Calculate Your Implied Risk Charge to Manage Catastrophic Casualty Risk
From a product defect that injures several customers to litigation stemming from auto collisions involving your vehicles to a series of costly workers’ compensation claims, even the best-prepared company can face large, unforeseen losses. To effectively protect against those potentially catastrophic losses, it’s important to understand your potential loss volatility.
Estimating Implied Risk Charge
An implied risk charge (IRC) is a measure of the volatility cost of a company’s loss potential. IRC can be measured by evaluating your company’s potential for loss exceeding its average expected losses, and calculating the borrowing costs required to fund for loss above that level — meaning the company’s unexpected losses.
IRC can be calculated by taking three steps:
- Define the company’s risk tolerance or its ability to withstand unexpected losses.
- Look at the loss history of the company’s industry, to understand its potential for suffering severe losses.
- Examine the company’s borrowing costs — the contingent capital requirement in the event of a severe loss.
A company’s IRC can vary depending on how predictable or consistent its loss history has been. For example: Over the last five years, Company A and Company B both had an average of $10 million in annual product liability losses. But while Company A has had only one year exceeding that average (a year in which the company had $11 million in losses), Company B suffered losses of $15 million in one year and $18 million in another. Assuming borrowing costs are the same, Company B’s loss history is more volatile — meaning it has a higher IRC.
Reducing Your Loss Volatility
Once an organization has calculated its casualty IRC, the next question is: What can be done to reduce it? You could consider efforts in areas such as:
- Pre-loss mitigation. If your biggest area of potential risk is product liability, you can reduce your risk volatility by optimizing the engineering, design, and manufacture of your products. And you can introduce strong quality control programs aimed at identifying and resolving product defects before they become major events. Meanwhile, you can reduce your workers’ compensation and auto liability loss volatility through workplace safety programs and driver training programs.
- Legal and contractual management. Scrutinizing the language in your contracts with customers, suppliers, and others can help to limit your liabilities and cap the potential severity of a significant loss.
- Insurance program structure. Minimizing coverage gaps and increasing your limits can help reduce the frequency and severity of catastrophic casualty losses.
Taking these steps will not only reduce your company’s loss volatility but also have a favorable impact on related elements of the total cost of casualty risk — yielding even bigger bottom line results and better protecting you from catastrophic losses.
For more on this topic, listen to a replay of our The New Reality of Risk webcast.