Risk retention: self-insurance

Jun 24
2009
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This is an alternative where a large corporation such as IBM, Exxon, BMW can retain a large risk because of the size and strength of its balance sheets. Another choice would allow companies to forget insurance and incorporate other hedging instruments themselves. The rationale is that the total savings on insurance premiums for the company are more than the will cut costs so that operational efficiency in the insurance companies diminishes, so that client satisfaction falls and business leaves.
This means that there will be more regulations from Basel II as the insurance business overlaps with that of pure banking. The insurance industry needs to be innovative.
substitute hedging costs of the portfolio. The hedging instruments would match or exceed the total insured losses for an adequate substitution. Banks may adopt self-insurance (SIR) retained part for only a portion or threshold level of the potential operational risk hazard. The rest that they feel unable to handle would be covered by the captives.
Yet, the matter can be different where the big losses surround the downside risk.
The view of long-term value theorists is that such sudden losses or short-term volatility offer too much potential for damage to the portfolio. Once the company’s long-term earnings are discounted for short-term losses, the calculus still comes out in credit territory. But, such huge drops in stock prices in 2000–2 remain highly worrying to fund managers. The comparison and substitution of increasing insurance premiums after September 11th 2001 against other forms of loss cover will still continue.
The usual insurance practice is pooling, transferring to institutions with more capital, or transferring to those who know the risk better. We have seen that a loss database, plus the associated actuarial skills, puts the insurers way ahead of the banks when it comes to analysing risk. Backed up with easy access to large sums of capital for insuring potentially huge disasters, these loss risk managers could be on to a winning business.
There can be no bigger or more well-known capital or knowledge base for risk transfer than Lloyds, London. The capital for covering losses and claims is derived from a large reserve base built up over a long time, as in the three centuries of the company.
The ramifications of September 11th for reinsurance are that people will buy and pay more insurance premiums. The insurers will buy more reinsurance, but both insurers and reinsurers will restrict their risk offer and coverage. Supply shrunk, demand rose – insurance prices have already risen substantially.
What is needed is an industrial shift from pure insurance to risk protection services. Outsourcing tail event risks is a good business practice, but a better procedure is to work in partnership with risk experts to manage these risks. Business continuity planning is the typical part of active risk management, rather than simplistic outsourcing. Mitigating risks by pooling within the same insurance group is called “spray and pray”.
The risks are that:
1. The insurance companies will not have enough capital reserves to pay the insurance liabilities of their clients’ claims.
2. The insurance companies will expand their policy small-print so that their clients find that certain conditions nullify, or reduce, their insurance coverage.
3. Operational weaknesses within the structure of the insurance companies continue so that client satisfaction diminishes.
The insurance industry should learn and expand skills. Instead of designating risks bought or eliminated from policies as being “uninsurable”, we should train ourselves to be active risk managers beforehand. The unintended result so far is a host of uncovered risks; risks that could be avoided are pooled. This produces a lack of risk awareness and risk mismanagement. We must move forward.

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Insurance: a short description (2)

Jun 24
2009
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With the increasing use of derivatives and the impending deadlines of Basel II, we should see more variety in the types of insurance policies to cover foreseeable loss events. Insurance provides a safety net for sustaining losses where the costs in a single period would be too punitive. If the risk is deemed too large to handle singly by the company and collectively by shareholders, the risk must be transferred out and dispersed among a wider pool.
Insurance is the latest but one line of defence against risk, after capital reserves and before benefiting from bankruptcy law. It does not protect against risk but just smoothens the risk over time, transforming risks into costs. Pooling by transferring to institutions with more capital; or transferring to those who know the risk better.
Insurance results in a transfer of insurable risk into a tail credit risk and a host of legal risks. For these reasons of legal friction and contractual costs, insurance ends up a very incomplete market. A lot of risks are not covered at any price other than at excessive levels because of the paucity of up-to-date market information and the risk-aversion of many companies. If financial markets were as incomplete as insurance, a considerable number of arbitrages between market segments would not be possible, and trading would be minimal.
The effects of large impact disasters, certainly after the emergence of terrorist waves post 9/11, and the collapse of stock-market prices are causes for concern. The major worries for the insurance industry are that they:
will not be able to pay the insurance liabilities of clients’ claims
will reduce their cover by expanding exclusion clauses, so that clients will find self-insurance protection more attractive
When we are unsure of a specific type of risk, e.g. with complex damage or liability risk, a convenient get-out is to pass it to the insurer. You can protect yourself better against investment or corporate failure – for a premium. Thus, a popular policy was the D&O insurance – the Director and Officer cover. A company could cover the performance of its key staff, as well as protect against shareholder lawsuits through purchasing this policy. Unfortunately, with the rise in company scandals and accounts restatements post-AEW, this D&O cover has become more expensive. So, General Electric found its D&O policy quadrupling within one year.
Market players should familiarise themselves with the idea that buying insurance not solve all their risk problems. Furthermore, investors and company chiefs should acquaint themselves with the basic techniques of risk maps and loss databases to provide advance warning of potential corporate damage. Funnily enough, the insurers are the ones who are most likely to have understood the benefits of a loss database and created one, years before the banks and managed funds.
Do the groundwork – you need to be:
Assessing areas of risk weakness or corporate vulnerability.
Assessing cost-benefits of buying in risk management expertise or cover.
Assessing areas of non-coverage for corporate cover.
Read the small-print beforehand in great detail, there are obvious advantages to be gained. Corporations and individuals have become used to retaining risk that would have been insured. Insurers trap the cost of losses over time, charging their expenses for the risk burden. Insurance provides a safety-net for sustaining losses where the costs in a single period would be too punitive. The normal view was that a corporation takes a diversified portfolio of investments plus their associated risks. The increasingly common perspective will be to view enterprise risk management (ERM) status of the client.
This means that clients will be assessed upon the value and quality of their portfolio, plus to what degree they have the tools, techniques and business processes to manage risk. This is analogous to the Basel II view of operational risk. The insurer would work progressively with the client to develop strategies, implement them tactically and monitor business performance. A hands-off “just post us the premium cheque” will be less commonplace. More detailed inspection will take place before policies are signed.
If the risk is deemed too large to handle singly, the risk is farmed out or dispersed. The directors and shareholders will tend to shun investments where the insurance premiums eat too much of the associated profits. The idea of ceasing to buy insurance is not new, the investor can take on the total potential loss.

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