Negosentro| What Is Risk Consistency and Why Does It Matter? | How do you know if you’re buying too much insurance?
Put another way:
How much insurance should you buy?
For many, it might seem this question has a complex and multifaceted answer. Instead, there’s a simple rule of thumb you can use. And that’s to merely remain consistent with the risk you’re willing to take.
After all, why would you take on significant risk with some items on your balance sheet and be ruthlessly risk-averse about others? The key is maintaining risk consistency.
What Are You Risking?
It’s simple enough to say “insure what you can’t afford to lose,” and go about your day. However, this fails to take many important factors into account.
For starters, why are you buying insurance?
In short, insurance gives you access to someone else’s balance sheet. In other words, you get to transfer the risk of some items from your balance sheet to your insurer’s.
So, which items should you transfer? If you look at each item individually, they all present X or Y amount of risk.
However, there’s a more holistic approach.
Look at what you’re already comfortable risking. Purchasing insurance independently from your balance sheet makes no sense. Even if you reduce risk around some items, it does nothing to reduce overall risk if you’re still willing to absorb catastrophic loss in others.
So, start with your biggest risks and be consistent.
For instance:
Liability Risks
What are you risking with the loans on your balance sheet? How much value do you stand to lose if interest rates go up, and how likely is that to happen?
Quite likely for many loans. And yet, it’s a risk most organisations are happy to take on uninsured.
Moreover, what will an increase in the price of fuel or raw materials do to your bottom line? How long will it take you to recover?
And these are all predictable risks. By definition for most organisations, these are not insurance liabilities and therefore remain uninsured.
Asset Risks
Much like your liabilities, your assets also present risks. There’s a substantial market risk that organisations take on with their investments.
You might say the purpose of hedging is to act as a form of insurance for these types of risk. However, hedges also carry downside risks, so strictly speaking, they’re not insurance.
Debtors might fail to settle their debts, presenting a credit risk. Subsidiary investments could become impaired. All these are uninsured risks and some could lead to a collapse of your bottom line.
Even insured risks continue to represent a degree of risk.
Insurance policy wording may judiciously exclude some of the actual losses associated with insured items. Your insurer might even fail, depriving you of any compensation for a claim that you rely on.
So What’s a Better Approach?
What this all goes to show is that you’re taking on substantial risk whether you like it or not. Meaning, you shouldn’t make insurance decisions based on individual item risk while leaving the balance sheet as a whole in the lurch.
When you put your insurance decisions into the context of your entire balance sheet, you might find you’re risking catastrophic loss in a lot of places.
So it only makes sense to remain consistent about the risks you’re willing to take.
It’s worth noting here that some organisations may be tempted to go the other way. Instead of increasing the general risk across the balance sheet, it may seem like a good idea to reduce risk everywhere.
Trying to mitigate risk in such a general sense will usually cost much more than the cost of self-insuring the risks. Moreover, it’s generally not a good idea – insurers expect to you take some risk.
Although there are many risks you’re taking on that could ruin you, they’re actually much more predictable than you might think. That’s why you’re willing to take those risks.
Therefore, next time you’re looking at what you can and can’t afford to lose, think about what you’re already risking on a day-to-day basis. Use this as your guide and remain risk-consistent with your insurance.
What to Do Next
The first step is recognising that you’re probably being inconsistent with your risks. Once you do that, we can help you.
By helping you understand Your Past and Your Future – and what role they play in your insurance buying process – we can make it easier for you to make informed and consistent choices.
Our InsuranceInspect Services consultancy product can help you form a consistent, holistic view of your risks (insured and uninsured), to optimise your use of insurance.
Author’s Bio:
John is an actuary and owner and Director of HJC Actuarial, which he founded in 2003 and which has advised over 100 clients since it’s’ inception. He has worked in the insurance industry for 30 years, qualifying as an actuary in 1995 and becoming a Partner in a major global consulting firm in 2000. Since 2003 he has provided independent advice to his clients on optimal insurance program design, presentation of risks, and premium negotiation with insurers, insurer solvency assessments, policy wordings, insurer selection, and insurance broker selection.
