Is Your Business Taking Enough Risk?

After 18 months of work, the merger was finally complete. CFO Ken Daniels breathed a sigh of relief and looked forward to the growth opportunities that NewCo, the new combined company, offered his organization and investors.

But Ken had already overlooked an opportunity for funding that growth. Many M&A teams overlook it. Are you guilty as well?

Risk and the Best Use of Capital

When organizations merge, NewCo’s growth prospects and top-line revenue will differ from those of the two (or more) formerly separate entities. Its risk profile and financial risk-bearing capacity also will be different.

So, it makes sense for NewCo to consider its insurance spending in a new light. Can the company increase its retentions (i.e., deductibles) and take on more risk? If so, how much risk can it safely absorb? Should it purchase insurance through a third-party provider? Or does forming a captive or using another risk financing method make more sense?

If NewCo can safely decapitalize its insurance spend, it can redeploy that capital into strategic projects that will spur growth and competition. With the right information, NewCo’s use of insurance can become an investment decision rather than an expense.

Understanding Business Risk from an Insurance Perspective

To manage risks and capital effectively, organizations must be properly informed. Insurance risk consultants educate their clients by doing the following:

• Identifying and prioritizing risks
• Identifying financial risk-bearing capacity
• Quantifying loss ranges
• Structuring and placing insurance

Identifying and prioritizing risks: not all risks are created equal. As a new entity, NewCo potentially will have hundreds of business risks. The company can’t focus on all of them, and not all risks carry the same potential impact. A risk management consultant will have a formal process for identifying and prioritizing the top five to eight risks that deserve the greatest time, attention and financing. Know your top eight risks.

Identifying financial risk-bearing capacity: combinations increase financial wherewithal. When a company considers a significant investment, it conducts a formal financial analysis. NewCo should do the same for its risk management program. Before NewCo can determine whether it wants to—or should— capitalize insurance or assume risk on its balance sheet, it must understand its financial risk-bearing capacity. An insurance risk consultant will help NewCo understand the amount it realistically has to work with if it chooses to assume more risk. Understand your available capacity.

Quantifying loss ranges: sensitivity analysis for insurance. What are NewCo’s losses expected to be on an annual basis by coverage line (i.e., general liability, workers’ compensation, employee health plan, etc.)? NewCo’s insurance risk consultant will model both entities individually and then combine the forward-looking exposure base, unit rate averages and volatility to arrive at an actuarial forecast for NewCo. This forecast will describe NewCo’s future losses with statistical certainty to help inform decision-making. For example, suppose NewCo knows with statistical certainty that its losses will likely be well below the amount an insurance company asks them to pay to insure those risks. In that case, NewCo may decide to capitalize those risks differently. Have financial data to make better decisions.

Structuring and placing insurance: best and highest use of capital. With an understanding of NewCo’s prioritized risks, risk-bearing capacity and likely losses, and considering the company’s risk comfort level, the risk management consultant will present options for efficiently addressing those risks. If the company decides to purchase traditional insurance, the information gathered through this process can be used to determine what an appropriate investment is and negotiate the best rates. If the company can safely insure its risks more efficiently and use some of its capital to build and grow the business instead, that’s risk optimization. The choice to use insurance is an investment decision.

Creating Value

One way to manage risk is by purchasing third-party insurance, but other options exist. M&A teams that work with an experienced insurance risk management consultant will understand all their options, make the best use of their capital and achieve a competitive advantage.

Related Reading: M&A Due Diligence Must Include Insurance Due Diligence

The above information does not constitute advice. Always contact your insurance broker or trusted advisor for insurance-related questions.