ECONOMIC COST OF RISK
Making Better Risk Financing Decisions by Measuring the Value of Uncertainty
Insurance purchasing decisions are decisions about how best to finance risk.
How much capital should be put at risk, and at what point is it better to transfer risk to an insurer?
Construction companies can make informed decisions by viewing these questions through the lens of economic cost of risk (ECOR). ECOR can be defined
as the sum of:
• Expected retained losses
• Other expenses (e.g., claims handling fees and collateral cost)
• Implied risk charge
Companies traditionally think about the first three bulleted components
when measuring the cost of insurable risk. Unfortunately, it places no value
on uncertainty, instead treating losses as a known quantity. Of course, the
amount of losses at any one company fluctuates unpredictably from year
to year. The more volatility, the more a company should be willing to pay a
premium to remove that volatility.
As an example, consider two hypothetical companies with the following loss
histories (assuming constant size over the past five years):
Both companies have an average loss of $10 million per year. Traditional
metrics might suggest that there is no difference in the cost of risk for these
two companies. However, there is much more volatility in Company B’s losses,
which can lead to unexpected and unpleasant impacts on earnings and performance. The cost of risk for Company B is intuitively higher than Company
A because of the higher downside risk. The question then becomes how to
value this additional cost of risk.
An implied risk charge (IRC) is the key component of ECOR that measures the
value of this volatility, and differentiates ECOR from traditional total cost of
risk (TCOR) calculations.
IRC is computed as the capital at risk multiplied by the company’s cost of capital. Capital at risk is estimated as the expected losses above average losses.
Stochastic modeling is typically used to measure IRC. However, for purposes
of simplicity, the following methodology is based on historical losses used in
the earlier example.
For Company A, average losses are $10 million, and there is one year (2011)
with losses above this amount. Therefore, in the example, total losses above
the average are $1 million ($11 million minus $10 million). There is a 20%
chance of experiencing losses above the average (one year out of five).
Therefore, expected losses above the average annually are 20% multiplied by
$1 million, or $200,000.
For Company B, average losses are also $10 million, but there are two years
with losses above $10 million (2009 and 2011). Therefore, total losses above
expected are $13 million (the sum of $15 million minus $10 million = $5 million, and $18 million minus $10 million = $8 million) and average losses above
expected are $6.5 million (the average of $5 million and $8 million). There is a
40% chance of experiencing losses above the average (two years out of five).
Therefore, expected losses above the average are 40% multiplied by $6.5 million, or $2.6 million.
The IRC for Company A is $200,000 multiplied by the company’s cost of capital. In relation to ECOR, this is a trivial amount, which should be the case when
losses are highly predictable.
The IRC for Company B is $2.6 million multiplied by the company’s cost of
capital. This becomes a significant cost component of ECOR and, in this
example, is more than 10 times higher for Company B than Company A. This
should be the case when losses are highly volatile, particularly when considering that the capital is at risk for the lifetime of the claims rather than only a
short period, such as 12 months.
MAKING RETENTION & LIMIT DECISIONS WITH ECOR
Now consider the decision-making process for Company A and Company B in
determining the amount of risk to retain vs. the amount of risk to transfer to
the insurance market. Company A is likely to be in a better position to retain
most or all of the risk, while Company B is more likely to transfer a portion of
the risk to protect its balance sheet from volatility.
An ECOR calculation can help in determining which retention and limit
option provides the lowest true cost to the company. The process is similar to
evaluating ECOR from a ground-up perspective as in the previous example.
Both expected losses and IRC can be computed with respect to retained
losses. By adding premium and other costs associated with insurance, total
ECOR can be computed for any retention and limit combination. ECOR can
be compared across structures and can also be compared to ECOR from a
ground-up perspective. Companies can use this information to choose the
most economically efficient insurance structure that stays within the bounds
of their own risk tolerance.
Consider the hypothetical ECOR example for Company B from a ground-up
perspective and for three separate retention options: $250,000, $500,000, and
$1 million. This example only focuses on the impact of retentions. The same
type of analysis could apply for limit/retention combinations as well.
Each option shows the main components of ECOR: average retained loss,
implied risk charge, and premium (where applicable), in millions of dollars.
Without inclusion of the IRC, the economic value of each retention option is
identical at $10.5 million (expected retained losses plus premium). However,
when calculating in Company B’s implied risk charge, the $250,000 retention
proves to be the best economic value.
Per Occurrence Retention ($M)
Ground-Up $250K $500K $1M
Average Retained Loss $10.0 $6.5 $7.0 $8.0
Implied Risk Charge $1.5 $0.5 $0.7 $1.0
Premium N/A $4.0 $3.5 $2.5
Total Economic Cost of Risk ($M) $11.5 $11.0 $11.2 $11.5
EVERY PENNY COUNTS
Reducing Workers’ Comp Costs
Year Ground-Up Losses ($M)
Year Ground-Up Losses ($M)