Earlier this year, the Wall Street Journal interviewed Myron Scholes, the Nobel Laureate economist who, with Fischer Black, devised the Black-Scholes stock option pricing model. One of his comments struck me as particularly salient to the risk retention vs. risk transfer decision-making process.

He said, "I don't see...hedging of generalized risks as being unto itself. I see the cost of using those contracts as competing with the cost of equity. We'll see more substitution of risk management for equity."

He was referring to financial risks, but his logic extends to insurable risks as well. When companies retain risk, whether they recognize it or not, they place their equity at risk. Conversely, when they purchase insurance, they purchase the right to access another company's capital given the occurrence of a specified event. Insurance is a form of off-balance-sheet, contingent capital.

Returning to Mr. Scholes' remark in the context of the decision to retain vs. risk transfer, since all equity has a cost and retained risk places owned equity at risk, what is the true cost of retaining risk vs. transferring risk?

Historically, risk managers measured the cost of risk as including insurance premiums, the amount of retained risk, and the frictional expenses associated with preventing losses and managing claims. For small and midsize companies that count their retained risk as the sum of their insurance deductibles, this formula suffices. However, large companies--especially public companies--that choose to manage significant amounts of retained risk should recognize a charge when they calculate their average cost of capital.

In fact, retained risk is but one component of the variables that comprise a company's capital charge for risk. Insurance premiums and the limits purchased also comprise forms of capital, albeit devoted to insurable risk. Taken together, these three components form a company's insurable risk hedging strategy.

According to Mr. Scholes, we must be able to compare the marginal costs of risk-bearing equity (retention) against the relative cost of buying insurance. Furthermore, Mr. Scholes thinks that the latter, what he calls "risk management," may at some level replace equity. To some people, this might seem reasonable in the context of financial risk, but it is a radical departure from the risk management orthodoxy of retaining huge amounts of risk to keep insurance premiums as low as possible.

Of course, the orthodoxy has merit up to a point. If companies successfully control their insurable risks and losses are minimal, there is no good reason to buy first-dollar insurance and avoid trading dollars with the insurer. However, consider the question from a cost-of-capital perspective. Which is more expensive--owned capital or nonowned capital?

Usually, owned capital is more expensive.

Risk specialist firms, or insurance companies, often can provide their capital at a lower cost than can the company considering the huge risk retentions. This might sound counterintuitive, especially in light of the fact that most large firms faithfully follow the orthodoxy. The problem, of course, is that without a way to calculate a capital charge for your hedging strategy, there is no way of knowing where the most efficient nexus of risk retention and transfer exists.

Current practices

A quick review of current practices illustrates the problem. Most large companies retain most of their actuarially expected losses, as well as significant amounts of risk for which no predictive methodology exists; directors and officers liability is one example:

Company A purchases $100 million of D&O insurance for $3 million in premium, in excess of a $10 million deductible. In total, Company A has $107 million in risk capital from two sources of capital: retained losses (equity) and purchased insurance limits, and one use of capital--the insurance premium. Let us further assume that Company A is a public company. As we know, public companies' stock prices should reflect all of the risks investors assume when purchasing the stock. This is the basis upon which all markets operate.

In this case, however, the shareholders are unaware that a significant D&O loss may impair the company's equity, as the chief financial officer did not include an appropriate capital charge, also known as a risk premium, in the company's weighted average cost of capital. So the stock price does not reflect its potential.

We can debate the relative materiality of the amount of additional risk created by the potential D&O loss, but it exists nevertheless.

As I noted above, a risk capital charge involves more than just retained risk; it should reflect the company's entire hedging strategy. In the next article I will discuss the concept of marginal utility, its impact on the retention/transfer decision and its importance in calculating a capital charge for insurable risk-hedging strategies.