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A volatile environment requires data-driven risk financing decisions

High rates of inflation affecting countries around the globe in 2022 led to a reckoning for many business leaders.
Graph inflation volatility

10/04/2023 · 6-minute read

High rates of inflation affecting countries around the globe in 2022 led to a reckoning for many business leaders. With fears of an economic slowdown, many organisations have reviewed their expenses and taken action to preserve capital and protect their operations.

As inflation rates rose steadily, business leaders — especially in regions that had not experienced increases of this magnitude for decades — had to consider how higher costs were affecting both their cash flow and their ability to finance risk.

And while in many parts of the world inflation rates are starting to cool, there are still concerns about a potential recession at a time when supply chains remain fragile and organisations are still recovering from COVID-19-related challenges and other risks. Today’s confluence of challenges — or polycrises, as outlined in this year’s Global Risks Report, released by the World Economic Forum with the support of Marsh McLennan and other partners — are seeing organisations remain on the defensive as they seek to protect their operations.

As costs escalate, companies opt to retain more risk

Unprecedented inflation led to a significant increase in costs for businesses. The UK, for example, registered an 11.1% inflation rate in October 2022, while in June the US registered a Consumer Price Index increase of 9.1% — both the highest in four decades. Even nations with a history of inflationary pressures, such as countries in Latin America, saw inflation increase significantly.

Inflation has had an uneven effect on industries, too. For example, companies that manufacture, transport, or sell consumer staples, such as food products, have been able to pass on some costs to the end user. Confident that demand would persist, they typically had fewer concerns about the potential impact on cash flow. On the other hand, industries already dealing with dwindling business due to the pandemic or other issues faced increased costs that have made it more difficult to remain competitive.

Along with affecting everyday items required to keep operations running, the steep rises have also made risk mitigation strategies more expensive. This comes at a time when average global commercial insurance prices continued to increase, with a 4% rise registered in the fourth quarter of 2022. Conversations with Marsh clients from across the world revealed that many have increased their willingness to retain risk, potentially due to these increased costs.

Adjustments to risk strategies should be based on a sound data-centric approach that helps risk managers and boards to clearly understand the potential costs of a new strategy. For example, senior leaders should ask how much a catastrophic loss could cost today as they factor in higher prices for replacements and potentially longer down time due to difficulties securing supplies or specialists. They should also consider how much of any losses would be covered by current insurance programs. Will the organisation’s balance sheet be able to absorb deductibles plus losses above their insurance cover? How might that affect planned future investments?

Revaluation exercises critical

Reviewing your risk strategy and insurance program is an important exercise, with valuation an essential component. Consider how inflation might have led to a rise in the prices of both properties and their contents. Due to considerably increased rebuild and replacement costs, many insurers are requiring updated property valuations in order to renew coverage. As such, risk managers should consider recommending an organization-wide valuation study.

More difficult is assessing business interruption costs when considering potential longer down times due to both supply and labor shortages. A data-driven framework can help map out these potential costs for different loss events, positioning risk managers to make more informed decisions about structuring insurance programs in a manner designed to optimise coverage for losses.

Robust analytics can help you build the resiliency you need

As the economic environment continues to shift, companies are pivoting to adapt to new realities and embed risk management strategies to improve their resilience for both evolving and emerging risks. To do this, it’s important to work from a data-driven framework to identify and understand both today’s risks and those that may arise in the short and long term.

The challenging economic environment has led many organisations to review expenses and trim non-essential costs. Decisions on investments, including the purchase of risk transfer solutions, often require more data for board-level buy-in.

A robust risk transfer program remains critical for organisations, especially during a period of uncertainty. But higher costs are pushing organisations to revisit their insurance programs. Many clients have indicated they are exploring changing their retentions at the next renewal, with most saying they would likely retain more risk. Others have still not fully quantified their current cost of risk.

This raises the question: Are organisations basing their decisions solely on cost of coverage? Or are they taking into consideration how much risk they can absorb on their balance sheet, and whether doing so could hinder their ability to respond to and recover from a catastrophic loss?

A risk finance optimisation (RFO) exercise that combines data and analytics with a qualitative review of your risk objectives can help you design an insurance program tailored to the risks you face, your current risk appetite, and the cost of insurance. This approach can help you understand the costs of different risk transfer solutions, including alternative solutions such as captives or parametric programs. And, it can help you gain a better idea of the limits and retentions that fit your risk appetite.

Aside from analysing how current operations could be impacted by different crises, business leaders should also look at the potential effect of different catastrophes on current or planned investments, and whether changes should be made to insurance programs to mitigate these risks.

Data-based insights can help your organisation build a risk transfer program that strengthens resiliency. It is critical to use customised models that reflect your specific risk drivers and business objectives, especially as inflation remains in flux, with its impact uneven across regions and industries.

As economic pressures change, consider revisiting your risk appetite, and determine whether your risk transfer programs should be adjusted to better reflect today’s business landscape. Even as rates of inflation start to normalise, working with an experienced insurance broker or risk advisor can help you review goals, and leverage both internal and external data to better understand how different challenges may affect your organisation.

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