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Risk in Context

Are You Measuring Economic Cost of Risk? Here’s Why You Should

Posted by Claude Yoder June 22, 2015

Massive data breaches. Costly product recalls. Devastating natural disasters. Every day, we’re reminded that unexpected events can have serious consequences for your business. Risk managers must plan for this volatility in their risk financing and management decisions, or take a chance on paying the price later.

Volatility can lead to unexpected and even negative effects on earnings and financial performance. Insurance markets price programs based on levels of volatility. By accounting for volatility, you can directly tie financial performance metrics to insurance decisions.

To measure volatility and risk exposure, companies have historically relied on traditional total cost of risk (TCOR) calculations. But TCOR is an incomplete measure as it typically represents the insurance premiums an insured spends, costs of losses retained, and other items such as administrative costs, fees, and taxes. It places no value on uncertainty, even though the amount of losses at any one company fluctuates from year to year.

Companies need a better way to measure risk.

IMPROVING VOLATILITY MEASUREMENTS

The importance of measuring uncertainty and volatility has led to the creation of a new measure of risk: economic cost of risk (ECOR). ECOR is defined as the sum of expected retained losses, insurance premiums, other expenses such as fees, and a new metric, the implied risk charge.

By assessing the severity and likelihood of detrimental outcomes and their associated cost, the implied risk charge places a value on volatility for each company. Even the best-prepared company can face unforeseen events, so every organization bears an implied charge for the unexpected.

How can your company assess its volatility risk through ECOR? Here are some strategies to consider:

  • Understand historical losses. Review your year-over-year loss history for a snapshot into recent loss trends, including swings from high to low levels of loss.
  • Quantify your risk exposure. Use ECOR to measure real-time impacts of changes in your expected losses, market conditions, and insurance premiums.
  • Evaluate risk financing options. Through risk financing optimization (RFO), simulate your company’s risk exposure before and after insurance. RFO provides insight into future potential losses and the different options available to transfer risk, helping you make the optimal decision based on the easy-to-understand metric of ECOR.

By using ECOR to measure cost of risk, you can now place a value on volatility and more effectively connect the dots between your risk financing and performance metrics.

Related to:  Analytics

Claude Yoder

Claude leads the Global Analytics Practice, an area responsible for enhancing and evolving Marsh’s analytical offerings on behalf of clients, colleagues, and markets.