Taking stock of your risks.

• Author: Sanderson, Scott
• Position: Includes related article

When you look at risk as an investment decision, figuring out how much risk to retain - and when - gets more complicated. But it may save you money in the long run.

Today, many risk managers are trying to cut expenses by retaining more risk. Many large businesses and nonprofit organizations now feel that even very high risk assumptions, if commercially insurable, are also retainable. The rationale is often along these lines: "If it hasn't happened before, let's assume the risk and save the premium."

On the surface, this sounds logical, because risk retention appears to be the inverse of an investment. The organization isn't investing premium dollars in an insured arrangement; it's retaining funds it would otherwise pay out as premiums. In a typical year, this is the least costly way to finance risk, because catastrophic occurrences are rare. The company eliminates risk transfer and, therefore, its frictional costs.

But viewing risk retention as a capital-free investment is an illusion that can expose the organization to ruin merely to save a small amount of premium. In the event of a worst-case loss, your entire capital structure could be considered the potential investment.

That doesn't necessarily mean you shouldn't assume more risk, but you should look at risk retention as an investment like any other. When you do, it's clear that adjusting risk retention up or down (depending on the cost of assumption, transfer or other factors) to match your company's needs is a process that potentially can save the company a fair amount of money.

The test of a good risk-retention decision is whether senior management, the board of directors and, ultimately, the investors still consider it a wise choice after the company has experienced a loss. When you view the entire process as an investment decision with risk and reward components, you're much more likely to get a thumbs-up.

In many respects, risk retention resembles equities options, such as puts or calls. The call buyer pays a premium for the right to buy the stock at a value typically above the current price on the option purchase date. The writer has an income stream without the need to make a cash investment. Thus, if the stock price stays the same until the expiration date, the "rate of return" is substantial, albeit undefined (the premium divided by zero). But the writer isn't risk-free, since the stock price could increase dramatically.

This is a contingent investment of capital. Purchasing coverage is the reverse situation: the contingent use of...