Risk Transfer Process
Hiring insurance programs is one way to “transfer” (share) the risk. In fact, the insurance will guarantee the replacement of the loss and the preservation of the cash flow of the company, avoiding the decapitalization to restore the loss of some sinister. As an alternative to insurance, we have the mutualisation that consists of a common fund made by companies or associations to face some risk that comes to fruition. The logic is the same as insurance, however, the cost is reduced due to the reduction of administration fees. This practice has been common for companies in the same segment and has difficulty in placing some specific risks in the market or companies of the same group. However, it should be remembered that this process is not a simple process and requires specific technical knowledge for its implementation.
Sometimes the practice of pooling certain risks is accompanied by requirements that, in order to be part of that loan, the risks must be mitigated according to a single risk policy and following specific rules and procedures for risk management, as well as subjecting periodic audits, that is, it is mandatory that companies mitigate their risks in advance.
One of the most common mistakes in hiring an insurance program is your hiring without prior or parallel risk mitigation work. This implies an increase in the cost of the insurance premium to be charged, since in this way the premium is being calculated according to the pure (untreated) risk instead of being calculated according to the residual risk (risk already mitigated ). It is also common for companies to take a range of measures to mitigate their risks and not disclose to insurers, making it difficult to assess their risks.
It is desirable that when placing the risks in the insurance market, a road show is made that consists of a series of presentations to the insurers demonstrating what the risks are and what is being done to mitigate them.
The lack of information to insurers has been one of the key factors for subwriters to increase the value of insurance premiums during a listing process. While there are predefined risk acceptance models, subscribers need to have an accurate perception of how the company treats and controls its risks. This evaluation becomes more difficult as the subscriber does not have the appropriate information. This leads to more rigorous risk assessment. We could say that in the absence of certain information to classify a given risk, the subscriber will tend to assume that the scenario or the consequences of the risk will be greater. Therefore, the lack of information and the lack of a clear policy and robust risk management mechanisms tend to aggravate the risk assessment, reflecting the final value of the insurance rate.
Another tool to be used by the risk manager is the increase in risk retention (self-insurance). This can be total or partial and according to each type of risk. Typically, this tool is used for low-impact operational risks that occur very frequently due to lack of robustness in the operational process.
These abovementioned risks are very expensive in the insurance market and are normally quoted on the market without any consistent work to mitigate them. Since the lower insurance bands (which cover lower claims) are considered to be appreciably more expensive than the bands covering higher-value risks and the frequency of these risks may show significant improvement as a result of improved process controls, they suggest increase the value of the franchise as the controls of these risks are improved and the frequency with which they occur is reduced. Obviously, as the franchise is increased, the reserve value (self-insurance) should be increased to make in the face of some claims, as well as the quality of the internal controls and the measures and tools of controls of the critical processes in order to make them more effective.
By adopting a policy of increasing risk retention (raising the franchise’s value for the lowest value bands and the highest frequency of events: working layer), the risk manager must be aware that the capital reserve to deal with this should be adequate. If it does not have this sensitivity, it may be turning an operational risk into a financial risk due to a lack of reserves or cash generation to restore the loss.
It is recommended to conduct a financial resilience / risk tolerance study before initiating a process of raising the level of risk retention or self-insurance. In this process, the main liquidity and financial leverage indicators of the company must be obtained in order to have a correct picture of the financial impact of an operational loss outside the insurance program (below the new deductible to be defined).
It should be noted that when we talk about self-insurance in the text above, most of the time, we are referring to the definition of the point of retention of risk that the company that contracts the insurance program will define. In other words, the limits of insurance coverage are being defined, the higher the value of the deductible, the more risk is being withheld by the company, that is, a company that has a deductible of $ 35,000.00 means that the risks from this amount are covered by the insurance program and that below that value the company has to bear the costs of any loss up to this limit. This means that the company retains the risks up to the limit of the franchise (in this example $ 35,000.00).
Regrettably, there is little debate on the subject between risk managers, brokers and insurance companies here in Brazil. Often for lack of adequate technical knowledge of some of these professionals. This entails hiring inadequate insurance coverage and a lack of a robust risk management policy aimed at reducing the claims ratio in a consistent and sustainable manner.
Risk Allocation / Risk Management Allocation Policy
One of the most complex phases is the definition of the Risk Allocation Policy for Risk Management and Insurance. This policy defines the guidelines for the allocation of risk management and insurance costs by areas within the company. This policy must be based on rational models that allow the awards to those units that have been carrying out a good work of risk management and have been achieving a good result in reducing the level of vulnerability and the number of damages and losses of its business units.
One of the most common mistakes in the allocation of insurance costs is the division of the cost of insurance based solely on the billing of the business units of the company. Of course, the financial capacity of each unit to pay the insurance premium must be taken into consideration. However, using only this factor creates a myopic view and a distortion that will not take into account managers who adopt good risk management practices and ensure that their protection systems are properly maintained and contribute to the development of a culture prevention.
It can be considered as a good practice in the policy of allocation of insurance premium costs to define apportionment criteria for business units based on at least 4 basic pillars: Billing, Value at Risk, Loss History and Vulnerability Index.
Billingrefers to the unit’s ability to generate revenue and directly implies the amount of value moved or stored or produced by that business unit. The higher your billing the greater the exposure and the higher your cash generation capacity (usually) to pay for insurance costs.
Value at Risk refers to the assets that are being covered by insurance. Of course, the higher the value at risk of the unit, the greater will be this reflection in the valuation of the insurance premium. Obviously, there must be a coherence between the amount of contracted coverage and Value at Risk. We often find situations where the Value at Risk is much higher than the contracted coverage or vice versa.
The Accident History reflects the degree of care of a unit in managing its risks. It is one of the main beacons for the definition of insurance premium amount to be paid. This factor, undoubtedly, must be considered when the apportionment is defined by the business units. By doing so, we benefit from the units that are more cynical with their risk management process and which cause a low loss ratio.
Another important variable to consider for the allocation of insurance premium costs is the Vulnerability Index. This index allows to assess the degree of effectiveness of the protection systems of a given business unit. It therefore allows managers of these units to be encouraged to take preventive action on risk prevention and mitigation. This index can be obtained by auditing the risks to be performed in the units.
A suggested apportionment for the division of the insurance premium to be distributed by the business units would be the adoption of the apportionment ratio defined in the table below