Friday, March 11, 2004
The Insured's Perspective:
Risk Retention as an Investment Decision
Insurance and Value Creation
Mark Ames
Outline

Background to the Retention Decision
– Does RM generate “value”?
– Toward a quantitative approach to optimization…

Economic Capital
– What is it?
– Who uses it and why?
Mercer Oliver Wyman
2
I. Background to Retentions

Practical applications that miss the point

Clearly differentiating risk from return

Finance Theory and Use of Capital
Mercer Oliver Wyman
3
Capacity Does Not Imply Desirability
100
90
“Just because a company may
have the capacity to bear
substantial risk, does not mean
that it’s in the firm’s best
interest to do so.”
Capacity to Bear Additional Risk (millions)
80
70
60
50
40
30
20
10
0
Working
Capital

Cashflow
Surplus
Cashflow
Earnings per
Share
Stockholder's
Equity
Net Sales
Total Assets
A firm’s capacity to bear risk can be thought of as a pain threshold above which
the decision makers do not wish to experience.
–
–

Pre-Tax
Earnings
tolerable
range for
maximum
unexpected
losses
Capacity is often found through an analysis of the firm’s financials, and application of “rules of
thumb”. Wall street’s expectations often play a significant role.
By definition, capacity goes across all sources of risk, not just insurable risks. Also, as expected
losses are budgeted for, expected losses do not erode capacity.
A large strong organization with many investment opportunities should not retain
large amounts of fortuitous risk, as its capital base may be better employed.
Mercer Oliver Wyman
4
Minimizing Expected Values
A Traditional Approach that Captures Half the Picture

An often-seen approach to choosing the
proper retention level is to compare the
tradeoff between discounted expected
losses and premium.
Expected
Losses
Market
Premium
–
In the example shown at right, the decision maker
might well choose to raise retentions to capture the
net savings.
– This approach can work for risks characterized by
high-frequency low-severity losses such as Workers
Compensation.

Ironically though, this approach completely
ignores risk, i.e. the true risk inherent in the
retentions is loss volatility or uncertainty.
–
Naively raising retentions on a low-frequency high
severity risk such as Property could result in a bad
year producing a significant hit to earnings.
Mercer Oliver Wyman
500,000
$135,000
$95,000
375,000
$170,000
$165,000
250,000
$240,000
$280,000
100,000
Current
Retention
5
Risk Management Generates Value
Foundations in Financial Theory

Modern
– Modigliani & Miller’s separation theorem.
– Convex tax schedules and arbitrage.
– Reducing the costs of bankruptcy.

Post-Modern
– Aligning the interests of stakeholders.
– The under-investment model.

The Economic Capital Paradigm
Mercer Oliver Wyman
6
The Under-Investment Model
Increasing Future Cash-flows
Risk Management is most appropriately applied to
ensure that strategic cash investments may be made
from internally generated funds.
Froot, Scharfstein, and Stein (HBR 11/94)

The value of the firm increases with investment.

Risk Management protects liquidity and thus the ability to
make value-enhancing investments.

Cash-Flow is King.
Mercer Oliver Wyman
7
II. Economic Capital

provides a buffer against
unexpected losses.

is a tool for management reporting
and performance measurement.
Mercer Oliver Wyman
8
Capital as Financial Buffer
Distancing operations from Unexpected Losses
losses
Unexpected
Losses
Economic
Capital
Expected
Losses
Budgeted
Expense
1

2
3
4
5
6
7
8
9
10
11
12
13
14
15
time
A retention implies the use of the Firm’s economic capital in addition to
needing to fund retained losses.
Mercer Oliver Wyman
9
Defining Economic Capital
As a Statistical Measure on a Loss Distribution
Probability
Size of Loss
Unexpected Losses
=
Economic Capital
Expected
Losses
Tail
Estimate

Expected losses can be budgeted for.

Unexpected losses pose a threat to the P&L, and is an economic measure
of exposure to the firm's capital base.
Mercer Oliver Wyman
10
Use of Economic Capital Measures
in Financial Institutions

Management Reporting
– Common language.
– Setting operational limits that involve the use of capital.

Performance Measurement
– Example: Rewarding traders in an investment bank.
– Distinguishing between value generating and value destroying
business activities.
Mercer Oliver Wyman
11
When Risk is Capital
Insurance Protection Reduces Economic Cost

The decision to assume risk is equated to an investment
opportunity.
– Investors take risks only in hopes of making a return.

Optimal insurance structure means efficient use of
economic capital.

Insurance is a surrogate form of capital.

Risk management positively contributes to value
generation.
Mercer Oliver Wyman
12
Value Creation Through Insurance
Reducing the Economic Cost Of Risk (ECOR)



Risk imposes economic
costs in the form of expected
losses and capital exposure.
The modelling process
allows these components to
be estimated both before
(gross) and after (net) of
insurance.
Value is created for the
policyholder when insurance
reduces these costs to an
extent greater than the
premium.
Mercer Oliver Wyman
Economic
Cost ($s)
Value Creation
Capital
Costs
Premium
Capital
Costs
Expected
Losses
Before
Insurance
Expected
Losses
After
Insurance
13