Insurance—A CFO's Perspective

What Is Insurance?

Before making any choice of underwriting companies and/or distribution channel(s), you need to answer two basic questions: What is insurance? and What does it do for me?

Insurance is a short-term contingent letter of credit (LOC), without recourse. Insurance is a short-term contract, generally written for a 1-year period. It is a contingent LOC because the contract provides financial reimbursement for certain types of risks or specified events. It is without recourse because you do not have to repay the principle, nor is there any interest due by the insured following a claim. Therefore, insurance can be thought of as a short-term financial vehicle with similar, but not identical, characteristics of selected capital market instruments.

From an insurance company perspective, the intent is to underwrite risks where the total premium received is slightly more than its portfolio losses. From an individual risk perspective, insurance reimbursement for significant loss may translate into a 1-in-30, 1-in-50, or even a 1-in-100 year event.

Insurance covers selected fortuitous risks. Who is identifying, prioritizing, and managing other risks not covered by insurance? It is important to have a clear understanding of insurable as well as non-insurable risks. It might be advisable to redirect premium dollars toward a budget provision for managing risk for non-insurable risks, which can have a notable impact on a business.

What Does Insurance Do for Me?

It is important to focus on the fact that insurance is a financial reimbursement contract for a limited number of risks faced by businesses. For example, insurance may provide reimbursement for a business interruption loss caused by a fire at the plant of a critical supplier, but it does not provide any help in maintaining customer continuity of the flow and timely delivery of products to customers. Further, insurance does not provide for impairment of a business's reputation or brand. Therefore, while selected risks can be financed, all risks require management.

Keep in mind, also, that insurance companies generally do not have more than a snapshot of business sites, loss histories, and a sketchy knowledge about what makes a business successful. With this understanding, do not expect insurers to do more than provide financial reimbursement.

So, now that we have briefly focused on what insurance represents and what it generally does and does not do, we need to examine criteria for successful business relationships.

What's Really Important?

Many risk managers are overly concerned with pricing and "getting the best deal" when buying insurance for their firm. Perhaps this results from the fact that most businesses never expect to incur a serious claim.

What specific enterprise objectives are being accomplished by purchasing the "best deal" insurance? What is really important? Tell your boss what you believe is important and why. Then go do it!

First, it is important to determine your goals—what you intend to accomplish.

• Fair pricing is readily determined by asking other businesses what they pay for like insurance coverage. For catastrophe capacity above expected claims, the pricing is reasonably comparable. Pricing is a consideration only after you are satisfied your claims would be paid promptly (high credit quality); otherwise, the cheapest premium paid is too expensive.
• Market selection is not as difficult as it may seem. There are about 2,000 property/causality insurance companies; however, only about 25 are able and willing to lead large risk programs. Depending on your concerns over credit quality, the subset of 25 may be further reduced. Ultimately, you want claims paid promptly, especially the large ones.
• Policy or contract wordingmay require the attention of one of the rapidly growing number of law firms that specialize in insurance contract review and advice regarding appropriate terms and conditions. The insurance contract(s) used in common practice may or may not provide you with the scope of protection you expect or intend.

After assessing the above factors, you must determine what other criteria need to be considered. What do you really want from your underwriters? Below are a few suggestions.

• High credit quality firms
• The ability to deal with underwriters at their strategic center
• A management team that focuses more on balance sheet strength than current profits (e.g., the long-term view versus the short-term view)
• Firms that have a track record of paying claims promptly without a continuous process
• Direct linkage, periodically, to the underwriters' top management
• Stable/growth-oriented relationships that have individual continuity

What do you expect from your broker or agent?

• Does your account team understand your firm's business fundamentals and associated risks?
• Have you established clear, written service expectations with periodic audits of the actual service delivered?
• Does you broker align your firm with insurers that match with your needs profile, perhaps the one above?
• Are your interests placed in front of those of your brokers?
• Do you have open, candid communications with your broker(s) and underwriters?
• In general, do your service partners (e.g., underwriters and brokers) deliver as represented on time, every time?

Mini Case Scenario

Following a loss for $10 million, senior management of the impacted enterprise asks: Will we be paid in full? When can we expect to be paid? And the risk manager's response will be which of the following?

1. We have to determine the effect of the coinsurance clause or the retro formula.
2. The policy wording is subject to review and interpretation.
3. Our underwriters will request payment from their reinsurers and keep us advised.
4. We have requested an advance payment of 30 percent of the loss estimate, which will be wire transferred to our account within 10 business days. The balance will be paid when we finalize the accounting for the business interruption loss within the next 6 months.

When it comes to the risk manager's response, you don't need firsthand experience with a major loss to guess that not only is "d" the correct answer, but it is vital to the risk manager's next raise and/or promotion! Senior management of the insured wants to know the answer to their questions to determine what basis exists to book a receivable from underwriters versus a nonrecurring expense and a reduction to profits.

Do you have a relationship with underwriters that will allow you to directly ask for their claim payment and receive it promptly?

What Is the CFO's Short List?

In selecting and structuring an insurance program with an insurance company, you need to have a clear perspective on where and how it fits your business's needs. Some of the highlights are provided below.

Credit Quality. How are your insurance companies rated by Standard & Poor's and A.M. Best? These ratings are different. Do they meet or exceed your own firm's ratings and standards? Do your insurers have the reputation and track record for prompt and fair claim settlements?

Risk Tolerance. Do you understand your built-in hedges? [Counter cyclical markets for raw material supplies, the difference between book (accounting) versus replacement recovery (insurance) and/or the discovery valuation period for a long-tail liability claim.]

Is your "risk" attachment point providing expensive dollar swapping on expected claims, comparable to borrowing short-term at a 30 percent plus interest rate? Remember, 30 percent of $10 million is $3 million per year! Adequate budgeting can provide for the majority of claims by number, allowing a client to pay at the lowest ultimate cost.

Capital Market Risk. What is the likely reaction to a large downside event by external stakeholders? Is the sky falling, or was there merely a bump in the road? Are risk disclosures identified in the management discussion section of the shareholder's annual reports?

Insurance is not designed or intended to address "all risks." Remember Intel's Pentium recall? A $600 million write-off in one quarter that affected the stock price negatively for 30-40 business days. Then the price took off in an upward direction toward another universe.

There are numerous examples involving other firms. While the event is noteworthy, it is one where management admitted to having a problem, replaced all the chips and indicated what steps they were taking to prevent any similar recurrence. The financial markets had confidence in Intel's response, and the entire situation became one to propel them forward.

Intel focused on what was best for their customers rather than their own short-term financial results. Treating customers fairly and properly is the engine for profitable growth!

Reliability. Are your insurers and brokers credible? Do they deliver as represented every time? Have you established a written service contract to identify the desired services, metrics, and expected timing of delivery?

Communications.Do you have clear communication channels, as the ultimate client, to interact with your underwriting firms? Do you have a direct communication channel open to the leadership group at your insurer's strategic center?

The Bottom Line

Do you have a balance between your actions to assist senior management with managing all risks versus a passive role limited essentially to purchasing insurance? Certainly, this involves economic as well as political risks. But what senior manager is not faced with that prospect? Welcome aboard!