Kathryn Clarkson and Eddie McLaughlin discuss...

Kathryn Clarkson and Eddie McLaughlin discuss current trends in retaining risk, and suggest how to decide the level of risk that matches your own organisation's corporate culture and risk tolerance

Companies exist to maximise shareholder wealth and deliver benefits to key stakeholder groups. In order to do this they must take risks, evaluating the potential risk-reward trade-offs to determine which opportunities to maximise and which are too risky to offer enough potential benefit. However, there are some risks that companies will be exposed to just by existing. Equally, there are some risks where mitigation or transfer is necessary to make the risk-reward trade-off worthwhile.

  • How do you determine an appropriate level of risk to retain?
  • How do you evaluate the efficiency of retaining risk internally?
  • How do you appraise decisions to invest in reducing risk by mitigating it or transferring it to a third party?

    Tolerance trends
    The business environment has arguably become more risky in recent years. Corporate governance codes of practice have heightened companies' and investors' consciousness of risk and related issues. While some theorists believe it is merely our awareness of risk which has increased, few would argue that determining the optimal business strategy is becoming increasingly challenging, due to the sophisticated demands of stakeholders and the need to balance the risk and return trade-off.

    An increasing number of companies are choosing to retain more risks internally, in the hope of offering a higher return to shareholders. For example, corporations have traditionally bought insurance to protect them from losses that would produce excessive volatility in operating performance, or simply cause them to cease trading. The recent hard insurance market has led many companies to reconsider the level at which they should buy insurance. Appropriate funding techniques can help companies to better manage the impact of retaining risk. By purchasing insurance above high deductibles, they become less subject to volatility in insurance premiums.

    Deciding optimal risk retention levels
    Deciding the optimal amount of risk to retain requires the same consideration as any other business decision: does it maximise wealth for shareholders and deliver value to key stakeholders through protecting the longevity of the company? This can only be evaluated after the event, so the decision must be on the balance of probabilities. A structure is required to evaluate these.

    The overall process of determining the optimal risk tolerance as part of any risk financing strategy can be viewed as a series of phases (Fig 1).

    The first step is gathering the relevant data. This includes financial results, key performance and key risk indicators, historical losses, and the corporate risk register, highlighting the whole portfolio of risks to which the company is exposed. It is important to include all risks - hazard, strategic, operational and financial - and not just those which can be mitigated or transferred.

    Analysis begins by determining a level of risk retention congruent to the organisation's financial strength, culture and perceptions. Different approaches are outlined below.

    Having determined how much risk the company can withstand without materially impairing trading and operational performance, the next stage is deciding the level of risk which it is efficient to retain. This is based on a cost benefit analysis of each available option. In the context of an insurance programme, it is determined by the premium discounts available for taking higher levels of retention, versus the increased expected level of claims.

    Financial modelling can help to evaluate these decisions. Actuarial based techniques provide an indication of future expected volatility and by using confidence levels, decisions can be optimised on the balance of probabilities. The optimal decision will be that which minimises the cost of risk without exposing the company to unacceptable levels of volatility. Different risk categories show different characteristics in terms of frequency and severity. Companies should consider retaining high frequency (and therefore more predictable) and low severity losses, whilst transferring low frequency and potentially high severity risks.

    The penultimate stage of the overall risk strategy is assessing the optimal funding techniques for internally retained risks, possibly considering alternative risk financing techniques and the involvement of a captive insurer.

    The final stage is embedding the risk financing strategy in the culture of the organisation. This involves monitoring and reporting risk, and ensuring compliance with recent directives.

    How much risk to retain?
    The starting point is understanding the financial strength of the organisation and its ability to withstand variability in results without materially affecting key stakeholder perceptions. Methods of evaluating the optimal level of risk retention range from the academic approach of determining the level of risk which will change the Beta of the organisation, by using Capital Asset Pricing Model theory, or looking at the impact on the weighted average cost of capital, through to gut feel.

    Ultimately, the 'financial impairment threshold' or risk tolerance level is determined by a combination of subjective and objective methods. The organisation's ability to retain additional risk will be partly driven by perceptions, in conjunction with an assessment of the level of retained risk within the whole portfolio. A number of factors drive most decisions about optimal risk tolerance capacity, with various techniques helping to structure and support them.

  • Credit rating/covenant headroom One indication of risk materiality levels can be derived by looking at the current credit rating of the organisation and determining the level of headroom within the key ratios, before the company would breach a covenant or become subject to a credit rating downgrade.

    A variety of benchmarks for key financial ratios are used for each credit rating. For example for an A rating, gearing may be required to be above a certain level and interest cover greater than X times (the most appropriate financial ratios and the levels required are determined by the industry in which the company operates). By calculating the difference between the current level of the key ratio, and that which would cause a credit downgrade, a financial impairment threshold can be estimated.

    This is an over-simplification of the credit rating process but illustrates how it can be used to structure the decision over risk retention, to achieve a level which supports the financial success and operations of the business and also reflects its risk attitude.

    A similar method involves calculating the 'headroom' between current levels of key performance indicators and target levels. For example, any covenants on loans, such as requirements to maintain interest cover above a certain level, or for gearing to remain within certain predefined parameters, could be used to determine the level of additional risk which could be retained without breaching these covenants.

  • Auditors' materiality threshold Auditors will make a judgement on which facts are material to declare, for example materiality of post balance sheet events. These levels of materiality may be useful indicators of appropriate risk tolerance levels.
  • Market norms All companies compare themselves to their peer group. For certain industry sectors, there are market norms which often dictate the level of risk which companies will retain. For example, when buying business interruption insurance within the energy sector, the market norm is to apply a time deductible, usually in the region of 60 days. Similarly, market norms exist regarding the usual limits bought on different classes of insurance.

    Using these benchmarks can ensure that a company is not out of line with its peers - although companies in dynamic business environments may use them to ensure that they are always ahead of, rather than just following, the crowd.

  • Rules of thumb An alternative approach is to use 'rules of thumb'. This does not take into account management perceptions and attitudes and so will not give a definitive answer. However, it can help to structure a decision to determine a retention level congruent with the financial strength of the company.

    The rules of thumb most frequently used are based on the changes in key ratios which may materially alter stock market analysts' perceptions of the company. They should be a guide only, providing the basis for discussions in conjunction with other risk retention methodologies such as management judgement.

    Fig 2 shows one suggestion of the variance ranges which could be applied to a company's financials. These variance ranges will give tolerance levels for all risk categories and reflect the ability to retain additional risk, because any losses already incurred will already be incorporated within the financial year's figures. The financial report and accounts are based on historical information, and indicate a level of risk which reflects the strength of the organisation as it goes forward into the future.

    Therefore, this historical information should exclude any exceptional items, along with any contribution to performance from discontinued or discontinuing operations. Consideration should also be given to applying these ratios to forecast figures of performance rather than historic values.

    Perhaps looking at the impact that retaining more risk could have on key financial ratios is more useful as a management decision making tool. Fig 3 shows the impact on selected key ratios if more risk is retained and the loss materialises, assuming no change in the other operating financials.

    This can show the current degree of headroom within key ratios between current operation and the target levels, and thus be used to identify where additional risk could be retained. Again, this analysis does not give a definitive answer. However, it highlights an approach which could used to structure the decision.

  • Management judgement Ultimately, management's gut feel drives any decision regarding an appropriate level of risk to retain. Gut feel comes from knowledge of the business, management's views on likely frequency and severity of key risks and knowledge of the sensitivity of stakeholders' perceptions.

    Using risk tolerance
    Identifying a level of risk tolerance that reflects the organisation's capacity to withstand additional risks enables companies to:

  • maximise their financial strength and avoid inefficient use of group resources
  • cushion the impact of insurance market cycles by buying protection at higher levels
  • help ensure that they deploy capital more effectively
  • decide the optimal amount of external insurance protection to buy
  • assess the levels of risk that could be taken within a captive and the appropriateness of alternative risk financing.

    Eddie McLaughlin is a principal and leader of the modelling, analysis and design and risk strategies teams, and Kathryn Clarkson is a managing consultant at Marsh Ltd, www.marsh.co.uk