Using data to understand volatility in the cost of risk

In today’s ever-evolving business landscape, understanding risk exposure is more important than ever. Traditionally, many companies have focused on known costs like insurance premiums and retained losses. While this approach provides some insights, it often overlooks the inherent uncertainty and volatility of potential losses, which can fluctuate significantly from year to year.

For example, external factors such as trade disputes between nations can disrupt supply chains, increase costs, and create market instability. Additionally, events driven by climate change, like flooding and wildfire, are now more frequent and severe, threatening infrastructure, property, and operational continuity. These examples highlight how geopolitical tension and natural disasters can drive significant volatility in risk exposure, underscoring the need for a proactive and adaptable risk management strategy.

To better understand these dynamics, organizations can use frameworks that provide insights into risk, such as total cost of risk (TCOR) and economic cost of risk (ECOR). Unlike TCOR — which primarily considers direct costs such as insurance premiums and retained losses — ECOR incorporates an implied risk charge (IRC). The IRC evaluates the severity and likelihood of detrimental outcomes and their associated costs, recognizing that no company is perfectly protected against the unexpected. Every organization bears an implied charge for their unexpected risk, which can be quantified for any insurance or mitigation structure.

Measuring volatility: Metrics in practice

Let’s look at two companies, both averaging €8 million in annual losses over the past five years. At first glance, they might seem equally risky because their averages are the same. However, a closer look reveals a crucial difference: One company’s losses are quite stable, while the other experiences significant fluctuations, including high-loss years.

Over five years, only once did losses at Company A exceed the average, reaching €9 million. This consistency means its losses are predictable, with only minor fluctuations. In contrast, Company B’s loss history is more volatile — in one year, losses hit €12 million, in another, €15 million, while in yet another losses were only €2 million.

This difference in volatility is important. Company A, with stable losses, faces a relatively low and manageable cost of risk. The more volatile Company B faces a higher risk premium because its losses can vary widely, potentially necessitating a different strategic approach to managing exposures.

This example highlights that understanding the average loss is important, but that you also must understand the potential year-to-year variance in losses. Recognizing this variability helps organizations make smarter, more informed risk management decisions, balance risk transfer with resilience, and better prepare for the unexpected.

Finding the right tools to inform risk strategy

With the right tools and data, organizations can navigate the complexities of risk in a proactive and informed manner, ensuring they are well-prepared for the challenges ahead. Advanced analytics platforms, such as Marsh's Blue[i] Analytics solutions, play a crucial role, providing deep insights into risk exposure, volatility, and potential future scenarios. These tools enable organizations to move beyond traditional metrics, allowing for a nuanced understanding of both known and unknown risks.

Using sophisticated data analysis, clients can identify patterns and trends that might otherwise go unnoticed, quantify the financial impact of volatility, and assess the effectiveness of their risk mitigation strategies in real-time. This approach facilitates more accurate risk pricing, better capital allocation, and more resilient risk transfer programs. Moreover, analytics can support dynamic recalibration of risk management strategies, ensuring they evolve in tandem with changing market conditions and emerging threats.

Ultimately, integrating advanced analytics into risk management processes empowers organizations to make smarter, data-driven decisions. This enhances their ability to withstand unforeseen events and optimizes their overall financial performance and resilience in an increasingly volatile world.

As risks continue to evolve, the strategic use of analytics will be indispensable for organizations seeking to maintain a competitive edge and safeguard their long-term value.

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Article

Using data to understand volatility in the cost of risk

Measuring volatility: Metrics in practice

Finding the right tools to inform risk strategy

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Using data to understand volatility in the cost of risk

Measuring volatility: Metrics in practice

Finding the right tools to inform risk strategy

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