Defining the Cost of Risk

In anticipation of an economic slowdown, cost cutting is bound to become a common theme in the corporate sector. But with insurance rates, particularly in the commercial market, already hardening in Canada, risk management departments could be under even greater pressure to make the most of their company’s risk management dollars.

A survey conducted last year by the Risk and Insurance Management Society (RIMS) and Ernst & Young showed that the cost of risk increased in 1999, a dramatic 65% over 1998. Measuring the costs associated with an organization’s risk management operations, including net insurance premiums, retained losses, internal administration and outside services, Canadian respondents spent on average $2.88 per $1,000 of revenue, up from $1.74 the year prior. While 1998 was the lowest year in the past decade, and 1999’s result was still below 1990’s high of $3.90, the increase was significant (see Chart 1).

Tightening of the insurance market was evident, with repeat respondents noting an average increase of more than 10%. But it is not the insurance market that is chiefly to blame for the rising cost of risk. Retained losses, which survey compilers call “the most volatile component of risk”, brought about the bulk of the increase. For repeat respondents, retained losses increased more than 50% between 1998 and 1999.

And while both liability and property risk financing costs shot up (property costs more than doubled from $0.72 in 1998 to $1.66 in 1999), department budgets decreased. This decrease came at a time when, thanks to new technology and new risk financing options, many say more pressure than ever is coming to bear on risk management departments within organizations. Among the key concerns listed by respondents to the survey were e-commerce, enterprise risk management and alternative risk transfer (ART).

Hardening times

“It appears the [insurance] market is hardening in some areas, and for the most part across the board,” observes Wayne Hickey, chair of the Canadian Risk Management Council (CRMC) and supervisor of corporate risk and insurance for Cominco. And, he adds, those hikes will be most steep for policies viewed as bad risks, those with poor claims history and where losses have been highest. Hickey’s observations are borne out by the statistics.

Ted Belton, author of the Belton Report, says “there is no question” insurance rates are on the rise, particularly in auto and commercial property lines where loss ratios have been the highest. “There is [corrective] action going on out there.”

In the second quarter of 2000, Statistics Canada data shows net premiums up 14.1% in the primary market, 8.2% for reinsurers. And third quarter data shows commercial property premiums rising 8.8%, Belton notes, although losses, at 14.4%, still outpaced premium growth.

For risk managers, the rise in insurance rates is a “common experience”, says Nowell Seaman, head of risk management for the University of Saskatchewan. “We’re certainly not seeing rates going down.” But Seaman says he is hearing mainly about single-digit rates increases, except for on the most unprofitable lines of business, which might see double-digit hikes. “I’m not hearing about drastic swings that compare to the mid-1980s,” he adds. “The market is changing…but they are keeping a bit of a handle on it.”

One thing Seaman says is happening is that policy terms could be changed for policies that are not profitable for insurers. In terms of some specialty policies, even if terms had been negotiated for several years, insurers could decide to renew under different conditions. “It’s not just a matter of price.”

Stop the bleeding

Risk managers interviewed for this article did seem to have an appreciation, however, of the need for price correction as insurers experience increasing loss ratios. “Insurers had cut through the fat and already gotten down to muscle and bone,” comments David Mair, incoming president of RIMS and director for risk management of the U.S. Olympic Committee. “In the short term I see insurance markets are going to continue to harden.” Mair notes that the market “had been buoyed by strong investment performance, and in a slower growing economy this isn’t going to happen the same way.”

For “a period of pretty close to five years” rates were soft to a level that was unsustainable compared with expenses, adds Belton. “Premiums were being slashed indiscriminately just to get the business…basically it was a rate war that drove prices down.” This is especially true in the commercial property market where “the expense ratio was the highest of any of the classes” in third quarter 2000, he notes. The loss ratio was at 74.3%, and Belton points out that commercial costs are often higher because of the amount of assessment required in the underwriting process, including such things as inspections.

James Gamble, senior manager of business risk solutions with Ernst & Young, says the increase in insurance premiums indicated in the survey results could be traced back to losses from the 1998 ice storm. “You think of things like ice storms, these are very significant events…the losses that caused were absolutely tremendous, sometimes those events tend to be wake-up calls [to insurers].”

ART alternative?

The hardening of insurance rates is “an occurrence we’re prepared to deal with”, says Mair, adding that the ebbs and flows of the market are something risk managers have experienced in the past. But, he notes, “if you’re a buyer of insurance at a high level, this is going to have a big effect”. And the turning market may be an incentive for risk managers to look beyond insurance coverage to other forms of risk transfer. “It may cause us to look at the way we finance risk differently than the way we did at the height of the soft market.” Companies, Mair says, will have to evaluate carefully their appetite for risk and risk financing goals.

Seaman agrees that ART options can become more attractive in a hardening market. Risk managers may look to expand internal risk financing to “cover those things where the market isn’t attractive”. Working through the Canadian University Reciprocal Insurance Exchange (CURIE), Seaman’s department has had the benefit of CURIE’s multi-year contracts with reinsurers, intended to weather some of the storms of the market. But, he adds, “those only last until your multi-year contract comes up for renewal…you’re going to have to face it somewhere along the way”.

Hickey notes that a company’s risk financing philosophy plays a larger role in the desire to turn to alternatives beyond insurance, particularly the level of comfort with accepting this risk internally. Strategies could include higher deductibles, thus greater self-insured retention (SIR), more emphasis on risk management and loss control. “And these measures don’t always cost a lot of money,” he adds. He does see companies having a lower tolerance for “unnecessary or negligent losses”, given the conditions of the market.

Should insurers fear a turn to ART programs if they push rates up? While Seaman credits that rate increases seem so far to be reasonable, he notes that insurers may find their customers exploring other options. And he doubts whether companies who find alternatives for certain risks will revert back to insurance coverage again in the future, even should rates soften. “It’s doubtful whether that kind of business comes back into the pool…there isn’t a lot of incentive to come back.” Insurers have more than their competitors to worry about as alternative forms of risk transfer become more common. “Insurers don’t just face each other, they’re also facing other types of programs, other philosophies.”

And RIMS survey results indicate many organizations expect to at least consider these alternative more carefully in the future. “Firming [of the market] is clearly going to have something to do with that,” comments Mair. Another factor is the growing understanding of ART methods, including the limits of their application. For example, Mair recalls, “there was a lot of talk a year ago about the use of capital markets [as one ART option]…the use of those markets has disappointed.” But with growing knowledge, growing acceptance may follow, and given the range of corporations who have permanent risk management departments in place, the range of risk financing alternatives is endless. “Not now or at any time in the future is it going to be a ‘one size fits all’ market.”

Insurance rates may not be the only force at work in the decision to move to ART methods, Hickey says. “This can be a response to any number of factors, budgetary constraints, the insurance market, downsizing or mergers, joint ventures, a changing philosophy toward risk by a company.”

Volatile situation

As previously mentioned, although the RIMS survey indicates a tightening of the insurance market, retained losses were even more to blame for the rising cost of risk overall. This “volatile” component of risk is “not standard”, explains Gamble, meaning it is difficult to attribute it to a trend because it can fluctuate so drastically, particularly in light of catastrophic events.

Hickey says risk retention is “always a gamble” for companies. “If it’s a bad year for weather conditions, or crop failures, or lumber shortages or other factors, that retention will result in greater depletion of company resources. The greater the retention, the greater the threat of a big payout in the event of a catastrophic loss or failure.”

He notes that with the hardening of the market, companies may be retaining more risk than before, and experiencing some bad losses which account for the rising overall cost of risk.

The retained loss results in this case are of interest for at least one reason, Gamble notes. “The number of places where losses were higher was significant. It wasn’t just property lines.” Liability costs rose 42% between 1998 and 1999, and this was an increase in both liability premiums and retained losses (see Chart 2). Canada has seen an increase in legal liability in the past few years, Seaman remarks. What use to be viewed as a U.S. phenomena now appears to be making its way north. “If we’re having a bit of catch-up here, it might be a cause [of higher losses].”

Gamble adds that the survey only asks about uninsured losses, and it is safe to assume that if these rise, “it is very likely there are also significant insured losses”. Seaman notes that if insurers are experiencing large losses (for example, those resulting from the 1998 ice storm), then it makes sense that other organizations would also be hit by these same events.

Making it work

“When you put additional risk programs in place, you’ll have more cost,” says Seaman, in explaining how the expanding role of risk management in business may be contributing to its rising cost. “You’re hearing it from auditors, from the financial people”, that there is a growing emphasis being placed on risk. “We’ve seen a calculated rise in the cost of risk because we’ve seen a growth in the use of risk services…our hope is that it will pay off in the reduction of claims.”

At the same time, the RIMS survey reveals administrative costs fell by 50%, from $0.40 per $1,000 revenue in 1998 to $0.20 in 1999 (see “Other Costs” in Chart 2). This is directly attributable to a dramatic decline in risk management department budgets over the same time period, from $0.32 to $0.11. Risk managers are having to do more with less, “or more with the same, which has the same effect”, says Seaman. This is not just the result of budget cuts, he adds, but also the “growing awareness of risk issues in many departments that wasn’t there five years ago”.

“There is no question we’re all doing more with less,” agrees Hickey. He blames the current fiscal climate, downsizing and cost cutting. “Some companies do not see risk as a threat to their financial wellbeing, and are willing to purchase insurance and take their chances.” But this kind of approach is shortsighted, and will “ultimately come back to haunt them” with reduced loss control and prevention.

If the divide between growing risk costs and depleting risk department budgets increases, risk managers will definitely feel the pinch. As Hickey comments, “risk managers are required to do more with less resources and have to decide where the premium dollars are spent, on short-term insurance coverage or long-term loss prevention.”