How to maintain capital by revisiting your risk profile and financing options Featured

8:00pm EDT July 26, 2010
Craig Nelson, Senior consultant, Towers Watson

When it’s easy to secure insurance coverage or hard to fathom a catastrophic loss, executives may have little interest in reassessing their company’s risk profile or exploring financing options. But complacent risk practices can leave companies at the mercy of changing market conditions and burgeoning exposures at a time when preserving every dime of capital is critical to business survival.

“Buying insurance may seem like a necessary evil, but funding an unanticipated loss is worse,” says Anne Petrides, senior consultant and actuary for Risk Advisory and Brokerage Services at Towers Watson. “Unless organizations have gone down the path of assessing how much risk they want to assume and developing a financing strategy, they could face an unwelcome surprise.”

“Many firms would be unable to exist in their same form following the extreme financial volatility imposed by a catastrophic event,” says Craig Nelson, senior consultant for Risk Advisory and Brokerage Services at Towers Watson. “The time to look at worst-case scenarios and explore mitigation strategies is before you enter the marketplace.”

Smart Business spoke with Petrides and Nelson about the need for disciplined risk fundamentals as part of a plan to preserve capital.

Why conduct an annual risk review?

Petrides: Risk tolerance is the cornerstone for all risk decisions and everyone from board members to shareholders must be comfortable with the company’s profile and appetite for risk. Executives should review each risk category on a periodic basis to decide how much exposure they wish to retain, from all categories of risk for a single event and in the aggregate. Realistically, companies will face trade-offs when they enter the marketplace but they need to anticipate their choices, calculate the impact and not let the marketplace dictate their risk tolerance.

Nelson: Although we don’t know if British Petroleum has enough (or any) insurance to cover claims in the Gulf of Mexico, the event is a reminder that all scenarios and stakeholders must be considered while constructing a profile and the possibility of a catastrophic event warrants executive attention. While most large companies might survive a catastrophic event like this, most would suffer severe damage to shareholder/stakeholder value. So, in many respects, it’s not so much survival versus nonsurvival, but what you are going to look like after the event and how long it will take to recover. By their very nature, a major earthquake, hurricane, or even a large, unanticipated liability claim can occur without warning.

What data should be included in the review?

Nelson: Companies should use sophisticated data modeling techniques and software to predict future claims by analyzing prior losses. The review may expose savings opportunities through the strategic acquisition of additional risk or reduction in the frequency or severity of claims through loss control or safety measures. In the world of property insurance, historical analysis has given way to predictive modeling that includes a real-time view of major events such as brush fires or windstorms and forecasts the probability of such events within a relative range of certainty. The model shows how these events have historically played out, which helps companies develop contingency and mitigation plans to avoid business interruption and sustained revenue losses.

Petrides: Sophisticated organizations have been collecting data for long periods of time and, based on the credibility of that information, can parameterize models using analyses of this data. Whatever metrics you use, it’s important to model the cost of capital and the equity costs associated with changing retention levels before you decide on a risk financing strategy. Insurance should be viewed as contingent capital rather than an expense. Additionally, the domino-like financial ramifications associated with a major event, like lower credit ratings, increased debt obligations and client defections should be considered in the modeling exercise. Overlay different variables to estimate the financial impact of each scenario before finalizing a risk statement and financing strategy.

How can companies optimize insurance purchases through data?

Nelson: Whether the insurance market is soft or hard, leverage your negotiating power by determining your risk tolerance up front, surveying the marketplace and dictating your retention levels before you enter the market. If you find a deal, it may make sense to purchase additional coverage and reduce your risk, but conversely, a company should never take on more risk than it can withstand.

Petrides: Companies can use predictive models or more sophisticated models to help negotiate higher coverage limits and pricing concessions when they enter the market. The data and analyses may establish your company as a premium risk, which will open the door to additional markets or justify higher retention levels.

Which alternate financing strategies are worth considering?

Petrides: Flexing your model or using a blended approach can be advantageous when dealing with a volatile market. There’s nothing wrong with purchasing additional insurance today, if it offers greater financial security, and returning to higher retentions when the market hardens.

Nelson: The tax benefits associated with captives, such as accelerated deductions for losses, have made them very attractive. But we’re also seeing some industries utilize captives to get into the risk management business and turn it into a profit-making venture. Offering buyers extended warranties is one example, another is offering renters of self-storage units property insurance. Not only does it allow the risk taker to make a profit, it may curtail claims, in the event customers search for a deep pocket to cover uninsured losses. The options and models are almost limitless, but a successful risk strategy always begins with a well-defined risk statement.

Craig Nelson is a senior consultant for Risk Advisory and Brokerage Services at Towers Watson. Reach him at (303) 628-4026 or craig.nelson@towerswatson.com. Anne Petrides, FCAS, MAAA, is a senior consultant and actuary for Risk Advisory and Brokerage Services at Towers Watson. Reach her at (415) 836-1109 or anne.petrides@towerswatson.com.