Back to Basics: Understanding Risk Appetite Before Buying Insurance

The theme of this year’s AIRMIC conference, “Back to Basics”, prompted some important conversations across the risk and insurance community.

For JPIC Group, one question stood out:

How can an organisation decide what insurance to buy before it has properly understood its own attitude to risk?

It sounds obvious, but insurance buying decisions are often not  approached in this order.

Insurance programmes can evolve over many years, influenced by historic claims,  market conditions, established renewal processes and changing advice. Limits, deductibles and programme structures can become embedded over time without necessarily being revisited against the organisation’s current business model, risk profile, financial position or strategic objectives.

Going back to basics means starting somewhere different on a “clean sheet” basis.

It means first understanding the business model of the organisation and the risks that it faces, the location of the various types of risks, which risks it is prepared ,and financially able to, retain, and only then determine where insurance and other forms of risk financing should sit.

Risk appetite and risk tolerance: what is the difference? 

---

An organisation, after understanding its internal business model, should evaluate its risk appetite and risk tolerance. The terms are often misunderstood and often used together, but they are not interchangeable.

Risk appetite is the amount and type of risk an organisation is willing to accept in pursuit of its objectives. This is somewhat subjective and depends on the perception of the stakeholders within the organization.

Risk tolerance is more analytical and is the level of variation or loss that the organisation can withstand before action is required or its objectives are threatened.

In practical terms, one considers willingness; the other considers capacity.

Insurance strategy should reflect the individual organisation’s appetite and tolerance for risk.

Insurance should follow the risk strategy

---

A common danger is allowing the insurance renewal process to drive the risk financing strategy rather than the other way around.

The starting questions should not simply be:

• What did we insure last year?
• What limits do our peers buy?
• What premium reduction can be achieved?
• What products are available in the market?

Those questions have a place, but they come later.

The more fundamental questions are:

• What are the organisation’s principal risks and where are they located?
• Which risks could materially affect its financial and operational objectives?
• What level of financial loss can the organisation absorb?
• Where is earnings volatility acceptable, and where is it not?
• Which risks can be reduced or controlled operationally?
• Which risks should be retained?
• Which risks should be transferred and what would be the Total Cost of Risk?
• What is the purpose of buying insurance for each exposure and what is the value of that insurance to the organisation?
• Is it even possible to insure given that the majority of risks faced by businesses are uninsured or uninsurable.
• If most risks remain uninsured, how are they financed currently and what is the value of insurance compared with other risk financing mechanisms?
• Will the insurance programme respond in accordance with the organisation’s business and financial model and corporate tax strategies?

Without clarity on these areas, organisations risk buying insurance without a fully defined strategy behind it..

The danger of inherited insurance programmes 

---

Insurance programmes often contain elements that are the result of decisions made many years ago.

A particular deductible may have been appropriate when the organisation was smaller. A policy limit may have been set before a significant acquisition or change in asset values. A coverage structure may have been designed around a very different operating model.

Over time, the group structure and internal business model of an organisation changes.

It acquires and disposes of assets, enters new territories, introduces new technology and products/services, develops different revenue streams and experiences changing claims patterns. Its financial capacity and attitude to volatility may also change.

The insurance programme should not remain static while the organisation evolves around it.

Regularly returning to the fundamentals helps ensure that historic arrangements remain relevant rather than simply familiar.

What should organisations be considering?

---

A robust review of risk appetite and insurance strategy should involve more than the risk or insurance team alone.

Depending on the organisation, input may be required from representatives from finance, tax, operations, legal, property, technology and senior leadership.

The objective is to build a shared understanding of:

The organisation’s key exposures

What events could create the greatest financial, operational or reputational impact?

This should include both insurable and non-insurable risks. Insurance is one tool within a wider risk management framework, not the answer to every exposure.

Financial capacity

How much loss can the organisation comfortably absorb?

This needs to be considered at individual loss level and in aggregate. Most risks are uninsured, so how does the organisation finance these and at what point does the tolerance for these risks prove too great?

Loss experience

What does historic loss data reveal?

Incident frequency, severity and volatility can provide valuable evidence when considering exposure to risk, financial and reputational impact and levels to which insurance may add value.

An absence of incidents should also be examined carefully. It may indicate strong risk management, but it may also mean that an organisation is paying to transfer losses it could comfortably retain.  The fact that something has never happened in the past is not necessarily an indicator that it will not happen in the future.

Risk controls

Risk financing decisions should take account of the controls already in place.

Good risk management may reduce the likelihood or severity of loss and can influence how an organisation chooses to finance the residual risk.

Strategic priorities

Risk financing decisions should support the wider business strategy.

An organisation entering a major growth phase, making acquisitions or taking on debt may have a very different tolerance for volatility from one with significant available capital and stable operations.

The total cost of risk matters more than premium alone

Insurance purchasing conversations can understandably become heavily focused on premium.

However, the lowest premium does not necessarily represent the most efficient outcome.

A more complete assessment should consider the organisation’s total cost of risk, including:

• Cost of finance
• Insurance premiums
• Premium tax liabilities – payable to insurers and directly to relevant authorities
• Corporate tax liability – particularly on claims
• Uninsured losses
• Claims administration costs
• Management time in dealing with risk events or incidents
• Internal risk management resources
• Risk control expenditure
• Operational disruption following losses
• The potential financial impact of uninsured or inadequately insured events
• The potential impact of multiple interconnected risk events

Ultimately, consideration of all of these factors leads to a clearer picture of how risk should be financed and therefore, the role that insurance can or should play in a strategic risk financing programme.

The answer should be evidence-led rather than driven solely by market pricing.

Asking the right question at insurance renewal

Insurance Renewal remains an important moment, but it should not be the only time an organisation thinks about its insurance strategy.

The question should move beyond:

“Can we renew this programme on better terms?”

A more valuable question is:

“Does this programme still reflect the risks we face, our financial capacity and the risks we are prepared to retain?”

Those are very different conversations.

The first focuses on a transaction.

The second focuses on strategy.

An independent perspective

Insurance brokers and insurers both play important roles in helping organisations manage and transfer risk.

There are also circumstances where an independent strategic review can provide additional value by stepping back from the placement process and considering risk financing and insurance from the organisation’s perspective.

At JPIC Group, we work with organisations to review whether their existing risk financing arrangements remain appropriate, efficient and aligned with their wider business objectives.

This can include reviewing:

• Risk appetite and tolerance
• Key risks and insurance gaps
• Programme structure and policy limits
• Deductibles and self-insured retentions
• Premium allocations and premium tax liabilities
• Claims experience and loss trends
• Alternative forms of risk financing
• Governance and decision-making frameworks

The objective is not change for the sake of change, but to ensure that insurance and risk financing decisions have a clear rationale behind them and remain aligned with the organisation they are intended to protect.