As companies formalize governance processes and procedures, risk managers are being required to validate risk and insurance management practices, activities and decisions. Such validation emanates from organizational requirements to demonstrate formal role oversight, decision support, transaction transparency and disclosure documentation.
For example, the audit committee of the board of directors questions the level of risk assumed by the firm, its overall cost of insurance and the adequacy of insurance coverage provided. A new chief finance officer wants to know the economic value of the firm's Dublin captive insurance subsidiary. A long time risk manager ponders whether the firm's insurance program represents best practices vis-à vis similar organizations.
Traditional risk management program validation often applies a checklist-driven audit methodology. This approach typically does not offer the opportunity to make program improvements.
As risk managers seek to create true value for the organization, they are turning more frequently to enterprise risk management techniques that lead to development and implementation of actionable program improvements.
Within ERM, the risk and response assessment offers a practical approach to increase understanding of the critical risks of the business and how the organization can best be structured to address such risks.
Potential changes from current practices must demonstrate a clear value proposition and include prioritized action steps for making improvements.
In applying ERM techniques to the firm's risk and insurance management program, value is created through comparing current practices with desired best practices, determining if gaps exist and building an action plan to close those gaps.
This approach allows risk managers to define strengths and weaknesses of current practices; evaluate the effectiveness of risk transfer and control mechanisms; identify gaps in performance objectives; and recommend changes, improvements, enhancements and corrective actions.
AN ACTIONABLE APPROACH
ERM's actionable approach to performing an objective risk and insurance management review incorporates the firm's core values within a process that defines goals and objectives, critical factors and constraints for achieving success, and performance measurements.
The subject matter within the risk review includes risk identification, assessment and control processes.
The organization must: be proactive in efforts to identify root causes of loss and emerging risks; evaluate financial consequences of exposures to loss; and measure the efficacy of control treatments.
Within its risk financing strategy, the firm needs to align with and support overall business and other financial strategies while leveraging organizational resources and driving efficient processes and decisions. Effective risk management here requires a balance between the volatility of the risk exposures, attitude toward risk assumption and the risk tolerance of the firm.
Risk management also has responsibility for utilizing formal risk and reward metrics as decision support for the firm's risk retention and insurance risk-transfer and coverage amount decisions. Critical areas to review include the variability of risk, insurance availability and cost, the legal and regulatory environment, management's attitudes toward risk and industry-specific benchmarks.
The effectiveness of a firm's portfolio of property and business-interruption coverage and liability policies is critical to its financial viability. Key components for review include breadth of coverage and seamless dovetailing of policies, along with limitations imposed by exclusions, unintended gaps and/or structural deficiencies in covered interests.
Implementation of a captive insurance subsidiary can offer a formal approach to managing a firm's self-insurance program. Benefits can include reduced costs, improved flexibility and control over the program, and new revenue streams. Assessment criteria for examining captive arrangements include feasibility and business planning, value creation and operational performance.
Firms often allocate retained losses and fixed insurance premiums and associated expenses to individual operating units. The selected allocation methodology is intended to produce results that align with established allocation goals, including fairness/equitability, budget stability and performance management.
For all insurance purchases, the selection, accountability and compensation for the firm's insurance brokers should be based upon the scope and priority of outsourced activities, the level of resources provided and the brokers' overall service effectiveness. Topics to review include insurance placement and alternative risk financing; risk-control consulting (e.g., claims, safety and environmental); and administration (e.g., certificates of insurance, stewardship and captive management).
Beyond risk transfer and retention, of course, comes loss control and claims management. Effective loss control and claims management directly impacts the firm's overall cost of risk. Safety and loss prevention activities target identification of root causes of loss and implementing managerial and/or engineering changes that address issues at the source. Claims management activities address best practices for claims-handling processes and procedures, reserving criteria and litigation management.
For all of the above and more, the firm's risk management unit ought to have a defined mission, based on organizational requirements, processes and resources. Internal and outsourced personnel must be effectively balanced.
Many firms' risk financing programs remain static over time, exhibiting their own form of inertia. Once coverage terms and conditions, retention levels and limits are set, they infrequently change from year to year, regardless of substantive changes in overall financial position and/or risk profile.
In one example involving a corporation with decentralized risk management and risk financing, a risk review identified excessive risk financing costs associated with the decentralized approach to risk management and risk financing.
The firm's managers had rationalized overutilization of insurance risk transfer as a result of the European parent's limited knowledge of the litigious U.S. environment and workers' compensation regulations. This decentralized approach prevented the U.S. subsidiaries from leveraging the larger, financially stronger, global organization.
The risk review encouraged the development of corporatewide risk financing programs supported by the parent company's strong financial base. The U.S. subsidiaries retained their ability to "manage" unique U.S. risks, including workers' compensation. Risk financing costs for the U.S. subsidiaries were reduced by 20 percent. The leverage created by this new global risk financing structure cut costs, albeit not to the level attained by the U.S. subsidiaries.
In a second example, take a rapidly growing U.S. retail organization. As a result of rapid growth, the risk profile of the company changed dramatically. Early in its development, the firm had one distribution center and several stores in three states. Following expansion, the firm had hundreds of stores across the country, with distribution centers strategically located to supply the stores regionally.
During the course of this company's growth, the traditional property insurance program with low deductibles and increasing values at risk had been renewed essentially unchanged year after year. The review revealed the company's transformation into the "perfect insurance risk," defined as a large number of homogeneous exposure units spread across a large geographic region. The review further identified that buying property and business-interruption coverage on the individual stores was simply trading dollars with the insurance company.
Based on results of the review, the decision was made to retain the risk posed by individual stores and only insure the distribution centers. After several years, the company saved millions of dollars in premium with few losses to stores to offset the savings achieved. A benefit was the increased emphasis on loss prevention at the store level, reducing direct and indirect loss costs.
Actions taken in these examples might seem obvious, based on the facts. However, companies frequently lack the decision-support tools needed to surface the details. With an objective analysis of a company's overall risk management and risk financing program, improved program design and appreciable savings can ensue.
EVAN R. BUSMAN
and CHARLES R. LEE specialize in strategic risk consulting for the Tillinghast business of Towers Perrin.
May 1, 2007
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