Magazine article Risk Management

Measuring the Full Effects of Risk Financing Alternatives

Magazine article Risk Management

Measuring the Full Effects of Risk Financing Alternatives

Article excerpt

In early November, Warren Buffet, CEO of Omaha, Nebraska-based Berkshire Hathaway, wrote to his shareholders about the company's third quarter results:

"There are three basic rules in running an insurance company:

1. Only accept risks you are able to properly evaluate (stay within your circle of competence) and confine your underwriting to business that ... carries the expectancy of profit.

2. Limit the business accepted in a manner that guarantees you will suffer no aggregation of losses from a single event or from related events that will threaten your solvency.

3. Avoid business involving moral risk."

Later in the same letter, Buffet continued:

"General Re is revamping its underwriting practices and discipline with a new urgency to insure that all three tests described earlier are met."

The events on and following September 11 have already propelled commercial insurance rates further upward, and if Buffet's rules are adopted widely in the market, some reinsurers and their primary clients may find that they have to ration coverage, resulting in shortages of capacity for certain risks.

These developments may force a fundamental review of risk financing strategies, and many risk managers may need to employ risk adjusted return on capital (RAROC) analysis to evaluate alternatives, including reassessing the capital required to support the alternatives as well as the target and actual returns on that capital.

The first step in this process is measuring financial performance. Virtually all companies develop growth and profit targets, and most have translated these into return on capital (ROC), which-by adjusting for the debt portion of capital-can be translated into return on equity (ROE).

ROC is a guide to the most efficient allocation of a firm's capital among its business units and among alternatives for new investment. Actual and projected ROC is compared with the target return to ensure that it meets the expectations of the company's shareholders. ROE is a key performance measure used by investors and analysts and is a driver of a company's stock price.

For use within an organization (as distinct from communicating with shareholders and security analysts), the allocated capital and target return should be computed for each business unit. Both of the following elements are adjusted for a particular kind of risk:

Capital allocation. The basic purpose of capital is to protect a company against the risk of bankruptcy-i.e., to ensure that total liabilities do not exceed total assets. Therefore, enough capital should be allocated to cover the financial impact of a selected proportion of adverse events that could impact the business. Such capital is called risk-adjusted allocated capital.

Target return. The target return is the rate that adequately compensates equity investors for the risks they assume, other than the risk of bankruptcy. A widely used method for determining the target return is the capital asset pricing model (CAPM), which derives the target return from three factors:

* the risk-free rate of return,

* the average premium normally required by investors, and

* an adjustment for the relative level of risk for a particular company or business.

For many companies, the vehicle for developing these parameters for individual business units is a multidisciplinary team. Some companies' teams may include the risk manager and incorporate the assessment of risk financing alternatives into the analysis. This makes addressing new risk financing alternatives easier.

The question for the risk manager is: what impact do insurance and other risk financing alternatives have on the allocated capital and target return of each of the company's businesses? …

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