The Need for Efficient Risk Financing Strategies
Property & Casualty
The Need for Efficient Risk Financing Strategies
Introduction
As corporations and their risks grow in scale and complexity, risk managers face numerous challenges navigating the world of risk financing, from assessing coverage needs to evaluating alternative financing mechanisms beyond traditional insurance. This white paper series serves as a starting point for addressing these challenges. Through our discussions, we will explore how adopting a portfolio view of risk, informed by stochastic risk models, can pave the way for crafting optimal risk financing strategies that align with insurance cost, coverage and profitability goals.
Historical Pitfalls: The Siloed Approach
Traditionally, many firms approached insurance risk financing strategy primarily by looking at each source of risk in isolation. Property risk is assessed and financed under one insurance program, directors and officers liability under another, cyber under yet another, so on and so forth. Taking this siloed, monoline approach to managing a company’s overall hazard risk profile can be inefficient for an organization.
This traditional strategy of insurance purchasing naturally evolved in response to product specialization pressures from the underwriting community. When viewed from the insurance buyer’s perspective, this approach can run the risk of gradually drifting into an overly reactive or transactional organizational mindset. A company assessing risks in isolation may find itself addressing only the most immediate threats without considering the broader risk landscape, always one step behind and subjecting its insurance costs to the market fluctuations of underwriting cycles. Taking a more dynamic and holistic view of enterprise-level hazard risk enables organizations to plan for and weather these fluctuations, favoring long-term strategic planning through managing the collective impact of exposures.
A siloed approach to assessing risks may also inadvertently lead to overspending on excess insurance coverage relative to the firm’s appetite for hazard risk. Pooling together risks of low correlation often results in total volatility less than summing the volatilities of each risk. This phenomenon is referred to as a diversification benefit, with adverse events from one risk offset by positive outcomes from another. When risks don’t move together, realizing their adverse outcomes simultaneously is less likely, offering a buffer to potential losses over a given period and creating a lucrative risk financing opportunity.
Total Cost of Risk (TCOR)
Total Cost of Risk (TCOR) can be defined in many ways. Typically, it refers to the expected retained losses (losses that the company is responsible for paying) plus the insurance premium and frictional costs (premium taxes, collateral costs, etc.), summed across all the sources of risk to which the company is exposed.
For a refresher of these core risk finance topics, we refer the reader to Brown & Brown’s Alternative Risk White Paper Series exploring the fundamental tools that companies use to estimate and review their corporate risk profiles.
