Why Total Cost of Risk May be Your Most Important Valuation

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Many organizations concern themselves with various methods of valuation. They contemplate multiples of revenue, multiples of EBITDA and sometimes multiples of profit. The valuation of a business is it's lifeblood. After all, that's why we all went into business isn't it?

How many companies contemplate those valuations that are most important to protecting their most precious asset? The short answer is: not enough. I feel like I am partly to blame for that along with my peers. For years, the financial services sector has spent more time shouting "Buy me! Buy my product! I give great service! I'm different! I just shout louder and work harder!" We should have devoted that same level of effort to delivering a great education to our clients. For that, I apologize.

The fact is, most small and medium sized businesses have never thought about their Total Cost of Risk Valuation because they think one of three things. First, they think they are too small to have a total cost of risk. Second, they don't understand how to compute it so they don't even try. Third, and maybe most dangerously, they think that their total cost of risk is equal to the amount of money they pay in insurance premiums. This information will change the way you think. Are you ready for the revolution?

Last week, we talked about the different steps in the risk management process and how they can affect companies of all shapes and sizes. This week, I will attempt to set the table for the next several months in an effort to give you something you can measure. If you have the tools and no way to measure success or lack thereof, how do you know if it is working? Today, you get that tool!

The cost of risk is defined as the quantified costs and expenses associated with the risk management function of an organization.  Sounds simple, right?  We will expand in the next section. 

The cost of risk is important to the organization for a variety of reasons:

1. Making effective risk management decisions
2. Measuring progress toward risk management objectives
3. Focusing and promoting safety and loss control
4. Providing management and employee incentives
5. Pricing of products and services   

 As you can see, there is an effect that already is beginning to reach far beyond "insurance premiums".  How do you make decisions?  How do you measure those decisions?  How do you focus safety and loss control efforts in the organization if you don't even know your top financial loss drivers in both frequency and severity?  Do you have the ability to get management and employee buy-in by offering incentives?  How do you measure progress to be sure those incentives are justified?  Are you charging enough money for your product to cover and excessive total cost of risk?

Direct Costs

• Insurance Costs - this is the easiest to grasp. Unfortunately, it is also the one that most people start and stop with. It is not uncommon for someone to be paying $10,000 in insurance premiums and think that their Total Cost of Risk is $10,000. Not so.
• Retained Losses(passive or active) - active losses are those losses that you have identified, analyzed and made a business decision to retain in your organization. A good example of this is a higher deductible or self-insured retention. You probably made a decision based on loss history to take a higher deductible for a lower premium with the assumption you would not have to pay for losses inside the deductible. That is active risk. You know about it. Passive risk as those risks that you retain in your organization and don't know about it. An example of passive risk is the movement from a claims made to a claims made and reported form on your professional liability. Many claims are now not covered and you may not know that. Passive risk is what should be keeping you up at night.
• Risk Management Departmental Costs- do you have a safety person? Do you have a CFO or HR Manager that spends a portion of their time on the risk management function? Is it your time? How much time are you spending? How much is that worth?
• Outside Services Fees (Risk management consultants, Third Party Administrators and other vendors, Loss Control, Actuarial, Legal, Fee-for-service insurance broker. This list could go on for quite a while, but I have a feeling you catch the drift by now. A lot to think about? See below, we're just getting started!

Indirect Costs

Qualitative in Nature

• Loss of Productivity- did you have to operate "one man down"? 
• Overtime Costs- did you incur costs to keep other employees longer?  Did their longer hours worked also affect your productivity?  More wages for less output is not the formula for success.
• Hiring and Training Replacement Costs- we all know how hard it is to find good talent.  It is even harder to keep it.  Once you lose it, how much do you think it costs to hire someone from the street and get them to the level of the employee you lost?
• Opportunity costs- what opportunities to sell you product did you lose because you couldn't meet the customers' demands?  Do you think you will have the golden opportunity to sell to them again?
• Social Costs- how does a loss affect your reputation?  in the community?  with your peers?  with your competition?

You have a business to run. There are many moving pieces to the puzzle and managing your total cost of risk is one of the more complex and one that takes a certain level of experience and expertise. The good news is that there are plenty of qualified people to help you. Just like your attorney or your accountant, a risk management consultant will save you more money than they cost you in just about every case. Find someone that knows your industry that has a good track record and make them a part of your advisory team. Include them in meetings, let them into your operations and watch the impact that an effective risk management program has on your overall profitability.

David R. Carothers, CIC, CRM is a Risk Management Consultant and Licensed Insurance Agent with Praxiom based in Tampa, FL. To contact David Directly, please email him at drc@praxiom-rm.com.