Businesses in both public and private sectors look to improve the efficiency and effectiveness of their services. Risk management is no exception. A business desires its risk management efforts to add value to the organisation. This means that risk management activities from resources within the organisation as well as from external service providers like consultants and insurance brokers must be efficient and effective.

The cost of risk too is no exception. This cost comprises costs of losses, insurances and related overheads. Businesses wish to keep these costs low, under control and with some certainty for budgeting.

The purpose of this case study is to outline how a large corporation established its strategy for addressing these matters as a part of its broader approach to risk and risk management. Specifically, this case study describes how the corporation assessed its cost of risk, set targets for improving this cost and acted to achieve cost savings and cost control.

Setting

The third case is a large corporation with national and international operations. It has a large number of sites and facilities. It has a multi-billion annual dollar turnover. Its risks encompass a wide scope of property and casualty exposures. Accordingly, it has a comprehensive insurance program. The insurance deductible levels are $500K for property and $250K in the aggregate for general liability.

The cost of its insurances is predominantly for property cover, including business interruption. In comparison, the cost of casualty insurances (that is, liabilities and vehicles) is relatively low. The company's loss experience has been fairly good given its size and scope, with few losses over the past 10 years of any significant magnitude. The company's property loss experience ($K, NPV) for example is summarized in the table below. Year 1 is the most recent year.

The corporation has a risk management unit of some eight people, responsible for insurances, claims, company security, risk management engineering, advice and training but not workers compensation and OHS. This is dealt with by human resources.

The risk management unit is headed by a senior manager who reports to the company's finance director. On occasions, the corporation uses an insurance broker for risk reviews and site risk inspections.

Background

A number of changes have passed through the company recently. Business units are reviewing their costs, structures and the efficiency of their functions. The corporation increasingly emphasises and looks at the value added by functions to its balance sheet and to shareholders.

Secondly, the corporation's cost of insurance rose sharply last year and in fact exceeded budget by a substantial margin. The company's property insurance premium was $5M. Accordingly, it is concerned to control this cost and limit its volatility in future.

In response, the risk manager has undertaken a review and benchmarking of the company's cost of risk and the efficiency of the risk management unit. In addition, the risk manager has developed a strategy to control the cost of the company's forthcoming property insurance renewal.The following describes the results.

Corporate cost of risk

The risk manager has established a simple framework for identifying the company's cost of risk. The components and their respective costs are summarised in the table below:

Note:

• Budget includes claims handling, recoveries and interest income. Excluding workers compensation cost
• Cost of risk excludes workers compensation cost

The targets shown above have been set based on benchmarking the corporation's cost of risk against available data. The data obtained by the risk manager in this case for benchmarking the corporation's cost of risk is tabulated below. Surveys of the corporate cost of risk for a number of industry groups in Canada and USA have been published annually: 1991-97 by Towers Perrin and 1998-99 by Ernst & Young.

Compared against the available benchmark data, the corporation has a higher cost of risk than the benchmark indicator. It is understood that the benchmark data may not be directly comparable to the company, but notwithstanding this, it is considered to be a useful guide.

In particular, the corporation's cost of property insurance appears high; its self-insurance of loss seems low. These comparisons suggest the corporation could increase its self-retention of risk.

Risk retention

The risk manager believes that the corporation can take higher deductibles in its property insurance in particular, commensurate with its size of revenue. This raises several questions:

• How much can the company afford to retain? And what are the expected losses?
• Are there premium savings available worth the additional risk exposure?

The risk manager considers some 'rules of thumb' which recognise that risk retention decisions affect the balance sheet, income statement and cash flow. These rough and rudimentary guides to retention are:

• 0.5 –1.25 per cent of annual revenue
• 2 – 6 per cent of non-dedicated cashflow
• 0.2–1.5 per cent of total asset value
• 10 per cent of annual premium.

The risk manager applies a simple three-point estimation model to forecast expected losses for next year from the company's loss history, as follows:

Expected losses = [ Min value + 4(average) + Max value ]/6 = $150K

This figure is way within the ability of the corporation to afford. The risk manager also uses a specialist software program that examines loss history, expected losses and the corporation's financial standing to estimate an optimum retention level.

Using this software model and the guides above, the risk manager believes a retention level of $2 million in the annual aggregate would be appropriate. He sets this as a target. His intention is to see what premium savings a substantially higher level of deductible will achieve at the next insurance renewal. Savings can then be compared with the increased loss exposure and a cost-benefit decision made.

Value added by risk management

Reducing the total cost of risk is one contribution risk management can make to the 'capacity'of the corporation – that is, the amount of capital which supports or is available to support its business, and the efficiency with which it is used.

Risk management creates value because the savings it produces will go to the bottom line. This contribution (savings in the company's cost of risk) usually requires some investment, and accordingly a return, or value-added, is expected on that investment.

Risk management value added (RMVA) is calculated by identifying the savings in the corporation's cost of risk and deducting the associated risk management expense (For further explanation of RMVA, see K A Westover, Financial Modelling for Risk Managers, IRMI Publications 1998). That is:

RMVA = Savings in cost of risk (between different time periods or different programs) - Opportunity cost of resources applied to risk management

Depending on the degree of sophistication of analysis desired, quite detailed financial modelling of RMVA can be undertaken. In this case, the corporation's finance division undertook a detailed EVA/RMVA analysis of the risk management program. This analysis confirmed that savings were available and that the risk manager's targets (as shown previously) were appropriate.

Moreover, in terms of the effectiveness of risk management to the corporation, the value analysis also confirmed that the risk management unit had clearly defined its value-added (and non value-added) services to the company.

The unit had used a qualitative assessment of the effectiveness and efficiency of its individual functions for this purpose (see McNair CJ and Liebfried KHJ, Benchmarking – a tool for continuous improvement, Coopers & Lybrand Series. Oliver Wight Publications Inc. 1992).

The results of this are presented as an Excel spreadsheet. These results formed one of the inputs to the unit's forward business planning and program improvement strategy.

Cost control strategy

As the key part of cost control, the risk manager has developed a strategy for the next property insurance renewal. The major elements of this strategy are, in brief:

• Ensuring underwriters fully understand the risk and the risk management
• Using several insurance brokers, effectively in competition, for the renewal
• Using a price incentive mechanism.

A risk profile on each of the corporation's major sites and facilities was prepared and consolidated into an overall risk profile for the company as a whole. This was provided to all incumbent and prospective insurers. Meetings were held with the lead insurer and all major insurers. These organisations were also shown over a number of the company's major sites to improve their appreciation of exposures and risk controls.

The property insurance placement used insurers globally. The risk manager therefore decided to use four insurance brokers: one locally, one for the USA region, one for Europe and one to sweep up behind and fill any gaps. All brokers were assigned their specific insurance markets, a specific portion of the placement, given a schedule and a target premium. In this way, the corporation obtained the best leverage in the markets. The brokers had two incentives to perform towards target:

• If they completed their portion of the placement on or ahead of schedule and target price, they could start on additional markets and thus effectively compete with (or take away business from) the other brokers
• All brokers operated on a 'reverse' commission for their remuneration. Usual broker remuneration is a commission (say 10 per cent of premium) or a fee. In this case, the arrangement was reversed to provide price incentive. Simply put, broker commission was 15 per cent if premium met target, 20 per cent for below target but 5 per cent if above target.

In the new year, the placement worked well and to the satisfaction of all parties. The renewal premium was 28 per cent lower than previous, close to meeting target and saving about $1.4 million, despite a general trend upwards in insurance market pricing. By comparison, some other large corporations sustained marked premium increases at the same time, despite no change in their risk or loss performance.

At year's end, the corporation had achieved a cost of risk of 0.32 per cent of revenue, bettering its target cost of risk for the year of 0.35 per cent of revenue. Though the cost of self-insured losses was twice that of the previous year, this had been more than offset by the premium saving.

This case illustrates that:

• Measurement of the organisation's cost of risk can help focus risk management efforts and also focus on the value-added for the organisation
• Targets to improve the cost of risk can improve the efficiency and effectiveness of risk management

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