Designing a Comprehensive Risk Transfer Program with Stochastic Models

Property & Casualty

Designing a Comprehensive Risk Transfer Program with Stochastic Models

Building a Safety Net for XYZ

Understanding XYZ’s Insurance Purchasing Motivations

Before any risk financing strategies are considered for Company XYZ, it’s important to understand the motivations for using insurance as a potential solution. There are many reasons a firm may purchase property and casualty insurance to manage hazard risk, ranging from compliance requirements to optimizing the accounting treatment of losses. For extreme heavy-tailed risks such as D&O and cyber, volatility reduction is often the driving factor behind purchasing insurance, to help minimize the impact of large-scale cyber events, lawsuits and other hazard peril effects on prospective corporate earnings, liquidity and balance sheet strength.

The Strategies for Addressing Risk

Beyond these purchasing motivations, XYZ leadership has also expressed interest in exploring alternatives to traditional insurance to decrease its total cost of risk. In theory, several strategies exist to address any risk: avoid the risk entirely, control or mitigate the risk, accept or retain the risk and transfer or share the risk with a third party at cost. For cyber and D&O, some of these strategies are less applicable than others (avoiding may be altogether infeasible), and realistically, most firms engage in a combination of these strategies. For example, Company XYZ might hire an IT security consulting firm to control cyber risk (mitigate), retain a less volatile layer of risk in a captive insurer (accept) and buy insurance for the risk in excess of the captive layers (transfer).

We will assume that XYZ has already undertaken the highest-priority risk mitigation strategies, from implementing critical cybersecurity controls such as multi-factor authentication to setting up a structured compliance program that addresses all relevant laws and regulations. A robust modeling framework should be able to incorporate the impact of such controls on risk quantification.

From here, we will assess and quantify the options for retaining and transferring risk. We generate a set of potential risk financing options, each aligning with XYZ’s insurance purchasing motivations and providing strategies with varying levels of risk transfer and retention. All available options are explored, from traditional insurance of varying limits and deductibles to various alternative risk financing mechanisms such as captive insurance.

Simplifying Assumptions

Our definition of the Total Cost of Risk (TCOR) includes only the expected retained loss and the premium costs for transferring that risk. While this provides a useful starting point for assessing risk financing options, occasionally this definition is incomplete and fuller consideration must be given to any additional costs and benefits that are material to a given strategy. Examples of adjustments could include claims management costs or other administrative fees, collateral costs, volatility charges, or potential cash flow benefits from self-insurance and other alternative risk financing mechanisms.

Each of these components could be incorporated into the TCOR equation for a more accurate comparison of risk financing strategies. For simplification, however, we exclude these complexities.

Caleb Blodgett

Analytics and R&D Actuary

Thomas Scott

Analytics and R&D Actuary