Managing Your Risk
Financing risk begins with calculating its cost

By Michael Kelly
Property and Casualty Program Specialist

This month marks the first anniversary for the "Managing Your Risk" column in CountyLines, and I must admit it has been an interesting as well as fun endeavor. Since June, I have written about three of the five major categories in the risk management process and given general overviews of the purpose and goals for each.

The fourth integral part of risk management, after you have identified, analyzed and established loss prevention/reduction procedures to control risk, is finding the money to fund your risks. In order to be able to fund it, you first have to be able to accurately calculate the actual cost of your county's risk.

By definition your cost of risk is the method of assessing the results of a county's risk management activities by measuring the expenditures used to actually fund the costs associated with risk on a year-to-year basis and/or by comparing these expenditures to similar sized counties in North Carolina.

Such cost examples could be any risk management departmental costs, i.e. staff – including salaries, health insurance, matching retirement savings, computer hard/software, office equipment, etc.

Next would be any outside contracted vendor services such as expenses associated with hiring an outside risk management consultant, third party administrators (TPA) for claim services, a risk control specialist (safety engineering), actuarial/accounting services, legal services and insurance agents/broker commissions.

Following next would normally be any retained losses such as deductibles, larger self-insured retentions (active costs), and any unforeseen, overlooked and hence unidentified losses (passive costs). The latter class is the one that can hurt you the most and is often generalized as the "oops" category. The goal is to have as few as possible of these passive, unanticipated costs. Good risk/exposure identification will help accomplish this.

The fourth category includes any other indirect costs such as staff overtime, loss of productivity from key personnel not being on the job, and even loss of opportunity costs from not being able to take advantage of a favorable business situation due to personnel absences.

Last to consider for calculating your county's cost of risk is, of course, any actual insurance premiums (or contributions if you are in the NCACC Pools). Often, some groups err by considering only the insurance premiums to calculate the cost of risk. As illustrated, the premiums comprise only a portion of the entire expenditures attributed to the total cost of risk.

After having done this, the critical components within risk financing are deciding what should be retained (and funding provided for internally) versus what should be transferred to others (insurance carriers, other parties via contracts, etc.). It is important that a balance be established between what level of risk you intentionally agree to take on versus what you lay off or transfer to others. Your county's appetite for assuming risk is the primary factor in this decision, and it is comprised of the expected retention of budgeted losses plus your tolerance corridor.

Tolerance corridor is the marginal retention amount beyond the budgeted retention that may also be included in what you intend to actively retain in your cost of risk budget. Its size/amount can vary considerably depending upon your financial position (reserve balance level) and the confidence in your risk management staff.

Your tolerance for risk should be a flexible value that will fluctuate with your own loss experience, accumulation of funded cash reserves, and insurance market conditions. When the market is soft (heavily favoring the buyer), lower retention/deductibles (including guaranteed cost programs) and higher liability limits should be considered, provided total cost variance can remain close to flat. Conversely when market conditions make it harder to procure coverage for reasonable numbers, exploration of higher retentions and increased participation in lower, more limited exposures become necessarily more attractive.

Being able to retain higher portions of each loss allows the pure insurance costs to be less since the carrier's coverage does not financially come into play until your chosen retention level has been met. All factors remaining constant, the higher your chosen retention level, the less your insurance will cost. This makes sense in that the insurance company's exposure to paying losses is lessened as their beginning layer of coverage participation increases.

Now the key to making your assumption of a higher retention level "fly financially" is to have a sound risk management program in place so that you are aggressively controlling and limiting the lower portion of each loss that you are responsible for. Essentially this eliminates your trading premium dollars for assumed deductibles or retentions.

If you can sustain higher deductibles, you should work to make this happen. Accomplishing this can take several policy terms to allow accumulation of cash for higher future deductibles or retentions. The easiest method is to set up a line item in your risk management budget labeled "pre-funded retention," and each year deposit the difference in premiums saved from accepting a higher deductible/retention until that account builds up to the point to again consider raising the retention level. If insurance market conditions continue to be soft and your premiums come in lower than last year, again take the difference and "deposit" them in your pre-funded retention account.

Even though you are essentially more exposed per claim, given a good working risk management program you are still very much protected for the catastrophic type exposures (which should be formally insured against through insurance carriers). This is all while still maintaining control over the lower "working layer" of expected low severity, high-frequency type losses. Efficiently handling these lower levels of loss on your own will allow you to eliminate the insurance carrier's overhead, plus agent/broker commissions and their respected level of profits. As such, you should experience substantial savings in the long run, all while having more control over your total cost of risk.

As I have stated before, it all boils down to four very basic tenets for risk financing:

• Never risk a lot for a little.
• Never retain more than you can afford to fund (lose).
• Always consider the probability of something happening (odds).
• Never – NEVER – treat insurance as a substitute for good loss control.

A strategic, carefully planned method to accumulate a pre-funded retention account is a risk financing tool to be considered that will increase your control of losses and decrease your cost of risk over a three- to five-year horizon.

NCACC Property and Casualty Program Specialist Michael Kelly writes a regular column on risk management for CountyLines. With more than 32 years of risk management/insurance experience, he holds the Associate in Risk Management, Associate in Risk Management for Public Entities, Certified Risk Managers and Certified Insurance Counselors professional designations. Archived versions of the column can be found online at www.ncacc.org/managingyourrisk.html.