In last week’s post, I mentioned political risk insurance doesn’t cover insolvency and protracted payment default; for that you need comprehensive nonpayment policies. Many of the world’s leading corporations do not have an explicit and agreed definition of their risk tolerance or appetite.
In the client FIA example below, the financial metrics turn red (become unacceptable) when an unbudgeted loss exceeds $25 million in a given year.
We have developed a proprietary model that defines exactly what set of insurance program structures (per event and aggregate deductibles, premium, limits) yields the lowest risk for a given cost of risk for a company given its specific history and risk appetite. Again, risk is defined in terms of ‘intolerable downsides’ to a company’s most important financial measure or measures—for example, cash flow, EBITDA, or ROIC. The cost of risk is expressed as the premium plus the expected losses incurred for a given insurance strategy (set of insurance programs).

Exiting a number of other liability layers reduced cost by another $2.5 million annually while only marginally increasing risk.
At the end of the work, we demonstrated nearly $ 7 million in expected cash flow savings plus a significant reduction in risk to EBITDA, from $90 million to $60 million when looking at the 0.5% probability case. We use the FIA model we have developed to demonstrate how growing levels of unbudgeted financial losses would affect key financial measures for the client. We then worked with the client to design insurance programs and risk management activities to ensure that a loss of $100 million or worse is a sufficiently remote possibility.
Using the example of a company that wants to avoid a $100 million impact to cash flow in a given year, our modelling can tell what insurance program structures are most efficient in protecting them against that downside. The efficient frontier is the set of these insurance strategies (program alternatives), with which you cannot decrease risk without increasing costs, and for which you cannot decrease cost without increasing risk.

We modelled the value added from each layer of each line of insurance and then demonstrated how ‘switching off’ specific layers—that is, removing them—would add value either by reducing cost without increasing risk, or decreasing risk without increasing cost, or reducing both cost and risk. An important tool for us to start a conversation about tolerance and appetite is the financial impact analysis (FIA). The parameters and the loss scenarios can be changed in real time so the client can test sensitivities; this assists conversations among executives and risk managers about what the tolerances are and, once tolerances are set, helps define what executives’ risk appetite is. In this way, we demonstrate the value of insurance programs as a hedge to key financial measures.

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