With risk modelling capabilities on the rise, firms are looking to optimize their insurable risk transfer and retention strategies to protect their balance sheets.
Analysing financial exposures like interest rates and FX risk is commonplace among large organisations. Yet many of them still treat insurance as a commodity, to be bought on a transactional, cost-driven basis.
While this can offer short-term gains, a more strategic approach to financing insurable risk can prove more efficient.
However, it’s important that risk managers can communicate to senior management the benefits of taking a strategic approach. These include balance-sheet protection and the containment of financial volatility within tolerable levels.
“Organisations often purchase insurance to cover risks that their businesses could quite comfortably accept – while not always protecting themselves adequately against other risks,” explains Adrian Donald, Partner at JLT Specialty.
“A more strategic risk financing approach helps insurance buyers to identify the risks they should and shouldn’t retain, and assess where insurance is of value in protecting the company.”
What does a risk finance process involve?
According to Emma Craddock, Partner at JLT Re, a risk financing approach comprises four key stages:
- Establishing risk tolerance and appetite
- Modelling risk
- Identifying transfer options
- Delivering the right solution
1. Risk tolerance and appetite
The organisation must first identify its risk tolerance: that’s the amount of unfunded volatility or losses it is able to absorb without impairing its key financial metrics. Then it must identify its appetite, or willingness, to absorb risk on its balance sheet.
Craddock says: “Establishing a company’s risk appetite means understanding several parameters: its financial objectives in particular, but also how its financial results compare with its industry peers and how the firm perceives itself within its sector.”
Financial objectives can be expressed in various ways: for example, a return on equity target, dividend growth, or a financial rating. It’s essential to understand how big a financial loss the organisation can withstand, without adversely affecting its chosen metrics.
And Donald notes: “Insurable risk is one of many factors that can influence a company’s tolerance, along with variables like interest and FX rates and commodity prices. Decision-makers must consider how much equity they’re willing to expose to the volatility associated with the company’s insurable risks.”
2. Modelling risk
Once the risk appetite is understood, the next step is to identify the risks with the biggest material impact on the organisation.
These could range from natural catastrophe risks, such as flood or earthquake exposure, to cyber risks, terrorism or a host of liability exposures – every company and sector has its own unique challenges.
With the key risks identified, a broker can use information from the company, insurance claims data and risk modelling techniques to analyse their financial implications.
“We use a combination of commercial models and our own proprietary modelling software,” says Craddock.
JLT’s in-house modelling capability includes models for construction, terrorism, earthquake, cyber, offshore energy and marine risks. These provide some indication of the size and probability of potential losses from a selected risk. This helps the organisation to decide the size and type of risks it makes sense to retain, and which to transfer.
3. Transfer options
The risk profiles are then modelled against various risk transfer options. This helps the company to decide whether it’s more cost-effective to fund expected losses using its own capital, or to use the insurance market based on the value each option has in protecting the balance sheet.
“This shows the cost, benefit and risk-reward of the company’s current insurance structure, compared to other risk transfer and self-insurance options. It demonstrates which risks might be best retained or funded within a captive subsidiary, and which should be insured externally,” says Craddock.
Donald adds: “If insurers price your exposures above your cost of capital, you’re arguably better off retaining the risk, provided it’s an exposure that’s also within your risk appetite.”
4. Delivering the solution
The last step of the risk financing process is three-fold:
- Negotiating broad, cost-effective cover with the firm’s chosen insurance providers
- Overseeing the seamless transfer of any self-insured risks into a captive vehicle where necessary
- Implementing any risk management measures identified during the analysis
Armed with knowledge obtained from the previous three stages, and with a clearer assessment of where insurance is valuable, a company can evolve from being a reactive buyer of insurance to a proactive seller of risk.
The importance of regular risk financing reviews
The whole risk financing process should be revisited periodically, to take account of changes to the organisation or its operating environment.
“A business’s attitude to risk and balance-sheet volatility can change with its objectives and operating environment,” says Donald, who gives the energy sector as an example.
“Five years ago, with oil at $100 per barrel, energy players may have been bullish about their ability to absorb losses,” he says. “But at $40 per barrel, they won’t be generating as much cash. So their attitude to unexpected, unfunded volatility may have changed markedly.”
Mergers or acquisitions can also be a reason for a company to re-evaluate its risk appetite, he adds.
Risk financing is often the preserve of larger organisations with flexible balance sheets. But Donald points out that mid-size companies with challenging risk profiles can also benefit.
“It’s a good way for any business to look at how it uses insurance,” he says.
What’s more, a rigorous risk financing review can help insurance buyers to articulate its benefits to senior management.
“The industry hasn’t been good at expressing the value of insurance in financial terms,” says Donald. “So the value is inevitably measured by cost. Explaining how insurance is being used to protect the balance sheet makes the discussion more relevant for CFOs and treasurers.”
For more information, please contact Emma Craddock, Partner at JLT Re on +44 (0)20 7528 4629 or email email@example.com
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