Understanding the cost of risk

The cost of risk is misunderstood. Far too many businesses calculate the total “cost of risk” as the money they pay away in insurance premiums. Nothing could be further from the truth...

Companies face more risk today than ever before. Management has to consider the threat posed by fire, theft, regulatory compliance and the environment – as well as employee risks such as staff turnover and the loss of key individuals, among others.

A sound risk management strategy entails identifying relevant risks to your business, mitigating these risks by implementing controls to reduce the risk probability and introducing efficient financing methods to cover the risk severity in the event the loss occurs.

Severity and Probability

The severity of a risk, usually expressed in financial terms, is the impact the event would have on the business whereas probability refers to the likelihood of the event occurring at all. While the rating of risks is subjective and unique to each business, all companies face a serious risk when high or medium probability intersects with high or medium severity. You should take actions to mitigate such risks as a matter of urgency.

The key objective of risk mitigation is to create a residual risk environment that your company is comfortable with. You can reduce the severity of losing a key individual by introducing succession planning, while the probability of this risk can be addressed by implementing an incentive-based staff retention plan.

The cost of risk

Insurance – the transfer of risk to a third party – is an efficient method of financing the severity of a risk. Many people consider the insurance premium to be the total cost of risk – but there are “costs of risk” that are not transferred to the third party. In other words the critical components of “costs of risk” include the price paid for insurance and the cost of any uninsured losses.

A company’s decision to insure or retain risk is guided by the cost of insurance relative to the perceived benefit of the protection purchased, the capacity and appetite of the insurance market to accept the relevant risk, the ability and capacity of the company to retain risk, and the relevance the company assigns to the particular risk.

Striking a balance

The cost of insurance is a function of supply and demand so we can assume this is an efficient method of financing risk. But the optimal solution is not readily evident when determining the cost of risk retained.

Your risk management strategy must consider the most efficient method to finance risk retention. A first option is to do nothing – and proceed on the basis there will be sufficient income and cash to cover uninsured loss events.

A second option is to secure a line of credit from the bank as a contingent liquidity facility. You have to pay a fee for this facility, which could also hamper your ability to secure credit for other purposes.

And third, you can choose to build up a reserve by setting aside cash. The obvious problem is that the company may not have sufficient time to build up a reserve before the loss occurs… The reserve is not tax efficient either, as it is set aside from after-tax money!

Retained risk solutions

The insurance industry has structures to assist risk managers in “covering” risk retention. Policies exist to participate in the risk by the insured and reward sound risk management by the payment of profit commissions back to the insured. Policy premiums are calculated as a function of the amount of protection required.

The premium is typically tax deducible and you are covered for the full amount at policy inception, notwithstanding that premiums calculated to finance this amount may be paid over several years.