Commercial Insurance Update – Cost of Risk: Who’s Managing Yours?

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February 2007

Cost of Risk: Who’s Managing Yours?

By Jeffrey W. Cavignac, CPCU, RPLU, CRIS © 2007 Cavignac & Associates—All Rights Reserved

You won’t find a category for “cost of risk” on a company’s income statement. However, cost of risk is a huge expense item. Most companies spend 2.5% to 5% of their gross income on risk, and some spend substantially more. In many cases, cost of risk can be the second or third largest expense item on an income statement! In fact, it’s estimated that insurance premiums for many firms is 50% or less of the total cost of risk.*

* There is usually a listing for insurance premiums on an income statement, but this is only one element of the total cost of risk.

If the cost of risk is such a big deal, why is it so often overlooked? Some aspects of managing risk, in fact, are generally managed pretty well. Most companies try to negotiate their insurance premiums and effectively manage the claims they have. Some even have personnel assigned to be responsible for safety and loss control. Regardless, a more holistic approach and awareness of risk management can substantially reduce your total cost of risk and drive dollars to your bottom line.

Business Risk Versus Hazard Risk

In its simplest terms, “risk management” involves the identification, evaluation, and management of all the potential hazards and exposures to loss a firm may face.

A distinction needs to be made between business risk and hazard risk. Business risk refers to the risk inherent in the operation of a particular organization. Business risk includes the possibility of gain, no loss, or loss. Hazard risk, on the other hand, deals with accidental losses that can cost the organization money. There is no opportunity for gain. Collectively, business risk and hazard risk have become known as Enterprise Risk Management (ERM).

While ERM is worth pursuing for many large Fortune 500-type companies, it is not realistic for most others. We will focus on hazard risk.

What Is Risk Management?

Whether it knows it or not, every company has a risk manager. In a large organization there may be a Risk Management Department, but in most companies, the risk management function is only one responsibility of an individual’s overall job responsibilities. The risk management function is often shared among numerous individuals, and rarely is it coordinated.

In order to effectively manage risk, however, someone – whether it’s the chief financial officer, the human resources professional or someone else – should be in charge of risk management. Assuming you have designated such a person, what are the risk manager’s responsibilities?

Risk Analysis

Identifying and Analyzing Risk

The first step is to determine what your company’s “exposures to loss” are. Loss exposures are conditions that could result in financial loss to an organization. From a hazard risk perspective, these conditions generally arise out of property, personnel, liability or net income categories.

Identifying and analyzing risk is the single most important function of the risk manager. If you can’t identify your exposures to loss, you can’t manage them. Unfortunately, this critical step is often overlooked or performed poorly.

The correct way to identify and analyze exposures is to do so systematically with an exposure analysis program or checklist and, if necessary, the assistance of a risk management professional. (Note: many insurance brokers do not have the expertise to help evaluate exposures to loss – it is important to ally yourself with one that does.)

In addition to completing an exposure analysis program or checklist, you’ll also need to review financial statements, flow charts, contracts, etc.

Once exposures have been identified, they need to be analyzed. Some exposures are minimal and can be retained. Others lend themselves to being controlled, and still others will need to be transferred, avoided, or financed. The key is being proactive in this process. It is better to understand your risks and make conscious decisions about how to handle them than to find out at the time of a loss that you are uncovered and unprepared.

Loss Control and Safety Risk Control

Risk control involves taking steps to minimize either the frequency or severity of a loss exposure. The only real way to lower your total cost of risk is to lower your underlying losses. Money invested to effectively control your exposures and manage the claims you have experienced can generate solid returns.

Some companies maintain their own in-house safety officers or loss control personnel. Many others have assigned this responsibility to an individual who also has other duties. The key is to have one person responsible for these functions. This individual is in charge of conducting inspections of facilities, jobsites, and overall safety. If the individual does not have the expertise to do this effectively, he or she will have to get outside help.

Generally, your insurance company will be able to provide some guidance, but the most logical resource is a “for fee” risk manager, or a capable insurance brokerage. Most insurance brokerages do not have dedicated in-house loss control and safety expertise; however, some do, and this can be invaluable.

Collectively, a schedule of services should be developed and responsibilities assigned. This involves participation by the company (insured), the insurer, and the broker (see sidebar for an example).

Claim Management

The best loss control in the world will not eliminate all claims. Effective claims handling procedures can substantially reduce the ultimate costs of claims. Claims need to be reported quickly and correctly. They need to be handled by the right adjusters, and if subrogation is a possibility, it needs to be pursued. Finally, claims need to be monitored and followed up.

The individual in charge of claims needs to make sure that coverage includes how to recognize and report not only actual claims, but circumstances that may give rise to claims. Effective post-accident response training is critical.

If a company has any claims frequency at all, a personal relationship with the insurance company’s claims adjuster and defense attorney is important.

As a final note, a professional insurance brokerage with dedicated claim personnel should be able to help you effectively manage the claim process.

Risk Financing

After you have identified and analyzed your exposures to loss and implemented risk control techniques to manage the frequency and severity of those exposures, it is time to figure out how to finance the losses that are left. There are two basic options: retention and transfer.

Retention is a risk financing technique by which losses are retained within the organization to pay for losses. Ideally, this is planned, but unfortunately “unplanned retention” is not uncommon. Unplanned retention is the inadvertent assumption of a loss exposure because it was not identified or correctly analyzed. “Planned” retention can take a number of different forms. Most common is a deductible or self-insured retention.

Alternatively, it might be an entire exposure that has low severity. Regardless, the firm’s ability and desire to retain risk should be evaluated, as it will affect the design of your insurance program.

Risk transfer involves the transfer of risk through insurance, and non-insurance techniques to shift the financial consequences of loss to another party.

Non-insurance risk transfer, as the name implies, involves the transfer of risk to someone other than an insurance company. Usually this is done through a hold harmless or indemnity agreement. Note that although these are “non-insurance” transfers, typically such agreements are at least partially supported by the indemnitee’s insurance program.

Insurance transfers the potential consequences of certain specified loss exposures to an insurance company. Essentially, the insurance company agrees to pay for certain losses in exchange for a premium.

Despite the fact that insurance is often the largest component of the total cost of risk, there is a reason it is the last step in the risk management process. It is only after you have identified and analyzed your exposures and figured out how you can eliminate, reduce, retain, manage and transfer those exposures that you can figure out what you need to insure. At this point, you are in a position to approach the insurance marketplace with a wellthought-out insurance submission that highlights the attributes of your company’s risk management efforts in order to negotiate the correct coverage at a competitive price.

Summary

Cost of risk is a concept many firms have never thought about, despite the fact that it is one of their largest expense items. Regardless of how big your company is, formalizing the risk management function will lower your total cost of risk and drive dollars to your bottom line.