Quantify risk first, before considering captives

Insureds need to quantify their catastrophe risks as accurately as possible first, before considering whether a captive is an appropriate financial tool for managing those risks, according to Kate Westover, the vice president of the Vermont-based alternative risk financing organization, Innovative Captive Srategies.
Westover spoke at the Strategy Institute’s ‘Canadian Captive Forum 2007,’ held at the Holiday Inn in Toronto.
Westover said once risks are quantified in dollar terms, then an insured can determine wheher it can afford to pre-finance its ultimate insured losses. If it can’t, then captives will not likely be the risk financing option they will want to take.
Taking the first step of quantifying risk may seem obvious, but this phase comes with many pitfalls, Westover observed.
She said many organizations do not quantify their exposures accurately before considering alternative risk financing. She attributed this to a variety of factors, including limitations inherent in the cat models that insureds are using and because the insureds are relying on incomplete data records.
In many cases, she said, companies will either use their own historical records of cat losses or the insurance industry’s previous losses as benchmarks to quantify their own risks. But, by their very nature, major catastrophes happen infrequently and at unknown times. As a result, there will not be enough data to get a reliable estimate of the true cost of an insured’s risks.
Westover encouraged organizations to use a “value-at-risk” model for assessing their risk, including an assessment not only of the company’s maximum probable loss, but also its maxiumum foreseeable loss in any single event or multiple events.
This would include a discussion of what Westover calls the “hidden costs” of risk. She cited the example of quantifying a business continuity risk: in her example, an insured would quantify the financial impact of a huge class action against it, incorporating the “hidden costs” associated with diverting the energy of senior company directors towards the litigation and away from their routine tasks performed in connection with running the company.
Once such risks are properly quantified, then an organization will have the proper information to decide whether to pursue pre-loss or post-loss risk financing options. Post-loss options include relying on government financing or a bank line of credit, whereas pre-loss options would include commercial insurance, self-insurance or captive insurance.