Enterprise Risk Management - Final Case Study

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Specific to our risk financing goals liquidity is required to pay retained losses, and can come from several sources. Retention and liquidity are directly correlated→ as retention increases so does the need for liquidity. The ability for that liquidity to be available to address a risk event can come from 2 essential places. 1- Internal, 2- External.

- Internally – Retained cash flow, balance sheet strength, worst cast →sell assets. Losses due to risk event directly hit the bottom line (1 for 1) and affect profit margins.

- Externally - borrow, issue debt, issue stock. Considered cumbersome due to compounding costs associated with interest/EPS dilution, potential credit downgrade.

Risk Financing Goals

What we have established is that Sherman-Wayne’s corporate philosophy & management team have put a high priority on ERM & a commitment to risk control. I believe it is safe to assume with ERM program operates as part of the company’s overall strategy & goals, rather than a supplement to it.

In many situation attaining managements buy-in is difficult, and with potentially high costs provides a barrier to implementation. In SW circumstance we already have the buy-in and following a review of their financials we can see that SW has gone to great lengths to diversify their risk coverages by installing a hybrid plan that covers a variety of situations for their global operation. In addition we can assume that the 2014-15 numbers assume carry-over growth from years past, and that more growth in on the horizon.

When it comes to risk financing I would classify their plan as skewing more toward the “traditional” risk spectrum rather than a forward thinking ERM programs. SW put together a hybrid plan that represents a large amount of admin & risk financing expenses, which I believe we can mitigate. Additionally these plans seem to lack the flexibility of a change marketplace, given the historical risk issues that SW has encountered, rising costs, and pending severity blowouts.

Due to these factors I would propose to upper management that Sherman-Wayne for a Captive Insurance company in addition to the current coverages. In doing we can effectively address the inherently connected risks at SW while efficient financing to provide flexibility while still transferring risk away from the firm. My suggestion would fall under a Single Parent (Pure) Captive given the unknown status if similar firms within the industry. This would all SW to be the sole owner of the captive and hold decision making abilities close to the chest, which should appeal not only to the CEO but to all stakeholders. Additionally a captive would provide several secondary benefits such as:

- Cash flow benefits – earning interest income on premium funds not yet paid, as well as underwriting premiums retained providing a positive cash flow event.

- Pricing stability – understanding all current policies are priced differently a captive would be able to provide stability & availability

- Reinsurance access— touched on below

- Inherent Risk control – A captive ushers in good safety and risk control practices as part of business operations.

Now it would not be very risk effective of me to only touch on the positives of a Pure Captive. I would include that although these disadvantages do exists, the offsetting benefits and financial environment that Sherman-Wayne operates within still make in very effective to create a captive insurance company.

- Capital Start up: Captives require a substantial capital outlay. After reviewing the financial stature of SW we believe they are in solid standing to take this cost on.

- Admin costs – these exist regardless so taking these in house could allow for overlapping process to either be modified or eliminated.

- Increased cost/uncertainty – by establishing a captive this new form subsidiary now has the ability to affect the overall operating business. In an adverse situation where higher than forecasted losses come to fruition not only could the solvency of the captive come into question but further capital from the parent could be required. Knowing this I still believe with prudent structuring a captive provides the best outlet to risk financing.[pic 1]

Structure

First, we will establish our captive in the State of Vermont, due to advantageous laws established in that state. As for what coverages our captive will address:

- Property & Casualty— the current insurance has $2b blanket limit, but more notably has a sublimit of $100mm for Earthquake coverage & Flood coverage in the United States. I believe that the sublimit coverage is inadequate assuming SW’s manufacturing plants dependency on being close to freshwater & the cost to rebuild a manufacturing facility currently at $120mm (4/6 manufacturing plants currently in US). The captive insurance company allows access to reinsurance where SW would pay extra premium to ensure their sublimit coverage up to $150mm for earthquake & flood. The current insurer can executes the reinsurance agreement to transfer excess of $100mm. Within the policy we build out a $10mm top end deductible, remaining to be coverage by supplemental policies.

- Incorporate Workers Compensation – Currently SW is a qualified self-insurer, by including this in the captive we will be able to provide 1) more adequate coverage and 2) mitigate potential costs that are currently expected to increase $1mm from $583k. The captive would serve to supplement worker compensation to incorporate at a minimum the $750k policy, with the option to increase coverage while staying under a premium of $1mm, any excess coverage for under $1mm premium with be purchased. Current policy price would hold true, to whatever coverage is available, excess/difference will be purchased through captive. Also, we must incorporate a pooling insurer that is ready and willing to cover our employees outside of the US. Right now we go to individuals insurers per each location- better to pool those. [pic 2]

- Excess Liability/Product Liability— finally we will want to include carve out a portion of our structure to address our current Products Liability SIR, due to the $5mm increase to the premium. Additionally, we will want to address the expected premium increase in global excess liability, specific to Products Liability (10% rise expected) it is no longer cost effective to rely on current plan. Due to the large product liability loss that could come to fruition in 2017 ($100

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