How to stop insurance being a drag on the bottom line

31 March 2017 - by Cara McFadyen

Financial aspects

Insurance is a drag on the bottom-line. This is a real challenge for an industry faced with selling grudge-purchases—but we think that this really should prompt the question of:

How much of a drag on the bottom-line?

It seems appropriate to look at this by taking insurance down to first-principles, the cash flows. We can make an appraisal by looking at the impact of insurance premium and residual risk, on profits.

Next reasonable questions are:

How much insurance do we need? Is this reasonable value for money?

It’s key to note that risk exposure is perpetual, it doesn’t go away. Risk-profiles are dynamic, they change as businesses change—risk is an ongoing pressure.

Insurance is traditionally presented as an annual arrangement—an annual transfer of risk, in consideration for an annual insurance premium— and so the cost of insurance can be considered in perpetuity.

This is done by taking the annual insurance premium cash flow and dividing it by our client’s weighted-average cost of capital (WACC), rather like other net present value (NPV) calculations.

We then model future risk scenarios, also in cash flow terms, to get an NPV for the cost of risk occurrence.

The question of the appropriate amount of insurance, and its value for money, are then just comparisons of two NPVs. If the cost of insurance is less than the likely cost of risk occurrence, then insurance is good value—and vice-versa.

These are key questions that handle financial aspects of risk & insurance decision-making, but this is not the only consideration. This is not the full-picture.

Strategic aspects

To complete the picture we need to consider strategic factors. Here we are looking at there being three key questions:

1. How does this arrangement affect the firm’s competitive advantage period?

This is a key consideration for any business in a competitive market. Unresponsive insurance arrangements—or arrangements that imply delays in the settlement of claims—are not only challenging in cash flow terms, but they can be a real challenge for a business’s resilience. Losses in market-share, brand-loyalty and a challenge to competitive-focus can be critical as product- lifecycles accelerate, and uncertainty and rates of change increase.

2. What is the effect on risk-profile?

Risk appetite is subjective. And the extent to which risk is either retained or transferred is not only a financial decision, but also one that is influenced by the memory of the business, and people within it.

Increasing availability of risk data can, and really should, be used to inform risk-analysis.

3. Does this fit the business’s portfolio?

It frequently makes sense to consider a business as a portfolio of cash flows. The portfolio can be used to leverage economies of scale for cheapest- possible costs of debt, equity and costs of goods sold. But real opportunities to optimise risk- portfolios exist in a similar way. We frequently see differences in business segments and risk- segments for example, and both challenges and opportunities ensue.