role of insurance companies. When an insurer promulgates
rates for excess risk transfer, it does so at convenient dollar amount intervals. For
example, $100,000, $250,000, and $500,000 are quite popular retention amounts.
In the absence of any economic reason why they should use any other figure, you
get what they offer.
There is a way to calculate the costs of retained risk and risk transfer, similar to how
your company calculates its internal rate of return (IRR), and the relationship
between the IRR associated with your risk management decisions and your weighted
average cost of capital (WACC). It doesn't alleviate the endemic problems of
negotiating the cost of excess insurance, but you will have a better idea of what the
coverage should cost.
The Weighted Average Cost of Capital (WACC)
The WACC is what it costs your firm to maintain its capital base. It is comprised of
the cost of issuing common and preferred stock, the cost of issuing debt, and in
come cases the cost of retained earnings.
Every company has a capital structure—a general understanding of what percentage
of debt comes from common stocks, preferred stocks, and bonds. By taking a
weighted average, we can see how much interest the company has to pay for every
dollar it borrows. This is the weighted average cost of capital. While most people
agree on what the WACC represents, few agree on a standardized method of
calculation. For example, some companies express a cost for retained earnings, while
others do not consider retained earnings as a source of capital, just funds "left over"
after the equity and debt capital are optimally employed.
The following is a highly simplified example of what constitutes the WACC.

Capital Component Cost Multiplied By % of Capital Structure Total

Common Stocks         11%         X                   10%             1.10%
Preferred Stocks       9%         X                   15%             1.35%
Bonds                  6%         X                   50%             3.00%
TOTAL                                                                 5.95%
Internal Rate of Return (IRR)
The internal rate of return (IRR) is the discount rate that makes the net present
value of periodic cash flows equal to zero. It is the return a company would earn if it
invested in itself rather than investing elsewhere. In standard capital budgeting
exercises, the IRR of a venture or project must surpass the company's WACC. If it
falls beneath the WACC, the project has no value to the company. Theoretically, a
company's overall IRR must exceed its WACC or it would not remain in business very
long—its cost of borrowing would exceed its ability to pay for it.
The internal rate of return formula assumes a series of positive and negative cash
flows, resulting in a positive or negative percentage result. A negative outcome
usually suggests that the project or business is a bad bet. As discussed above, a
result that does not meet or exceed the company's WACC may also qualify for the
trash heap. So the challenge we face is to find a way to mimic the value of the IRR
calculation for the "investment" in risk retention and insurance. The next question,
then, is what combination of retention and insurance produces the highest internal
rate of return? Another way to think of this is what combination of retention and
insurance produces the least opportunity costs? (This analysis does not take into
account a potentially positive reduction in losses though specific risk control
activities, which is a capital budgeting problem.)
While the calculation may be straightforward, estimating the variables is not. Since
each "payment," whether for retained loss or insurance premiums, is a cash outflow,
we need one or more assumed inflows to complete the calculation. We begin by
assuming that we transfer all (hazard) risk to an insurance company for a premium.
This is only true in the smallest of companies, of course, but it gives us a baseline
from which to begin the calculation. We then deconstruct the insurance premium into
its constituent parts based on multiple levels of risk retention. The following word
formula illustrates this concept.

      Pre-tax standard insurance premium without retaining any risk whatsoever,
            Minus
      Pre-tax premium reduction resulting from retained risk (pick any amount)—
       once this figure is subtracted from the standard premium, the result is mostly
       insurer expenses—this is the figure used in the IRR calculation
            Minus
      Tax benefit resulting from purchasing insurance excess of the retention,
            Plus
      The aggregate, discounted, after-tax cost of the retained risk—(over the
       appropriate payout period including investment income)

The following simple numeric example follows the above progression:
                                        Table 1
For simplicity's sake, in this example the premium credit for risk retention and the
expected losses are the same figure. This means that the insurance underwriter and
the actuary agree.
Using the above example, we can then calculate an internal rate of return for this
particular combination of risk retention and transfer, being careful to enter the cash
inflows and outflows in the sequence in which they occur. The resultant IRR of one
scenario has some value as it relates to the company's cost of capital. But if the IRR
does not meet or exceed your company's WACC, you do not have the option of doing
nothing. You must make a choice among competing alternatives, so performing an
IRR calculation on several combinations of risk retention/transfer reveals the option
with the most relative value.
This technique doesn't give us a specific capital charge, but it provides a financial
metric for comparing any combination of retention and transfer.
Courtesy of International Risk Management Institute.