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Risk management and the cost of risk

26 July 2008 Neil Ashcroft (Pictured) ,Marketing Director, Centriq Insurance

Risk management is a critical part of good corporate governance to ensure a company’s sustainability and protect shareholder value. One aspect of this, the cost of risk, is often not fully understood. Neil Ashcroft, marketing director of Centriq Insurance, sheds light on this important factor of risk management.

The cost of risk is often misunderstood because it covers such a wide spectrum, namely the entire cost of risk to your business. In terms of the principles of good corporate governance, a company should identify and assess the many varied risks it faces. These include physical risks such as fire, explosion and theft; employee risks like staff turnover, loss of key individuals and poaching; regulatory compliance, environmental risks, and business risks relating to the changing market place such as product obsolescence and economic turndown, to name but a few.

Once the company has a holistic view of the risks it faces, each risk should be rated in terms of severity and probability. (See Severity and Probability)

Severity and Probability

Severity:

Severity, usually expressed as a financial impact, refers to the impact the event would have on the business.

For example:

Would it cause a complete collapse of the business, or just a temporary interruption of business activities should the event occur?

Probability:

Probability refers to the likelihood of the event occurring.

For example:

The risk of a competitor poaching a key individual from a company is far greater as a result of the critical skills shortage.

While the rating of risks is subjective and unique to each business and its particular circumstances, all companies face a serious risk when high or medium probability intersects with high or medium severity. Actions to mitigate those risks should be taken as a priority.

Actions to mitigate risks

Actions to mitigate risks would typically focus on reducing both the severity and probability of identified risks.

For example, if the loss of a key individual will have a severe impact on the business, the impact can be reduced by succession planning while the probability of losing a key individual can be reduced by, for example, implementing a share option scheme to create an incentive retention plan. Therefore, the key objective behind a risk mitigation plan is to create a residual risk environment that the company is comfortable with. Once the company has reached this stage, it should also introduce appropriate methods of financing the residual risk should the event occur.

In summary:

Sound risk management entails identifying relevant risks to the business, mitigating them by implementing controls to reduce the probability as well as introducing efficient financing methods to cover the severity in the event the loss occurs.

Calculating the cost of risk

One efficient method of financing the severity of a risk may be to transfer it to a third party. This is where insurance coverage comes in. Insurance obviously comes at a cost, and it is this cost that many people consider to be “the cost of risk”. It is however important to note that while this cost is certainly a major element in determining the cost of risk, it is not the sole element to consider. Equally important is the cost of risk retained, i.e. the risks not transferred to a third party that can result in a loss to the business.

The two most critical elements to the cost of risk are therefore the price paid for insurance as well as the cost of uninsured losses. A company’s decision to insure or retain risk generally constitutes a number of factors, namely:

  • 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.

Risk retention

As the cost of insurance is a function of economics; i.e. supply and demand, one can assume that this is an efficient method of financing risk. However, the same is not as readily evident in the cost of risk retained. A company’s risk management strategy needs to consider the most efficient method to finance risk retention.

In these considerations several options exist.

One option is for the company to simply do nothing, believing that they will have sufficient income and cash to cover the loss as and when the incident occurs. Depending on the level of risk retention, this option could introduce significant volatility into earning streams and cash flow requirements in the company that are difficult to plan around. Another option may be to secure a credit line from the bank as a contingent liquidity facility. This option will incur a commitment fee and may also hamper credit lines potentially required for other purposes. A further option is for the company to build up a reserve by setting aside cash on a systematic basis. The obvious problem is that the company may not have sufficient time to build up a reserve before the loss occurs, and also that the reserve is not tax efficient as it is set aside from after-tax money. This effectively increases the cost of risk by the relevant tax rate applicable to the company, normally 28%.

As a solution to this particular challenge the insurance industry developed structures to assist risk managers in obtaining financial protection for risk retention. These structures are insurance policies that enable participation in the risk by the insured and reward sound risk management by the payment of significant profit commissions back to the insured. The policy premiums are calculated as a function of the amount of protection required, and as the premium is typically tax deducible, there is no tax frictional cost in this calculation. Furthermore the protection for the full amount is available at inception, notwithstanding that premiums calculated to finance this amount may be paid over several years.

By Neil Ashcroft, Marketing Director, Centriq Insurance

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