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How to Gauge the Cost of Corporate Risk

The rising expense of insuring property can hurt a company’s cost of capital.
Caroline McDonaldJuly 5, 2012

With earthquakes in Japan and New Zealand, floods in Australia and Thailand, and tornadoes in the United States causing large insured losses last year, it’s no shock that the total cost of risk (TCOR) — a widely used metric of corporate expense for insuring and managing risks — rose in 2011, according to a recent risk-management survey. The surprise is how little it went up.

Released in late June by the Risk and Insurance Management Society, the 2012 RIMS Benchmark Survey indicates the TCOR increased just 1.7%, from $10.02 per $1,000 of revenue in 2010 to $10.19 per $1,000 of revenue in 2011.

Why? Despite the high amount of its insured losses — estimated at $116 billion by Swiss Re — the property-casualty industry remains overcapitalized, keeping pressure on rate levels, according to the survey, which was produced in conjunction with RIMS by Advisen Ltd. and is based on data contributed by risk managers at more than 1,000 companies.

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Still, commercial insurance rates, mostly for property coverage, are rising. “Globally, 2011 was a near-record year for insured catastrophe losses. As a result, the price of property-insurance coverage increased for many insureds, especially in catastrophe-exposed areas,” says Dave Bradford, president of the Research & Editorial Division of Advisen, who edited the survey. Indeed, the property-insurance component of average risk costs grew nearly 9%, from $2.73 per $1,000 of revenue to $2.92 per $1,000 of revenue.

How important an expense could that be for CFOs? The rising cost of paying for property losses could have serious consequences for the many finance chiefs still trying to keep their corporations’ assets as liquid as possible, believes Lance J. Ewing, hospitality and leisure industry practice regional leader at Chartis, an insurance company owned by AIG.

“Liquidity is going to be at the top of a CFO’s priority list right now,” says Ewing, previously a corporate risk manager and a past president of the Risk and Insurance Management Society. “So when things like letters of credit or collateral begin to affect the credit ratings, that has to be bundled into TCOR.”

Ewing explains that under many property-casualty insurance contracts, a corporation must provide collateral to guarantee a source of funds in the event it can’t pay its insurance premium. The three most common forms of collateral are letters of credit (LOC), market securities, and cash. (The LOC is a promise to pay, leveraged against the insured company’s financials.)

Overly generous LOCs can curtail companies’ borrowing power, “and the amount of available credit diminishes with each LOC,” says Ewing. “That may also affect their credit ratings.” Thus, CFOs needs to make sure the LOC is not allocating more loss funding than the insurer requires. “That would needlessly tie up precious company capital,” he says.

What Is Total Cost of Risk?
What is TCOR? According to a white paper, “Measuring the Total Cost of Risk,” published by The University Risk Management & Insurance Assn., the formula is: premiums + retained losses + administrative expenses = total cost of risk. Here is what the components mean:

• Premiums are the amount of money paid to insurers by commercial insureds to assume property, commercial general liability, worker’s compensation, aviation, auto, directors’ & officers’, employment practices liability, and other risks. Premiums also include the money companies set aside for losses for those specific risks they chose not to transfer to an insurer.

• Retained losses are those a company pays for, either by means of a captive (a self-owned insurance company) or corporate self-insurance.

• Administrative expenses include claims-management expenses and collateral cost. Claims-management costs are incurred for the administration of self-insured losses. Collateral costs are the expense of setting collateral against self-insured losses.

Despite the existence of the formula, “there are variances in how companies account for the cost,” says Claude Yoder, global head of analytics for Marsh, the big insurance broker.

For retained losses in particular, Yoder says, “best practice would be to have an actuarial estimate of [the cost of] ultimate losses for the year or time period in question.” In essence, that means using accrual accounting, in which revenue and costs are both recorded when they are incurred.

Less helpful in terms of booking retained losses is the common practice, mostly among smaller companies, of using cash accounting, in which revenue is recorded regardless of the matching costs. The use of cash accounting can present a misleading view of the cost for that category, says Yoder.

One of the challenges in accounting for insurance is that the cost of loss events is not known immediately. In the event of a worker’s comp loss, for example, an initial reserve amount may be set up. In the case of an employee at a manufacturing plant with a back injury, a $10,000 reserve may be set up as a best estimate of how many dollars might end up being spent. “But the fact is that the back injury might end up being $1.5 million, or it may amount to very little,” says Yoder.

A problem in dealing with unknowns in the cost of risk is that investors dislike unpredictability, says Charles Mulford, a professor of accounting at Georgia Tech.

CFOs should pay special attention to the decision of whether or not to self-insure, since the outcome can affect an organization’s earnings as well as its cost of capital, he observes. Even though self-insuring may be cheaper than buying insurance, it can create unwanted ups and downs. When a company pays a premium to an insurer to cover a risk, the company knows exactly what its total cost will be for that risk, says Mulford, adding that that makes for smoother earnings reports.

But if a company self-insures, earnings statements are apt to be more volatile. “To an investor, that earnings stream appears to be riskier,” he says. As a result, a company that self-insures may be paying a higher cost of capital. “That hidden cost in the total cost of risk is not so apparent and may not be one that CFOs are thinking about,” says Mulford.

Another point is that the collateral companies often set aside to cover self-insured losses tends to be placed in low-yielding, liquid assets. But “if you use an insurance company to offload those risks, you don’t have to have those assets in low-yielding vehicles. That can also help to boost profits,” says Mulford, noting that such low yields may be a “hidden cost” of self-insuring.

The takeaway, Mulford notes, is that the cost of risk “includes many more things than simply looking at the cost of insurance versus the actual losses incurred if we have to cover a loss ourselves. The costs go beyond that.”

The 2012 RIMS Benchmark Survey is available for purchase at the society’s website. Data contributors receive the book for free, according to RIMS.