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By DONALD J. RIGGIN, CPCU, ARM, head of the risk financing practice at Spring Consulting Group LLC in Boston

If you're a chief financial officer or a treasurer you're intimately familiar with capital management. If you're a typical risk manager, broker, or consultant, however, capital management is a vague notion, covered somewhere along the way to your degree in finance or M.B.A. For those of you with neither of these educational experiences, capital management usually doesn't register on the radar screen whatsoever.

Some companies include retained earnings in their WACC calculation, but for our purposes, we'll stick with debt and equity, as they represent the main sources of capital for most companies.

Capital is a company's lifeblood, along with positive cash flow, of course. For public companies, their mix of debt and equity is a crucial metric. In concert with many other factors it helps to determine how much risk a company holds and the degree to which shareholders should be compensated for assuming that risk. In this case, of course, I'm referring to the myriad nonevent risk factors. Examples include market risk and earnings volatility as compared to similar risks of other firms in the same business.

While the cost of debt is fairly easy to understand, it's expressed as the rate of interest the company pays for its long-term debt; the cost of equity is a bit more complicated.

The cost of equity is determined by a formula that includes: a risk-free rate of interest such as the London Interbank Offered Rate (LIBOR) or a one-year Treasury bill rate; a factor designed to account for market risk; this is referred to as the Ibbotson premia, (Google Ibbotson for an understanding of what this factor is and how it's derived); and the beta. The beta is a measurement of a firm's earnings volatility as compared to that of other companies in the same business. Each of these components is known as a capital charge; they're also known as risk premiums paid to shareholders for assuming the company's risks.

The combination of the risk-free rate, market risk premium and the beta comprise the cost of equity. In order to get the weighted average cost of equity, we multiply the cost of equity times the total market capitalization, and then divide that by the total paid-in capital (which includes both debt and equity capital). For the sake of brevity, let's assume that a company's cost of equity is 5 percent, and its cost of debt is 3 percent, which results in a WACC of 4 percent. For simplicity's sake, this description ignores the role leverage plays in the company's capital management strategy.

This 4 percent WACC represents this company's cost of capital, meaning that it pays an average of 4 percent for the capital it requires to do business and more importantly, to grow the business. The WACC is important to investors because it sets the floor beneath which the rate of return for any capital investment cannot go. In other words, the company must be assured that it will earn at least its cost of capital on every investment. Many companies have what is known as a "hurdle rate." This is the rate that must be achieved for every capital commitment, and it's usually in excess of the firm's WACC.

RISK CAPITAL

Now that we understand the components of the WACC and its significance, let's introduce another, often ignored, component of the WACC--the cost of risk capital. As we noted above, shareholders must be compensated for the risk they assume. The cost of event risk, however, is rarely reflected in the WACC as a risk premium, but it should be.

Regardless of how your event risk is financed, whether it's with first-dollar insurance or through enormous self-insured retentions, the capital that the company devotes to its event risk has a cost, and that cost should be reflected in its cost of equity. So how do you calculate the cost of risk as a charge against capital?

First, identify risk capital's components, and then perform the calculation, which is virtually identical to calculating the cost of equity. Risk capital is comprised of three things: insurance premiums, retained risk, and insurance limits.

Let's start with insurance limits. Insurance is nothing more than contingent capital. Premiums are risk capital because if they weren't expended on insurance they'd be used elsewhere, or would contribute to the organization's profits.

Retained risk is a critical component of risk capital. Similar to insurance limits, self-insured retentions represent contingent capital, whether they are funded or simply accrued on the balance sheet.

In order to calculate the cost of risk capital, you must first determine the rates-on-line for the premium and the retentions. Rates-on-line are simply the premium (or retention) divided by the insurance limits. Then, to get the weighted average cost of risk capital, we multiply the cost of risk capital (the sum of the premium and retention rates-on-line) times the insurance limits, and then divide that by the total paid-in capital (which includes debt, equity, and insurance capital).

The typical cost of risk capital (CRC) for a large public company is generally less than one percent. The lower the CRC the more efficient is the use of risk capital. Earlier we discussed the hurdle rate--the required rate of return for any capital commitment. The hurdle rate is generally higher than the WACC, to make sure that every investment is earning something in excess of its cost of capital.

What if the company adds the newly calculated CRC to its hurdle rate? This would mean that in addition to covering the WACC, investment returns would also cover the cost of the company's risk capital.

THE CAPTIVE ANGLE

Single-parent insurance captives tend to be viewed as appendages to risk management programs. They're useful when commercial insurance pricing is unreasonably high, and/or capacity for a particular risk is scarce.

Some companies consider their captives to be indispensable, while others view them opportunistically. Regardless of how they are used, all captives must hold capital and surplus. Most single parent captives tend to be highly capitalized. In some cases this is intentional, but most captive owners tend to want excessive capital even if it isn't employed to its full potential.

The reason for calculating the cost of risk capital is to create a capital charge for event risk. Most CFOs, however, have little incentive to include the CRC in their WACC calculation, as additional capital charges increase the company's cost of capital.

However, some CFOs have found the CRC to be valuable when evaluating a major capital commitment, such as the acquisition of another company, in order to increase the hurdle rate, thus increasing the minimum required return on the investment.

Sometimes the value represented by the CRC is washed out by the fact that additional funds must be expended to cover the hazard risks of the acquired company. However, if the company has a captive, the additional risk associated with the acquisition can often be integrated into the captive with no increase in premium and no addition to capital; this is where the CRC's value lies. It creates a financial return by leveraging the captive's existing capital.

August 1, 2010

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