Magazine article Risk Management

Preparing for the Worst: How Large Losses Can Affect Stock Prices

Magazine article Risk Management

Preparing for the Worst: How Large Losses Can Affect Stock Prices

Article excerpt

The potential effect that a large self-insured loss can have on a company's stock price is often overlooked when risk retention strategies are crafted. Assuming that a large loss is funded through additional borrowing, the effect of such a loss on net income can be substantial. Consider, for instance, that funding a large loss through borrowing will increase the company's debt-to-equity ratio and retard the future growth of the company, which in turn reduces the company's price-earnings ratio.

We can use stock valuation models from finance literature to estimate and illustrate the effect of a loss. By doing so, we find that the stock market effect of retaining a large loss can easily exceed the direct cost of the loss, making the effective retention larger than the organization intended.

The number of companies adopting large retentions increased after British Petroleum's move to drastically change the way it approached its use of insurance. Rather than assuming large self-insured retentions and buying excess insurance above those retentions, the company decided to purchase basic insurance with relatively small coverage limits and to self-insure the losses in excess of its basic limits. British Petroleum cited several reasons for this decision. The company determined that insurance carriers were better able to provide certain services associated with high-frequency, low-severity losses such as claims processing, loss assessment and loss prevention. Also, having basic insurance allowed British Petroleum to satisfy certain regulatory and contractual requirements.

British Petroleum's analysis also indicated that excess insurance was overpriced. Moreover, the company had greater risk-bearing capacity than the insurance industry. Finally, the government was a large coinsurer because profits produced at BP's locations with the greatest exposure to loss were taxed at rates as high as 87 percent. (For details, see "Corporate Insurance Strategy: The Case of British Petroleum," by Neil A. Doherty and Clifford W. Smith, Jr., Journal of Applied Corporate Finance, Fall 1993, pp. 4-15.)

This rationale has been widely circulated among financial officers and risk managers. Many have found it persuasive, even when their own firms do not have the risk-bearing capacity of British Petroleum; a growing number are willing to assume more substantial retentions. Determining a company's maximum retention then becomes a very important element in their review.

Several authors have suggested methods for deciding how large a loss a company can comfortably retain and fund. Most of these guidelines are based on the effect of the loss on various financial ratios of the firm or the effect of the loss on the firm's net income or cash flow. This article goes a step further and examines the effect of stock price movements and the sensitivity of stock price changes to these financial ratios.

Stock Price Drivers

The financial ratios that have the most profound effect on the price of the company's stock are isolated. Once the effect of an uninsured loss on these ratios is determined, the resulting stock price effect can be estimated. For this examination, we have assumed that the loss will be financed by additional borrowing and not by any reduction to the company's dividend level.

The earnings capitalization model is widely used to determine stock price. In this approach, the market value of a company's stock is calculated by dividing the estimated net income for the next year by the return shareholders are anticipating, minus the estimated earnings growth associated with inflation, productivity improvements and growth resulting from the investment of retained earnings.

In analyzing the appropriate price for the company's stock, a security analyst will restate the stock price formula as the product of the estimated earnings and a multiple of the priceearnings ratio. After restating the pricing formula, the analyst will estimate projected earnings for the next year as well as an appropriate price-eamings multiple. …

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