Marking Risks to Market

If financial statements are set to mark to market, why aren’t they marking uninsured risks to market?
Under all accounting systems, a business that buys no fire insurance will show a better result then a similar company who is buying insurance. Except in the year when they have a claim. The market price for their risk is an insurance premium.  But for some reason, risk has never been treated in this way.

If risk was market to market, then a firm that buys no insurance, or does not hedge a risk would not report a gain, they would need to put aside an amount at least equal to the insurance premium. That amount could be put into a fund and released when they have an event that would have generated an insurance claim.

Of course, to be mathematically correct, they would need to make adjustments to the insurance premiums. One to remove the profit margin/risk charge in the premium and another to reflect the fact that they are in effect creating an insurance pool with one participant which appropriately replaces the risk charge.
An insurance pool with one participant? That doesn’t make any sense. But that is what a business who is not buying insurance is doing. What then would be the correct premium, not loaded for profits, for an insurance pool of one? The pool would have to bare the cost of holding capital (or a contingent capital facility) for the entire maximum claim amount to the extent that amount exceeds the reserves (or the amount in the pool).
So if the cost of capital is 3%, and the claims rate is 1%, then the mark to market cost would be about 400% of expected claims at first, declining as the fund builds up.
Pretty expensive. But that would make the financial statement make sense on a mark to market basis for risk.
This approach could be applied to unhedged risks as well. The mark to market accounting is actually much too lenient on hedgable risks that are unhedged. The MTM accounting in effect allows those companies to reflect the cost of hedging even if they are not hedging. In fact, when they do not hedge, they are self insuring and need to reflect a much higher cost as described above.

Not managing risk is expensive, particularly to investors.  Investors deserve appropriate information on risk.  The longstanding accounting paradigm that ignors risk gives investors the exact wrong information and needs to be immediately corrected.

One of the main reasons that risk management is not already completely embedded in all firms is that they can get away with this scam on their investors, supported by their accounting statement.

Risk needs to be accounted for properly, especially when it is not managed.

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Explore posts in the same categories: Accounting Risk, Enterprise Risk Management

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