Insurance is a source of capital that can be used to help manage and mitigate volatility; it should be viewed in the context of capital, alongside other capital sources available to finance insurable losses for example debt and equity.
When designing an optimal insurance strategy, i.e., the most financially efficient blend of retention and premium spend, two things should be considered:
- Balance sheet retention – using the company’s capital to retain risk. Risk retention introduces a level of volatility to your balance sheet. The cost associated with this can be measured using the company’s Weighted Average Cost of Capital (WACC).
- Buying insurance. This uses the insurer’s capital to mitigate losses at a cost of rate on line (transfer premium). Using insurance markets carries with it liquidity risk, basis risk and counter party credit risk which can be cost effective.
Marsh JLT Specialty’s Risk Finance Optimisation process allows companies to optimise their insurance strategy by:
- Calculating Risk Tolerance.
- Understanding Risk Appetite.
- Calculating loss costs and associated volatility through Risk Analytics.
- Having our actuaries and placement strategists produce Optimal Programme Design.
Risk Tolerance and Risk Appetite
The first step in optimising an insurance programme is to understand the current programme and potential exposures in the context of the company’s financial ability to retain risk, its Risk Tolerance.
Marsh JLT Specialty’s proprietary model analyses balance sheet and income statement Key Performance Indicators (KPIs) to determine the financial ‘cushion’ available to withstand negative outcomes over a twelve-month period. The Risk Tolerance analysis also provides context for measuring results, both against internal and external (industry and investor community) base lines.
This highlights a background against which various risk retentions can be compared and contrasted for appropriateness.
Risk Tolerance is an indicative figure used to initiate discussion towards finding your Risk Appetite, the amount of risk the business is willing to retain. Marsh JLT Specialty’s Risk Financing directors undertake a series of interviews with the leadership team to determine:
- Risk culture and reasons for buying insurance.
- Materiality thresholds and insurable Risk Appetite.
The low frequency and high severity nature of claims in Oil & Gas limits the effectiveness of standard actuarial techniques. For this reason we have a team of actuaries specialising in quantifying Energy Risks that supplements Marsh’s Loss Data Lake (LDL) with academic research and statistics from third-party organisations like SINTEF to build robust models reflective of a company’s underlying risk. Our Virtuous Circle approach brings in Claims, Engineering and Actuarial to challenge, refine and enhance loss models.
Using the expertise in the Virtuous Circle allows us to build large loss and clash scenarios to estimate loss potential of events not in data.
A good example of such an event is the Macondo incident in which a single event resulted in Property Damage, Loss of Production Income, Control of Well and Third Party Liability losses.
These events present an existential threat to the organisation and need to be identified. However, given their low frequency nature these events are typically not present in historical claims data and need expert judgement to compute and model.
Optimal Programme Design
The final stage of the process involves identifying the most financially efficient insurance programme structure. Using loss modelling results from Risk Analytics, the Marsh JLT Specialty placement team identify market realistic programme structures, which sit within your Risk Appetite.
For each of these programmes our models will determine the budget losses expected each year (burn rate) and the cost of keeping insurance risk on your own balance sheet, i.e., how much it would cost to fund losses using business capital.
We call this calculation the Implied Risk Charge (IRC) and it’s determined by the Weighted Average Cost of Capital (WACC).
This approach enables companies to compare the cost of using their own capital and insurance in alternative programme structures. For each programme a Total Cost of Risk (TCoR) and Economic Cost of Risk (ECoR) are calculated.
The benefit of the ECoR calculation over TCoR, is that it includes a capital charge (IRC) for retained and uninsured coverage layers (i.e., losses in excess of policy aggregates and limits).
This recognises that there is a real, though not obvious, financial cost to an organisation created by funding unexpected losses. ECoR calculates the true cost of retaining and transferring risk and the volatility surrounding expected losses, as well as demonstrating the value of buying insurance.
The programme with the lowest ECoR is the optimum structure.
Oil Price and Its impact On Programme Design
Capital decisions in the Oil and Gas sector are heavily dependent on the price of oil – the optimal insurance programme is no different.
Marsh JLT Specialty’s actuaries have developed predictive models that consider how key risk finance levers change with oil price. This allows us to design risk management programmes that are robust and immunised from small, frequent changes in the price of oil.
Risk Tolerance is a measure of the financial ability to retain risk. It is a function of financial KPIs such as Free Cash, Net Assets, Net Income (to name a few), which are heavily dependent on the price of the oil.
From studying Risk Tolerance from a random sample of integrated oil and gas companies, we found it more sensitive to a decrease in price than an increase.
Impact on WACC
A change in the cost of capital affects the cost of balance sheet retention relative to using an insurer’s capital.
Our analysis of WACC and the price of oil showed there is a direct correlation between the two meaning an increase in oil price leads to an increase in the cost of capital for an oil and gas company.
As a result, balance sheet retentions become more expensive against buying insurance and as the oil price decreases the opposite is true. This reflects the need for your capital to work harder when oil price is high.
Our actuaries have analysed the relationship between cost of materials in the energy sector and changes in the oil price.
A regression analysis of oil price movement against IHS Markit Capital Indices allows us to predict the estimated rebuild and replacement costs at a given price point. In the event of an increase in the oil price, demand for materials increases as development activities increase. This means the costs of the real value of deductibles, EMLs and limits are eroded as the average cost of claims increases.
Risk Finance Optimisation helps companies determine and design the optimal insurance programme.
Marsh JLT Specialty experts work with businesses to build an understanding of their appetite for insurance risk.
They apply advanced, industry-specific risk analytics and insurance market knowledge to create alternate, viable policy structures.
By pricing these using our Economic Cost of Risk model, we can identify the optimal insurance programme structure while providing valuable governance evidencing how decisions were taken.