Making Risk Quantification Work For You

Making Risk Quantification Work For You

The real benefit of this methodology is not in categorizing and quantifying the risks, but in placing those numbers in the context of business fundamentals and assessing the ROI on ESG/sustainability costs.

One way to begin looking at the value of ESG/sustainability programs is to estimate incremental sales required to generate profits adequate to recover the expense of various loss scenarios that were assessed above. Operating loss scenarios can be bracketed within the estimated loss values of the severity parameters.

This example uses a hypothetical operating profit margin of 7.7%. This number can be obtained from management or derived from the company’s financial reports. In some cases, companies may prefer to use non-GAAP numbers such as EBIT or EBITDA. You will need to find out what your company’s preference is and use those as the basis for this analysis.

These operating profit estimates are also used in the ROI calculation. You will also need to gather other costs, such as the total cost to run the ESG/sustainability department (or whatever internal function is involved) and insurance premium costs (only for the coverages that are relevant to the risks — another reason it is important to understand the relevant coverages in place and their exclusions). Determining premium costs is arguably easier where you have standalone coverage for the risks.

Where coverages overlap or are dis-aggregated, you may need to ask your insurance broker to help you develop premium allocations for the relevant risks. Where this isn’t possible, consider asking your risk management department about the possibility of getting a quote for coverage without the specific relevant risks. Narrowing coverage by excluding specific risks — while all else remains constant — may reduce the premium in the quote. You can then consider the difference between the quote and the actual current premium as the additional premium cost for those risks. But again, this may not be possible or practical.

For a typical ROI analysis, the general formula is:

For the methodology in this Guidebook, the general formula is adapted to reflect cost avoidance concepts rather than profit generation. The adapted formula (referred to as “ROI_a”) is:

In this adaptation, the value of a potential loss not incurred is treated as the Gain from Investment in the traditional ROI formula. In other words, preventing a loss is considered a “gain” in comparison to the loss prevention expense. Why? Loss prevention/risk mitigation solutions (and their costs) are only beneficial when they work — preventing a loss. Their value is, in essence, when nothing happens — but that usually means loss prevention and risk mitigation are invisible and out of sight. When they fail, losses are incurred (negative value).

This is one reason why in the above steps it is vital to keep focused on gross (uncontrolled) risks. Considering the effectiveness or value of controls prior to this step would either dilute or double count their value in the ROI_a formula. For example, netting out a loss based on an insurance claims payment artificially reduces the value of “avoided risk,” reducing the ROI_a. In addition, due to complexities, exclusions and limitations of insurance coverage, there is no certainty that claims will be paid as expected. It may not be appropriate to generalize that all insured losses will be subject to netting-out.

You can now take everything you’ve done previously and put it together:

The following definitions apply:

• Environmental Management Cost: The operating cost for managing environmental issues for the company. This amount can include department operational, administrative, remediation and consultant costs, and reserves established for known environmental liabilities. It may not include site-level operating expenses related to environmental issues, new product R&D or legal fees.
• Deductible/Retention: The dollar amount retained or self-funded by the insured before a claim would be eligible for payment. Because this amount would be expended by the company before an insured claim would be paid, this is an environmental cost for this purpose.
• Average Estimated Gross Cost: Based on the risk assessment, this is the averaged dollar value of a loss using the calculation explained previously.
• Average Estimated Probability: Based on the risk assessment, this is the averaged probability of environmental incidents using the calculation explained previously.
• Estimated Gross Revenues Required to Offset Loss: The amount of new gross revenues required to generate profit offsetting the estimated loss, based on the operating profit margin. Remember to use the company’s preferred approach to presenting revenues or earnings internally. This may be in accordance with GAAP or non- GAAP methods such as EBIT or EBITDA.
• ROI_a can be presented in different ways such as time-based or based on specific loss sizes, depending on company preferences. For instance:
  • Based on probability-weighted gross loss. In this example, assuming a $2,311,935 loss in a single year.
  • Based on total cost of generating offsetting profits. Using the established profit margin, this how much it costs the company to generate the profits needed to offset the single year estimated loss. Again, remember to use the company’s preferred approach to presenting revenues or earnings internally. This may be in accordance with GAAP or non-GAAP methods such as EBIT or EBITDA.
  • Based on highest loss value (in this example, $10 million). This compares the environmental management cost to the value of a high or catastrophic loss.

Other ways of presenting ROI_a can be developed as needed, based on what risk management, executives and management consider credible.