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Figure in cost of capital and appetite for risk


Many organizations base their current insurance program on a series of independent decisions made over time. Each single coverage decision is rational, but the aggregate result, when viewed as a portfolio, may not be cost effective or coherent.

An increased focus on creating shareholder value and capital efficiency causes the senior management in many firms to re-examine their insurance programs. Specifically, firms are beginning to use a capital efficiency approach that considers an organization's cost of capital and its overall appetite for risk in evaluating the economic efficiency of insurance purchases.

Challenging the natural presumption that it is cheaper to buy insurance to finance risk than to use the organization's own capital, insurance optimization identifies how much capital the organization places at risk and estimates its cost. Essentially, if the insurer's price--based on its risk-adjusted return for providing coverage--costs less than if the organization self-insures, then the risk should be ceded. If not, the risk should be retained. The risk adjusted return is the difference between the economic cost of risk before and after insurance.

The economic cost of risk is the sum of three components: insurance premiums, expected retained losses and the capital charges for retained risk. The inclusion of a capital charge puts a value on the capital that is exposed to unexpected retained losses, and corresponds to an organization's cost of finance. If the ECOR is lower with insurance coverage than without coverage, then insurance is economically justified. While simple in concept, insurance optimization raises many broad questions that tie directly into the core concepts of enterprise risk management and risk appetite, and it blurs traditional distinctions between insurable and noninsurable risk.

Risk appetite refers to the variability in results that an organization and its senior executives are prepared to accept in pursuit of a stated strategy, coupled with an assessment of which risks are aligned with the strategies of the organization and which are not. Reconciling the overall risk appetite of the organization--defined as the amount of variability in results that an organization is willing to accept in the pursuit of stated strategies--with the various viewpoints of internal and external stakeholders, enhances decision-making across the organization and provides a framework that defines what "too much" or "too little" risk really means for the organization.

The insurance optimization approach effectively incorporates the firm's risk appetite into the overall risk management program. It also balances the use of insurance against the retention of risks, maximizing the value of firm's capital. The basic premise of insurance optimization can be simplified into five steps.

Steps to take

1. Deconstruct the current program and develop a list of possible alternative. Each component must be analyzed fully and understood in terms of individual claim retentions, aggregate retention and policy limits--along with the attachment point of umbrella programs and the limits of those programs. Multiple alternative "straw man" insurance programs are then developed that consider the needs of the organization as a whole, as well as each division of the organization and each division's alignment to the organization's risk appetite. Any insurance program that cannot reasonably be placed should be eliminated.

2. Build an integrated loss model. An integrated loss model must include simulated gross claims for all risks an organization wishes to cover with its insurance program. The risk model must be comprehensive and integrated to reflect reality. An organization as a whole does not face risks from each potential occurrence individually, but rather, all the risks, taken together can threaten the organization.

3. Estimate premiums for each type of coverage in each program structure. The premium for each potential insurance program structure must be determined. This has to be done without going to market as the market will typically use price to steer the decision to the coverage it wants to sell.

4. Develop the optimal program from a risk/return perspective for each program structure. The economic cost of risk and risk-adjusted return numbers for each program under consideration are then calculated using the loss model. Once the structures have been modeled, each alternative program's ECOR is plotted against its RAR to yield a clear picture of the risk-return payoff for each alternative.

5. Go to market. To select which insurance program structure to take to market, the organization must define an amount of capital to place at risk to cover the retained losses. As noted above, the decision should be consistent with an organization's risk appetite. This process will provide the information necessary to better understand the organization's desired coverage to allow it to negotiate the best possible deal in the marketplace.

Traditionally, it has been practical for most organizations to manage risks by sharing them with established insurers. However, in today's volatile and highly competitive markets, that approach may not necessarily be the optimal one. Insurance optimization is an emerging technique any organization can use to identify the most efficient program for managing its risks and maximizing its capital.

Alex Wittenberg is managing director and practice leader of Enterprise Risk Consulting at Mercer Oliver Wyman in New York. He can be reached at