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ECONOMIC
CAPITAL A firm also needs capital to finance risk -- to pay for things that unexpectedly go wrong like fire, theft and lawsuits. This is called Risk Capital and is not measured by traditional financial statements. (There are other kinds of risks too such as risks that competitors will steal market share, the products will not be popular among the target market, etc. But this is business risk which is tightly wrapped up with the core mission of the company. This risk may or may not be included in risk capital, but often it is not and should not. It is part and parcel of the essence of the firm, not peripheral like the other kind of risk (pure risk). The total of operational capital plus risk capital is called Economic Capital. We'll get back to this definition below. Consider three sources of risk capital: 1. Risk capital can come from cash that the firm has on hand. To be sufficient, it would have to be an awfully significant amount, and it would probably not survive because of competing demands for its use. 2. Risk capital can also be off-balance sheet capital such as a credit line which would be tapped in the event of a loss which had to be financed. Of course, the loan would have to be paid back, however. 3. Another off-balance sheet source is insurance. With insurance the financial consequences of loss are transferred to an insurer in return for the premium. Additionally, risk management is broader that just insurance. Losses can be prevented by safety or quality control efforts, and risk can be transferred to customers, business partners, subcontractors, etc. via contract. This reduces the need for risk capital. The risks that the firm (and its lender or equity partner) are subject to are potentially catastrophic. The entire facility could be destroyed, or the company could owe $50 million to a plaintiff at the whim of a jury. How is management of these risks reflected in financial statements? Hardly at all! Banks and equity partners generally do not consider the need for risk capital. A cursory look at an insurance schedule comprises the due diligence. Whether limits are adequate in relation to actual exposure and whether terms and conditions (the actual policy language -- all 50 plus pages) are adequate is a crap shoot. In a contest, scenario #1 above would probably receive the most favorable rating because of the abundance of cash, whereas in reality it is the most tenuous. The other elements of a risk management program -- the loss control and contractual transfer -- would not be factored in at all. Bottom line: it's not even considered on a qualitative basis - not to mention quantitative. When the convention of economic capital is not used to make comparisons between firms, they all look alike as respects risk -- the financials do not reflect the difference. Risk always uses capital. If it is not funded it creates a deficit. Only after a disaster does the deficit finally surface -- while to the contrary the company is under water. RISK ADJUSTED RETURN ON CAPITAL RAROC is to the income statement what economic capital is to the the balance sheet. Consider two companies that generate a 15% return on equity. One manages risk completely, while the other floats along at the whim of the gods. Until something happens they appear to be equal according to the financial statements. Mysteriously, there is an abundance of notes to the financials, but none on risk management or the lack thereof. The true measure is return on economic capital. Firm activities will generate risk and a certain amount of capital is required to handle that risk. To the extent risk is prevented or transferred to other parties, less risk capital is required. If risk is financed via insurance, that is utilizing off-balance sheet capital and that reduces the need for on-balance sheet capital. If both firms
generate $.15 for every dollar of capital that is measured by the
financials, then the rate of return on equity is 15% (.15/1.00)
for each. If Company A manages risk completely via loss control
and insurance, then risk capital required is zero. The risk adjusted
rate of return for Company A is truly 15%. Company B, though, doesn't
even attempt to manage risk. By default In the marketplace Company B is competing with Company A for funds. In our world, funds are not unlimited -- they are rationed. Educate your lender and/or equity partner about how risk management should be accounted for -- and BE Company A. Given the inevitability of losses, you'll be judged not by whether you were the victim of an event, but by how well you planned for it. (C) 2003 Licata
Kelleher Risk and Insurance Advisers, Inc. Permission granted for
distribution as is (with full attribution). FLicata@LicataKelleher.com Other Articles: INSURANCE
BROKER SUED BY NEW YORK ATTORNEY GENERAL UNDERSTANDING
THE DYNAMICS OF THE INSURANCE MARKET- WORLD TRADE CASE UNVEILS INNER WORKINGS OF INSURANCE BROKER-Winter 2004 A RISK MANAGEMENT APPROACH CFOs (AND THEIR ACCOUNTANTS) CAN LOVE-Fall 2003 PRESERVING COVERAGE FOR INNOCENT INSUREDS-Summer 2003 LEAVING TERRORISM COVERAGE ON THE TABLE -Spring 2003 COMPUTER SECURITY IS NOT A BLACK HOLE -Winter 2003 "LET'S BE CAREFUL OUT THERE" -Fall 2002 WHAT
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ABOUND IN DEVELOPMENT "YOU
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