Corporate risks don’t exist or occur in isolation, so let’s change the nature of the discussion of exposures and risk management.
Shareholders rarely think about losses linked to certain bundles of hazards, exposure and perils in the context of lines of insurance, such as property or employer liability. Similarly, chief financial officers (CFOs) are tasked with managing downside risks across their organizations to achieve shareholder expectations on revenue, earnings and growth.
Yet corporate de-risking activities are typically handled in silos, oriented to the way the insurance industry has organized itself in such a way to specialize talent, resources and mitigation strategies — rather than being attuned to the specific financial needs of the enterprise.
The portfolio effect
I think the corporate risk community is generally missing a trick when it comes to the “portfolio effect”.
Really, insurance lines are just risks. If we broaden this perspective and represent risks in the common language of statistical probabilities, then we can view a corporate collection of diverse risks in a portfolio sense.
Here things really become interesting. When we do this, we see that not all risks manifest at the same time, and we also see the benefit of portfolio diversification. This knowledge is profoundly empowering when defining a risk strategy optimized to achieve an organization’s financial imperatives.
In fact, through a proper application of company-specific correlation and dependency analysis, you can fully appreciate the nuance of this portfolio of risks. You see the inherent offsetting benefit from a diverse portfolio of risks and can measure tail correlation in otherwise independent risks that cause major corporate reversals.
Even within a single risk type, viewing the exposure as a full portfolio can accurately measure the level of risk at a return period. Consider that the probability of a 1-in-100-year event at a single location is 1%, but the probability of a 1-in-100-year event striking at least one of 10 locations is approximately 10%. Over the course of 10 years, the probability of a 1-in-100-year event affecting at least one location rises to 63%.
The pursuit of arbitrage
By understanding risks and risk transfer strategies simply in terms of their cost and financial consequences, indifferent to the types of risk or insurance lines of business, we can take full advantage of pricing inefficiencies. Individual lines of business or geographies harden and soften at different times in response to a variety of pressures. If you can make apples-to-apples comparisons among lines of business, you can purchase high value hedges — those that give you the most “bang for your buck”.
Navigating the relative value for cost is at the heart of the pursuit of arbitrage, but it requires a change of mindset. Insurance brokers have become expert at helping corporate decision makers understand value for spend and determine whether to transfer or retain risk line by line, but we as an industry have not so far successfully provided this expertise across risks in portfolio. This is the intelligent frontier.
By disregarding organizational silos and understanding all risks across a portfolio and over time, one can optimize for expected and for severely adverse events and can construct de-risking strategies that harness the power of the portfolio effect to maximum value — tuned specifically to an organization’s unique financial imperatives.
Once you harness the power of the portfolio, you can have both a more complete and a more actionable understanding of how to best finance a total risk portfolio. You can become agnostic to insurance lines of business and frame de-risking activities (such as the purchase of insurance) according to the things that matter to finance executives and corporate boards: short- and long-term cash flow, profit and loss impact, balance sheet consequences, lending covenants, bond/debt rating ratios and so on.
You can empirically say that you have evaluated risks across the enterprise (including how they interrelate), and have devised a plan to de-risk the organization with maximum efficiency and effect. And in executing that plan, you will enable internal risk capital to be deployed elsewhere in pursuit of greater return.
A different discussion
Bringing these points together, imagine if we told a CFO that we have constructed a de-risking strategy (which includes buying some insurance) that is tuned to ensure preservation of the cash balances in the five-year forecast and protect the balance sheet ratios that concern them (because they concern the bond rating agency).
What if we said that we can provide empirical data and robust analytics that draw from the strongest legacy of risk portfolio optimization for the insurance industry to back our claim? What if we said that the board, the C-suite and shareholders could have confidence that organizational downside risk is protected at the best value for dollar, in complete alignment with their objectives?
Wouldn’t that be an interesting discussion?
Sean Rider is Head of Client Development — North America, Risk and Analytics, Willis Towers Watson.