Risk Management

Wanted: Risk Data to Support Insurance Buying

Calculating the intrinsic value of a risk can provide companies with a gold standard for effective insurance buying.
Rich MichelSeptember 19, 2014

In early 2014, we conducted research with a select group of 50 key executives and risk managers at companies within the Russell 2500™ Index to learn more about their risk management practices and perspectives. A large majority, 84% of them, said it was somewhat important or very important to measure risk — mainly to support decision-making, understand risk appetite and prioritize resources to the largest risks. But we were surprised to learn that more than half of those participants said they rely on subjective methods, such as the individual judgment of business leaders (66%) or team-based decision making (50%) to evaluate risk reward/tradeoffs.

When we asked what insurance-purchasing-process respondents would most like to see improved, the top two responses were:

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

  • Use of data and related analysis to support a purchasing decision framework; and
  • Persuasive use of data by external providers in developing a marketing approach.

On some ancient maps the words “Here be dragons” are written just beyond the edge of the known world as a warning to travelers that they were entering the unknown. For risk managers, the dragons are “Black Swans,” events we cannot predict. Some people argue that risk is uncertainty and no amount of analysis will change uncertainty into certainty.

But the existence of Black Swans, or dragons for that matter, doesn’t reduce the value of having a reasonably accurate map of the known world of risk. Measuring risk may be more like dead reckoning than precision navigation, but it allows us to make better informed decisions about risk/reward tradeoffs and whether or not buying insurance delivers real value.

Data in Insurance Marketing

While some insurance brokers speak proudly of their leverage or clout in the marketplace, the truth is that the most powerful thing a broker can bring to the market is a client with a great story to tell. Companies that can factually demonstrate a high quality of risk mitigation and control, as well as an ongoing commitment to excellence in risk management, will always get the best deals.

Rich Michel, risk management national practice leader, Wells Fargo Insurance Services USA.

Rich Michel, risk management national practice leader, Wells Fargo Insurance Services USA.

The more data available to forecast the effect of a company’s risk-mitigation efforts, especially the potential future reduction in frequency and severity of losses, the more credible the facts and the more powerful the story. Amassing such data is the only sustainably successful insurance-purchasing strategy, one that will deliver the best deals year after year, regardless of market conditions. All risk management activity, 365 days a year, should be directed towards building a strong story and reducing risk, cost and the need for insurance.

Evaluating Risk-Reward Tradeoffs

Getting the cheapest-priced deal available in the marketplace doesn’t necessarily mean you’re getting good value for your money. In order to determine if you are receiving good value, you need to do more than compare competing quotations from the market. You need a gold standard.

Companies have finite financial capacity to take risk; and without risk, there is no opportunity for gain. That means that taking risk is an essential need for every company seeking to profit or achieve some objective of value.

A company’s risk-bearing capacity is essentially the sum of its available cash and its ability to raise debt. Using risk-bearing capacity to support the case for risk-taking means limiting the ways in which that available capital can be used. By measuring the internal rate of return such capital could achieve if invested into the business rather than being held in reserve, it is possible to calculate a minimum threshold of return needed to justify the use of available risk-bearing capacity.

Given this minimum rate of return, the intrinsic value of each risk — a company’s internal cost to retain or self-insure the risk at break-even over time — can then be calculated. This intrinsic value of a risk is the sum of the expected average cost of a loss or losses to be retained, a risk charge based on the difference between the expected value of losses and a high-confidence-interval outcome (about 95%), a charge for the risk-bearing capacity needed to support taking the risk, and any other expenses associated with retaining it. All of these elements are derived from the risk measurement process.

With the intrinsic value established for each risk, a company can evaluate the full range of risk solutions available. If a solution is found that’s cheaper than the intrinsic risk value, it would add immediate economic value to the business to implement it rather than retain the risk. If all the solutions are more expensive than the intrinsic value, and the company has risk-bearing capacity to assume the risk, doing so with the lowest cost solution that meets your needs will be the most cost effective action.

Once this framework is established, risk measurement and the analytical processes that support it can play a powerful role in getting insurers to cover risks as well as evaluating risk-reward tradeoffs in the decision-making process. Using the intrinsic value of each risk as the gold standard of value, it is possible to set target pricing for the market to beat using credible facts and a powerful story to support the presentation to underwriters.

Rich Michel is the risk management national practice leader at Wells Fargo Insurance Services USA.