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Home > Financial Risk Management Checklists > Understanding and Calculating the Total Cost of Risk

Financial Risk Management Checklists

Understanding and Calculating the Total Cost of Risk


Checklist Description

This checklist explains the term and explores ways in which businesses can assess whether their risk management processes are delivering all the value they should be

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Definition

Risk exists virtually everywhere in business—from the obvious, easily insurable risks such as cover for property assets to more obscure, yet not insignificant, risks such as the loss of key employees to illness. However, in an effort to cover as many bases as possible, some companies channel resources into their risk management operations, potentially raising questions over whether these units are delivering good value for stakeholders in the company. The total cost of risk (TCOR) is a tool for measuring the overall costs associated with the running of the corporate risk management operation, including all insurance premiums, risk control and financing costs, administrative costs, and any self-retained losses incurred, relative to other key measures such as overall company revenues, total headcount, and its asset base. Over time, TCOR therefore provides a yardstick to assess how a company’s risk-related costs are changing relative to the overall growth rate of the business. In turn, management can then explore potential ways to assess how the company’s TCOR is changing relative to industry benchmarks, typically with the use of data derived from research—e.g., “physical” risk research conducted by trade groups and industry organizations. Given that the cost considerations are uppermost in the oil distribution business, yet food producers may focus more on liability insurance risks, working with these industry bodies can be the best way to obtain relevant and comparable risk-related cost data.

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Advantages

  • Calculating the total cost of risk can help companies to highlight inconsistencies in their approach to risk management.

  • The process can also identify areas where the cost of managing a particular risk may be excessive relative to risks elsewhere, potentially leading to reallocation of some elements of the risk management budget.

  • By highlighting inefficiencies in the risk management process, TCOR can also generate direct cost savings.

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Disadvantages

  • Truly comparable TCOR data can be difficult to access, though trade bodies can help. However, prized data on direct competitors—such as a key rival also pushing into a new, high-growth market segment—are plainly sensitive and therefore not generally available.

  • TCOR analysis can be mistakenly seen purely as a cost-cutting exercise.

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Action Checklist

  • Use a basic framework to break down costs into component categories such as risk financing, risk administration, risk compliance costs, and self-insured losses.

  • Identify existing costs for each category, expressed as a percentage of overall company revenues.

  • Use any available data from industry bodies for comparison with your existing TCOR figures in each category.

  • Consider possible reasons for differences between your company’s numbers and industry-wide figures.

  • Establish targets for each category for future years.

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Dos and Don’ts

Do

  • Remember that industry benchmarks may not always be truly comparable with your company in every aspect.

  • Consider whether some minor risks could be covered in-house.

  • Make use of specialist software to help you arrive at decisions on issues such as risk retention, as risk management budgeting is by nature complex.

Don’t

  • Don’t ignore the value added by the risk management function when making budgeting decisions. This is a mistake. Risk management should not be seen purely as a cost.

  • Don’t expect that TCOR analysis will lead to immediate cost savings. This could lead to disappointment. Be prepared to invest in risk management tools which will deliver financial benefits over time.

  • Don’t see the management of risk-related costs as an issue for which all possible solutions lie within the company. Explaining your objectives and priorities to external risk management specialists and insurance brokers could be very productive.

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Further reading

Books:

  • Frenkel, Michael, Ulrich Hommel, Gunter Dufey, and Markus Rudolf. Risk Management: Challenge and Opportunity. 2nd ed. Berlin: Springer, 2005.
  • Merna, Tony, and Thaisal F. Al-Fani. Corporate Risk Management: An Organisational Perspective. Chichester, UK: Wiley, 2008.

Report:

  • Green, Andrew, Randy Garber, and Jim Hanna. “The real cost of risk: Reducing cost and schedule overruns at the US Department of Defense.” AT Kearney, 2010. Online at: tinyurl.com/p8s97h2

Website:

  • Risk and Insurance Management Society (RIMS): www.rims.org

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