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Cost Effectiveness of Risk Management Practices

Author(s): Joan T. Schmit and Kendall Roth


Source: The Journal of Risk and Insurance, Vol. 57, No. 3 (Sep., 1990), pp. 455-470
Published by: American Risk and Insurance Association
Stable URL: http://www.jstor.org/stable/252842 .
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C The Journal of Risk and Insurance, 1990 Vol. LVII, No. 3, 455-470

Cost Effectiveness of Risk Management


Practices
Joan T. Schmit and Kendall Roth
Abstract
Despite the increasing importance of risk management in a successful
business organization, virtually no research has been undertaken to evaluate
the effectiveness of various risk management practices. Through analysis of
data obtained from a survey of risk management professionals, such an
evaluation has been made and is reported here. Results include the expected
effects of lower costs associated with higher levels of retention, increased size,
and less risky industries. The relationship of higher costs with the use of a
captive, and the ineffectiveness of centralization or use of analytical tools were
unexpected.
Introduction
Though how to achieve cost effectiveness of the risk management function
is an important question, it has been given relatively little attention in the
literature. The primary objective of the research presented here is to consider
that question. Specifically, the cost-effectiveness of available risk management
tools is measured while controlling for organizational risk characteristics.
Two steps are taken to meet this objective. First, the expected effectiveness
of alternate designs of the risk management function are theorized. Second,
data are analyzed to quantify how risk management functions are actualized
and to measure the relative cost effectiveness of differing risk management
designs.
Data to meet these objectives were obtained through a questionnaire sent to
risk managers of large U.S.-based corporations. No published study has.
Joan T. Schmitis AssociateProfessorat the Universityof Wisconsin-Madison.
KendallRoth
is AssistantProfessorat the Universityof South Carolina.
The authorsgratefullyacknowledgethe helpful commentsof Dan R. Anderson,NormanA.
Baglini, Anita Benedetti, Rita Epstein, and members of the Research and International
Committeesof the Risk and InsuranceManagementSociety, Inc. Executivesof CIGNA Corp.
and Johnson& Higginsalso aidedthis research.Two anonymousreviewers,the associateeditor,
and editor providedparticularlyinsightfulcomments.This researchwas funded in part by the
Internationalization
Program,Collegeof BusinessAdministration,Universityof SouthCarolina.

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The Journalof Risk and Insurance

attemptedto relate risk managementpracticesto cost; hence, the resultswill


contributeto the understandingof a neglectedtopic. In addition, some of the
information previouslyprovided by the Cost of Risk Survey,' is available
through this study. Thus historicalmeasuresof risk managementcosts may
help future decision-makersregardingvariouspolicy decisions.
Following a discussion of the literature,the remainderof the article is
comprised of three parts. The first is a description of the theoretical
backgroundfor the hypotheses tested with the data compiled through the
questionnaire.Next, a presentationof the resultsof the data analysisis given.
Lastly, conclusionsregardingthe resultsand discussionof futureresearchare
provided.
Literature Review

Most risk managementresearchreportedin this journal and elsewherehas


focused on whether or not the discipline should persist. Early pieces
consideredthe desirabilityof developinga specializedbusinesscurriculumfor
risk management (see, Christy, 1962; Criddle, 1963; Hammond, 1963;
Loman, 1966; Long, 1961; Mehr, 1987; and Snider, 1961). The authors
tended to agree that institutionalspecializationin risk managementgave it a
valued position in businesseducation.
Laterwork evaluatedrisk management'srole in the context of the "theory
of the firm." These efforts are exemplifiedby Mehr and Forbes (1973) who
state:
... risk managementmodels which assume away the complex and conflicting
objectivesfound withincorporationsappearto be naive.For example,whilenormative
theorymay prescribea formalmodel for makinga decisionregardingthe amountof
the insurancedeductible,such a formulationis likelyto be inapplicable,for if thereis
a conflict between internal managementand shareholderinterests (as reflected in
conflictingsolvencyand profitabilityobjectives),one can expect the interestsof the
former to call for very low deductibleswhich violate the model's rule of conduct
(p.396).

Mehr and Forbessuggest that "riskmanagementtheory needs to mergewith


traditional financial theory in order to bring added realism to the
decision-makingprocess" (p.389). Their work, in essence, foreshadowed
future finance theories, such as agency theory, and various other research
efforts such as those of Cummins(1976), Mayers and Smith (1982, 1983),
Main (1983), Doherty(1975, 1985),Smithand Buser(1987), MacMinn(1989),
Cho (1988), and others. These authors incorporate insurance and risk
'The 1985 Cost of Risk survey was a joint project conducted by the Risk and Insurance
Management Society, Inc. (RIMS) and Tillinghast Division of Towers, Perrin, Forster & Crosby
(three prior studies were sponsored by RIMS and Risk Planning Group, which has since merged
with Tillinghast). Data were gathered on insurance premiums, unreimbursed losses, risk control
costs, and administrative expenses. Because of the low response rate (13 percent in 1985), RIMS
agreed to continue the project only if at least 20 percent of the surveyed risk managers participated
in the next survey; they did not. Hence, the Cost of Risk Survey has not been continued.

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Cost Effectivenessof Risk ManagementPractices

457

managementdecisionsin what Mayersand Smithterm "the moderntheoryof


finance," consideringuse of insurancealong with various debt and equity
options in making financingdecisions.
Mayers and Smith (1982) show that the corporate decision to purchase
insuranceis desirable(i.e., the risk managementfunction adds value) when
advantages in risk bearing and/or service activities accrue to insurers,
reductionsin the costs of bankruptcyare significant, contractingcosts are
minimized, and/or taxes are reduced. Meyers and Smith also show how
bondholderscan control an incentiveconflict with shareholdersby requiring
the firm to purchaseinsurance(1987). Consideringhow to maximizethe value
of the risk managementfunction, of which purchasinginsuranceis a part, is
the purposeof the presentstudy.
A numberof surveyshavebeen conductedto measurethe risk management
function.2These includeO'Connell(1975), Cerveny(1979) and Baglini(1976,
1983).3 The generalintentof surveyingrisk managersin priorstudieshas been
to measuretheir responsibilitiesand the methodsby whichthey managedrisk
under various environmentalsituations (Baglini, for example, focused on
internationalrisk management).Takinga differentapproach,the Cost of Risk
Surveysconductedby RIMS measuredrisk managementcosts attributedto
various risk managementfunctions and categorizedthem by organizational
type. The surveyused for the researchreportedhere is an amalgamationof
those types of surveys,measuringboth risk managementpracticesand costs.
TheoreticalBackgroundfor Hypotheses
Risk managementcan be describedas the performanceof activitiesdesigned
to minimizethe negativeimpact(cost) of uncertainty(risk)regardingpossible
losses. Because risk reductionis costly, minimizingthe negativeimpact will
not necessarily eliminate risk. Rather, management must decide among
alternativemethodsto balance risk and cost, and the alternativechosen will
depend upon the organization'srisk characteristics.This study measuresthe
cost-effectivenessof availablerisk managementtools whilecontrollingfor risk
characteristics.
The costs to be measured (performance)and the attributesexpected to
affect cost must now be examined.Those attributesincluderisk management
strategy regarding centralization and risk assumption; risk management
techniquesto implementthe strategychosen; and organization-specificand
general industrycharacteristicsexpected to affect strategy,implementation,
and cost.

2'ther surveyshavegenerallyfocusedon specificaspectsof risk management,such as the use


of captiveinsurers.
3Baglini'stwo surveysservedas prototypesfor the one used here. In addition, many helpful
commentswerereceivedfrom Dr. Bagliniin the preparationof the survey.

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Performance

The process of evaluatingrisk managementperformanceis complex and


difficult.4For example,decisionsto retainor transferare best evaluatedover
severalyears ratherthan annuallybecauseof the averagingeffect of random
losses. Furthermore, measurement of loss control success requires a
comparisonof expendituresfor loss control with the value of losses averted.
The value of losses not experienced,of course, is unknown.5
Defining risk management performance or "success," therefore, is a
challenge.The approachtaken hereis to defineperformanceas premiumsplus
uninsuredlosses as a percentageof total assets, hereinafterreferredto as per
unit risk managementcosts. The initial field research6pointedto this per unit
cost value as representativeof the risk manager'sresponsibilities.The risk
managercan be expectedto minimizeper unit risk managementcosts overthe
long run. Loss control and administrativeexpensesare also elementsof the
risk managementdecision-makingprocess. These expenses have not been
included here, however, because of difficulties associated with survey
responsesas discussedunderresearchmethods.
The risk managementfunction often will incorporateless tangible goals
than minimizationof explicit costs. One such goal may be maintenanceof
reputation. Furthermore,the objective of the organization's survival is
implicitin any goal undertakenby the risk manager,yieldinga tolerablelevel
of zero probabilityfor certain unsustainableevents. The authors recognize,
therefore,the potentialexistenceof organizationalobjectivesother than pure
"financialones."
Strategies

Evaluation of the cost-effectivenessof various risk managementtools is


undertakenby measuring relationshipsbetween specific risk management
strategies and risk managementperformance. Those relationshipsare the
result of two basic strategicdecisions everyrisk manageraddresses,whether
explicitly or implicitly: how much risk to assume and whether to use a
centralizedor decentralizedrisk managementprogram.

'Williams and Heins (1985) state that, "Becauserisk managersmake decisionsunderuncertainty, much of theirperformanceis difficultto evaluatein the short run."
'The problemis discussedby Mehrand Hedges(1987)on page25 as involving"intangiblecosts
and benefitswhose measureis a purelyjudgmentalmatter."
6
field researchconstituted two parts, which provided input from approximately15
insurance,brokerage,and riskmanagementexecutives.Onepartinvolvedinterviewswith brokers
and insurershavingexpertiseregardinginternationalinsuranceprograms.Theseinterviewsoffered
informationconcerningthe financingoptionsavailableto riskmanagersof international-oriented
organizations.The secondpartof the field researchwas conductedthroughRIMS'Researchand
InternationalCommittees.Membersof these committeesoffered reactionsto the surveyinstrument.

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Cost Effectivenessof Risk ManagementPractices

459

Risk Retention: As a firm uses increasingamounts of retention, per unit


risk managementcosts are expectedto decline.7Becauseinsuranceincludesa
loading factor, the firm'scosts declineas the amountof coveragedeclines.Of
courseas statedearlier,in any singleyearincurredlosses may exceedexpected
losses so that insurancewould havebeen cheaperthan retention.Such a result
is assumedto be randomand ought to averageout in a cross-sectionalsample,
just as the hypothesizedrelationshipis expectedto apply overthe long run for
a single firm. Thus cross-sectionaldata addressthe preferencefor evaluating
performancein the long run, giventhat losses do not disproportionatelyaffect
a specific sample of the data. Risk assumptionmay result from retentionof
losses and/or employmentof a captiveinsurer.
Use of a Captive: Firms employingcaptive insurersare expectedto incur
lower per unit risk managementcosts than are those not using captives.
Generallythe implementationof a captiveis consideredthe most sophisticated
form of retention.A firm is expectedto use a captiveorganizationonly when
such use is cost-effective. Even when the captive's stated objective is, for
example,to obtain broadercoverageor betterterms,the ultimateresultought
to be lower overallcosts; otherwisethe broadercoveragesor improvedterms
are irrelevant.Non-riskrelatedobjectiveswere no stated by respondents.
As demonstrated by Cross, Davidson, and Thornton (1987), the
tax-deductibilityof premiumsappearsto be a significantfactor in forminga
captive. This advantagewould exist betweenpure self-insuranceand use of a
captivebut not betweencommercialinsuranceand a captive.Thus, to decide
upon formationof a captive,some cost advantagemust exist overcommercial
coverage. The captive, of course, can produce profits for the parent firm.
An assumption is made, however, that the firm can use resources more
productivelyin its chosen industrythan in investmentsof insuranceproceeds.
If not, the firm ought to switchoperationsto the investmentindustry.Hence,
despitethe omission of investmentincome and managementfees, hypothetically, the function of a captive(definedto includerisk retentiongroups)is to
reducerisk managementcosts.
Centralization: Increaseddecentralizationof the risk managementfunction
is expectedto resultin increasedper unit risk managementcosts. In addition
to deciding upon the proper level of risk assumption, risk managersmust
choose the desired degree of centralization.Business organizationsdiffer in
theirapproachesto autonomyof subsidiariesand divisions,some encouraging
significant independence,others permittinglittle individualdecision-making
authority.
From a risk managementperspective, a centralizedprogram would be
expectedto yield lowercosts. Centralizationgeneratesa varietyof advantages
includingimprovedpredictabilityof losses throughapplicationof the law of
7As noted in the literaturereview,Mayersand Smith (1982) presenta numberof benefits
attributableto the purchaseof insurance.Some of these benefitsreflectcosts not includedin the
performancemeasurediscussedhere. If included, the hypothesisrelatingperformanceto the
purchaseof insurancemay differ.

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460

dlargenumbers,availabilityof insurerpremiumcredits,and economiesof scale


for the developmentof risk managementand loss control expertise(and the
staff to supportthe expertise).In discussingthe advantagesof a centralized
program, Bradford (1988) quotes Eliot H. Pardee of Fred S. James & Co.
saying"a risk managerwho has to deal with only one brokerand one insurer
has an easier job than the buyer who must deal with several."Hence, the
administrativecosts also should be lower when managing with centralized
ratherthan decentralizedactivities.
Such advantages of centralization must be weighed against possible
disadvantages,such as inconsistencieswith the organizationalphilosophy
regardingcentralizationand possiblereductionin productivitydue to a sense
of lost autonomy.These disadvantages,however,ought not be reflectedin per
unit risk managementcosts as defined. Overall, therefore, per unit risk
managementcosts are expectedto be lowerfor centralizedthan decentralized
risk managementprograms.
Degree of Analysis

Per unit risk managementcosts are expectedto declineas the risk manager
utilizes increasingly advanced analytical techniques in making decisions.
Performancewill be affected not only by strategicdecisions,but also by the
implementationof those decisions.Risk managershaveavailablea wide range
of tools to make and executedecisions, each of which can be categorizedby
the degreeof analysisrequired.Furthermore,varioustechniquesdecidedupon
are consideredmore sophisticatedthan others.
Methods to implementrisk managementdecisions fall into a number of
categories.Decisionscan be made with little analysis,such as those based on
customor rulesof thumb. Alternatively,actions or decisionsmay be based on
extensiveanalysisconsideringexpectedloss, variance,historicaltrends,and so
on. Multiple measures are available and used in the regression analysis
discussedin the next section to assess the degreeof analysisemployedby the
firm. These include questions regardingthe firm's choice of retentionlevel
based on use of cash flow analysisand effect on earningsper shareversusthe
level of retention customarily used; the use of flow chart and financial
statementanalysis for identificationof loss exposures;and the use of risk
managementinformationsystems,loss triangles,and probablemaximumloss
estimatesfor evaluatingloss exposures.
Informationreducesthe uncertaintyof decision-making(see Tushmanand
Nadler, 1978). One would expect that the more sophisticatedthe analysis
performedby the risk manager,the more completewill be the informationon
whichdecisionsare made. Hence, a decisionbased on more advancedanalysis
would be expectedto yield betterresults.Additionally,the more advancedthe
analysis undertakenby the risk manager, the better should be his or her
position to negotiatewith insurancebrokers,and to managelocal personnel.
Because administrativeexpenses are not included in the measure of risk
management costs used here, performance will not be worsened by the
administrativeburdenof increasedanalysis.

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461

Organization-Specific and General Industry Characteristics

Risk managementcosts are expectedto be affected also by characteristicsof


the organizationand the industry.Size and risk are two such characteristics.
Size: Larger organizations are expected to have lower per unit risk
managementcosts than smallerfirms. As an organizationincreasesin size, it
can be expectedto benefitfrom advantagesof economiesof scale. Insurersare
willingto give largerorganizationsquantitydiscountsbecausetheir losses are
morepredictableand becauseadministrativecosts increaseat a decreasingrate
relativeto organizationalsize. As a result, lower per unit risk management
costs are expectedas size increases.
Risk: One of the most importantfactors likely to affect risk management
costs is the organization'srisk as definedby the industryin which it operates.
The divergence of insurance rates across industries clearly indicates this
importance. Thus organizations operating in industries with greater loss
potentialper exposureunit are expectedto havehigherrisk managementcosts
than those with smallerloss potential.
Research Methods
Questionnaire

To test the hypothesesdiscussedin the precedingpages, a questionnairewas


sent to 374 managersidentified by InstitutionalInvestor (1986) as holding
primaryresponsibilityfor risk managementfunctions in their organizations.
The companiesrepresentedby those 374 risk managersare large U.S.-based
organizations.Of the 374 risk managerssent the questionnaire,162 returned
completedsurveys,yieldinga responserate of 43 percent.
The questionnaire solicited responses regarding four topical areas:
identifyingand evaluatingexposures;decision-making;captiveinsurers;and
organizationaldata (See Appendix A for the survey questions and mean
responses).Responseswerecomprisedprimarilyof rankingsof importanceon
a scale of 1 to 5 of various risk managementactions and decisions. Data
collectedfrom the sectionsrequestingcaptiveand organizationalinformation
included premiums,losses, total assets, and retention levels. The organizational informationrepresentsaccounting,ratherthan marketdata, whichmay
have an effect on the results because of variationsin accountingrules. The
authors,however,do not perceiveany consistentbias that would influencethe
results.
A pre-test of the questionnairewas conducted with membersof RIMS'
Research and InternationalCommittees, and executivesof CIGNA Corp.,
Johnson & Higgins, and Frank B. Hall. The major modificationmade as a
result of the pre-test was to omit much of the financial data originally
requested. The reviewers cautioned that a low response rate could be
anticipatedby asking for informationconsideredproprietaryor not readily
available.Evidencefrom the 1985 Cost of Risk Survey,whereonly 50 percent
or fewerof the respondents(with an alreadylow responserate of 13 percent)

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462

answered queries regarding loss control costs and administrative expenses,


support this anticipation. Thus, questions such as the size of loss control
expenditures (a value often unavailable to the risk manager because he or she
does not have direct control of those expenditures), the amount of captive
management fees, and the extent of premiums/losses in an extended time
frame were omitted.
Research Results
Examination of Hypotheses
To test the hypotheses discussed in preceding pages, regression analysis was
performed. As previously argued, per unit risk management cost are assumed
to be a function of: the firm's retention strategy (ASSUM); the firm's
centralization strategy (CENTRL); the degree to which the firm employs
analytical tools in performing the risk management function (ANALY);
whether or not the firm uses a captive insurer (CAP); the log of the firm's size
(SIZE); and the firm's industry risk (INDCOST). Thus the regression equation
is of the following form:
FIRM COST = bo + b,ASSUM + b2CENTRL + b3ANALY +
b4CAP + b5SIZE + b6INDCOST + e
where bo represents ap intercept term, b, through b6 represent variable
coefficients, and e represents the random error term.
The dependent variable and six independent variables are defined as
follows:
FIRM COST: firm-specific ratio of premiums plus uninsured losses divided
by total assets
ASSUM:

firm-specific ratio of the summation of per occurrence


retention levels, as measured by the corporate risk manager

CENTRL: importance of local manager in choosing local retention


levels, as measured by the corporate risk manager
ANALY:

CAP:

importance of analytical tools in making risk management


decisions, as measured by the corporate risk manager (those
tools are defined in the preceding discussion of "degree of
analysis")
1 if the firm uses a captive; 0 otherwise

SIZE: log of the firm's total asset value


INDCOST: industry average of premiums plus uninsured losses divided
by total assets, as measured by the 1985 Cost of Risk Survey
(a measure of risk)
Results of the regression analysis are:

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Cost Effectiveness of Risk Management Practices

463

FIRM COST = .107 - .301ASSUM + .001CENTRL - .0001ANALY

(3.39)* (-1.35)**
+ .006CAP

(1.43)**

(.093)

(-.39)

.007SIZE + .023INDCOST

(-3.56)*

(2.78)*

Valuesin parenthesesrepresentt-statistics,
* indicates significanceat the .01 level, ** indicates significanceat the .10
level.
As the t-statistics indicate, four of the six variable coefficients are
significantlydifferent from zero using a one-tailedt-test. The two variables
whose coefficientsare not significantare centralizationand degreeof analysis.
All of the coefficientsexceptthat correspondingto the captivevariableare of
the hypothesizedsign. Tolerancelevelsexceed .86 for all variables,indicating
low collinearity.Further,correlationsare .23 or lowerfor all pairedvariables,
consideredacceptablelevels. Additionally,residualplots show no consistent
pattern, supportingthe regressionassumptionsof linearityof the data and
homogeneityof variance. The adjustedR2 is .19, F = 3.792, significantat
.0026.
Interpretation of Results

From the regression analysis reported above, four of the discussed


hypothesesare supported.Two of these hypothesesconcern variablesabout
which the risk managementdepartmenthas little control: size and industry.
The other two, which relate to level of risk assumption, involve important
decisions for risk managers.
As is generallyanticipatedby risk managementprofessionals,increasesin
levels of retentionresult in lower risk managementcosts. Of course, the risk
manager must weigh the benefits of lower costs against the detrimentsof
increasedvariability.The use of captiveinsurers,in contrast,does not reduce
risk management costs, a result not anticipated by the researchers.
Centralizationand use of analyticaltools apparentlyhave no consistenteffect
on risk managementcosts.
An important aspect of these results is that advancementsin decision
making seem to have little impact on the cost effectiveness of risk
management.Severalobservationsmay help explain this phenomenon.For
example, very few organizations employ risk management information
systemsin makingdecisions. In rankingexposureevaluationmethodsfrom 1
(not important)to 5 (very important),probablemaximumloss receivedthe
highest ranking with a mean score of 4.05. Risk managementinformation
systems placed last with a mean score of 3.64. Further,cash flow analysis
(with a mean score of 3.30) is ratedlowerthan all other methodsof choosing
retentionlevelsexceptfor the levelof retentioncustomarilyused (with a mean
scoreof 2.99) and local managementdecision(witha meanscoreof 2.20). The
highestrankedmethod of choosing retentionlevelsis level of expectedlosses,
capturinga mean score of 4.42. Simple t-tests of differences among these

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The Journal of Risk and Insurance

meanresponsesindicatethat they are significantlydifferentas describedat the


.05 level.
These observationsprovide evidencethat risk managersgenerallyare not
using the most advancedtools as much as they are using the less advanced
tools available to them. Hence, the lack of significancein the relationship
betweencost effectivenessand degreeof analysismay stem from the absence
of any true differentiationamong risk managers.That is, degreeof analysis
may have no bearingon costs becausefew managersare using the techniques
available. A possible explanation for the relativelylow usage of advanced
techniquesis that risk managersmay be on a steep learning curve, having
advancedsignificantlyin use of analyticaltools, but not yet havingcaughtup
to the leading edge. Some evidenceof this exists in comparingthe resultsof
this researchwith that of O'Connell(1976)who found that few risk managers
wereusing quantitativetechniqueseven though they had accessto computers.
Today risk managersappearto be using quantitativetechniquesto a greater
extentthan was true in 1975;however,the availabletechniqueshave also been
elevated.
Alternativelythose who do take advantageof the advancedtechniquesmay
fall into two opposing camps. One is the high-cost group, in which risk
managersare forcedto employadvancedrisk managementtools becausetheir
firm has been hurt badly by risk management costs, perhaps especially
noticeableduringthe recent hard market (see O'Connell, 1977). The second
group is the one that uses the techniqueswell, maintaininglow costs. If the
regressionanalysisfails to account for these potentialdifferences,combining
the two groupscould yield a net effect of insignificance.
Also troublingis the non-negativesign of the captivecoefficient. Generally
a firm would be expectedto implementa captiveprogramwith the intent of
reducingcosts. Even if, as was mentionedearlier,the stated objectiveis "to
obtain broader coverage,"supposedlyobtaining that coverageis desired in
orderto reduceoverallcosts. The measureused here does omit consideration
of investmentearnings and tax effects. Furthermissing is information on
captive managementfees and risk managementdepartmentcosts. If risk
managerswere willingto providesuch data, a bettermeasureof the effect of
captiveson performancewould be available.
Resultson the impactof captivesmay be distortedsomewhatbecauseof the
sample of firms surveyed.Captivesare mainly used by the sample firms as
corporate subsidiariesrather than as industry mutuals or rent-a-captives.
These other forms of group captivesare likely to be used more frequentlyby
small and medium-sizedfirms, where economic efficiency may be more
pronounced. As pointed out by Greene (1979), a captive may meet several
organizationalobjectives. He identified four major objectives of: reducing
insurance costs, facilitating the purchase of insurance coverage, obtaining
more favorable insuranceterms and conditions, and increasingprofits on
funds held for paymentof losses (see also Baglini 1976 and 1983, and Porat
1982). Respondents of the present study also identify these objectives as
important.

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Cost Effectiveness of Risk Management Practices

465

In fact, rankings of objectives for captives place "better control over


insuranceprogram"in first place and "profitpotential"in last. Perhapswith
reasoning similar to that proposed for the insignificance of analytical
techniques,those firms that choose to use a captive may be the ones with
greaterrisks and thus highercosts, such as is found in the oil and chemical
industries with regard to pollution and other difficult-to-place liability
exposures. The risk measurein this study may be insufficientlyrefined to
account for such complex differencesamong firms with regardto their loss
potential. The broad industry categories allow for wide variations among
firms in each category, thus possibly failing to account for important
idiosyncracies.
Evidencealso exists that the greaterthe extent to which captivesare used,
the better the impact on performance.The evidencederivesfrom regression
analysis of the subset of cases in which captives are used. In this smaller
sample, no dummy variable for captives is needed. Instead, the percent of
premiumspaid by the organizationwhich correspondto captive revenueis
added as an independentvariable.While not significant(perhapsbecause of
the small sample),the coefficientis negative.Whatmay be occurringis that in
some situationsthe captiveis performinga role as a statussymbol for the risk
manager, thereby causing higher risk managementcosts. In other circumstances, wherethe captiveis used extensively,the impactmay be the expected
positive effect. Alternatively,the measures used in this study to quantify
performancemay not account for the other objectives in using a captive
insurer.

Summary,Conclusions,and Areas of FutureResearch


Risk managementas a businessdisciplinehas undergoneextensivechange
over the past 25 years. New favored recognitionhas been given the field as
business executives, lawmakers,and the general public feel the effects of
volatile insurance cycles and recognize the important contribution of an
effective risk management program. Yet theoretical development and
systematic compilation of data concerning effective risk management
practiceshas been scarce.The researchreportedin this manuscriptis an effort
to fill some of that void.
A surveyof risk managementactivitiessent to risk managersof largeU.S.based organizationsprovidessome interestinginformation.For example,very
few survey respondents employ risk managementinformation systems in
makingdecisions.Further,cash flow analysisis only slightlymore important
in choosing retentionlevels than is the level of retentioncustomarilyused.
These facts may providesome insightinto the resultsof the analysisof factors
affecting risk managementcosts.
Regressionanalysiswas performedto test six hypothesesregardingvarious
factors expected to affect risk managementcosts: relative size of retention
levels, use of captive insurersor risk retentiongroups, centralizationof risk
managementactivities,degree of analysisundertakenin performingthe risk

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The Journalof Risk and Insurance

managementfunction, size of the organization,and industryrisk as measured


by the 1985 Cost of Risk Survey (1986). Results from the regressionanalysis
indicatethat, as expected,increasedsize, lowerindustryrisk, and higherlevels
of retention are significantly,negativelyrelated to risk managementcosts.
Captiveuse, in contrast, is associatedwith higher costs. Centralizationand
use of advanceddecision-makingtechniquesapparentlydo not haveconsistent
effects.
One possible reason for the insignificant impact of the risk manager's
analytical activities is the differing expertise of risk managers. A savvy
negotiatormay be able to obtain lowerinsurancepremiumsfor the same risk
level than a less able risk manager, regardlessof the extent of analysis
undertakenby either one. Of course, the omission of loss control data also
could be key to determiningdifferencesin effectivenessof risk management
activities.Althoughinformationis includedabout industryrisk, firms within
the same industrymay follow quite distinctloss control philosophies.
Yet anotherpossibleexplanationfor the insignificantresultsis that so little
advantageis being taken of sophisticatedrisk managementtools that none of
the firms is reapingthe benefitsavailable,i.e., no true differenceexists in the
sophisticationof the risk managers,the centralizationof the risk management
function, or the relative degree of retention. Alternatively, those risk
managers most in need of help, that is, those with relatively high risk
managementcosts, may be the managerswho are forced to use sophisticated
risk managementtechniques, including captives, as shown by O'Connell
(1977). The results may also be indicativeof the volatile insurancemarket
from 1986through 1987when data were compiled.
Whateverthe cause, results of this study provide justification for much
future research. For example, work is needed in determiningwhy risk
managershave failed to move forwardin the area of data analysis, forgoing
opportunitiesto use analyticaltechniquessuch as cash flow analysisshownto
be valuablein other settings. In conjunctionwith such information,study of
the relationship between implementation of analytical decision-making
techniquesand risk managementcosts appearswarranted.
The role of captive insurersought to be given furthercritical analysis as
well. Risk managersprovidehelpfulqualitativeinformationin explainingwhy
they use captives;yet, a criticalevaluationof the effectivenessof that decision
has not been undertaken.Whenthe riskmanagersays that captivesare used to
obtain better control over the risk managementprogram, for instance, how
does that translateinto improvedfirm performance(i.e., lower cost)? And,
how does that resultin a benefit to the organization?
In general,extendedquantitativeanalysisof the risk managementfunction
is required. Numerous texts and articles discuss the importance of risk
management. Validation of those claims through data analysis deserves
attention.

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Cost Effectiveness of Risk Management Practices

467

Appendix A
Survey Results
Identification
(Mean Score Rating)
How important are the following loss exposure identification techniques to your firm?

not
important
1
2
Inspection by local manager
Inspection by corporate risk mgr.
Inspection by outside expert
Risk survey or checklist
Financial statement analysis
Flow chart analysis
Internal communication, such as informal
conversation with employees

3
3.65
3.46
4.17
2.98
2.71
2.73

very
important
4
5

3.75

Evaluation
(Mean Score Rating)
How important are the following loss exposure evaluation techniques for your firm?
not
very
important
important
1
2
4
3
5
Historical loss development (loss triangles)
3.91
Frequency distributions of past losses
3.88
Probable maximum loss estimates
4.05
Maximum possible loss estimates
4.02
Expected loss analysis
3.85
Risk management information systems
3.64

Retention
(Mean Score Rating)
How important is each of the following considerations in deciding upon your firm's
level of retention?
not
very
important
important
1
2
4
3
5
Local management decision
2.20
Level of expected losses
4.42
Level of retention customarily used
2.99
Effect on earnings per share
3.73
3.39
Availability of insurer premium credit
Effect measured by cash flow analysis
3.30

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468

The Journal of Risk and Insurance


Appendix A (continued)
Captive Organizations
(Mean Score Rating)

How important are the following considerations in your firm's captive decision?
(asked only if have a captive)
not
important
2
1
Better control over insurance program
Broader (or only available coverage)
Lower expenses and/or loss costs
Profit potential
Better loss control or claims service
Improved cash flow

3
4.12
3.93
3.86
2.99
3.23
3.74

very
important
4
5

Organizational Data
Average annual premiums (captive and commercial) paid in fiscal year 1987
(in thousands of U.S. dollars)
$22,540
Average uninsured (self-insured and self-assumed) losses reported in fiscal year 1987
(in thousands of U.S. dollars)
$20.131
Average annual property and casualty premiums paid by parents to captives during
fiscal year 1987? (in thousands of U.S. dollars)
$2.701
Property
$5.705
Casualty
Number of organizations utilizing the following forms of captives
78
Corporate subsidiary
3
Rent-a-captive
30
Industry mutual (pool)
Average corporate retention (including self-insurance but excluding captives) per
occurrence in fiscal year 1987 (in thousands of U.S. dollars)
Fire & Extended Coverages
$2.313
$5.475
Earthquake
$2.564
Flood
$4.218
Premises-Operations Liability
$5,969
Products Liability
Average total assets for fiscal year 1987 (in millions of U.S. dollars).
$10.604

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