CH 4 Risk Financing

Capital Market

A financial market in which long-term securities are traded. Bonds an other financial securities having a maturity of more than one year are bought and sold.

Hedging

A financial transaction in which one asset is held to offset the risk associated with another asset. Asset held to offset the risk if often a contract. Risk financing measure well suited to business risks created by price changes. Commodities, foreign exchange rates, interest rates are hedged. The risk transferred is the exposure to loss from declines or increases in an asset's market price. Advantage: Hedging against possible net income losses from price changes can reduce an org's business risk loss exposures. Disadvantage: Can destabilize not only an org's general risk financing plans, but also it's entire financial structure.

Self Insurance

A form of retention under which an org records its losses and maintains a formal system to pay for them. Well suited for financing losses that are paid out over a period of time, which provides a cash flow benefit. WC, GL, BA. Used for high-frequency losses because it is more efficient that filing many claims with an insurer. Combined with a risk financing measure such as excess coverage for high severity loss. Requires record keeping, claim adjustments, loss reserving, litigation mgmt, regulatory requirements, excess coverage.

Risk Retention Group

A group captive formed under the requirements of the Liability Risk Retention Act of 1986 to insure the parent orgs. Provides liability coverage other than personal, WC, employers liability. Formed due to lack of liability insurance coverage available in the 1980s.

Pools

A group of organizations that band together to insure each other's loss exposures. Each member contributes premium based on its loss exposures and in exchange the pool pays for each insured's covered losses. WC state pools. Structure can vary, can be a stock insurer or NFP, but most pools are less formal than the structure of a group captive. Collects premiums, pays losses, purchases excess and reinsurance, provide services. Achieves savings through economies of scale.

Buffer Layer

A level of excess insurance coverage between a primary layer and an umbrella policy. Used when umbrella policy requires underlying coverage limits that are higher than those provided by the primary layer.

Excess Layer

A level of insurance coverage above the primary layer.

Umbrella Policy

A liability policy that provides excess coverage above underlying policies and may also provide coverage not available in the underlying policies, subject to a self insured retention.

Maintain an Appropriate Level of Liquidity

A liquid asset is one that can easily be converted to cash. Real property and machinery are not considered liquid because they are difficult to sell quickly at prices close to their market value. As retention level increases, so does the level of liquidity required. Liquidity can be increased by selling assets or retaining cash flow instead of using it to fund capital projects or pay dividends, borrowing, issuing a stocks or bonds. One disadvantage with maintaining high levels of liquidity is that liquid assets do not typically offer the same return on investments as other, longer-term, less liquid investments.

Hold Harmless Agreements

A noninsurance risk transfer measure. Can be a stand alone contract or a clause within a contract. Commonly used to assign the responsibility for losses arising out of a particular relationship or activity. Example: Mfg has hold-harmless with distributor. This is a risk financing measure that transfers the financial responsibility of a liability loss from a distributor to the mfg.

Retrospective Rating Plans

A rating plan that adjusts the insured's premium for the current policy period based on the insured's loss experience during the current period; paid losses or incurred losses may be used to determine loss experience. WC, BA, GL, phys damage, crime. Used to finance low to medium severity losses and are combined with other risk financing plans to cover high severity losses. Must have a substantial premium (several hundred thousand dollars) to benefit from rating plan. Insured pays premium at beginning of policy period and insurer issues an insurance policy and agrees to pay covered losses up to the policy limit. The insured's losses during the policy period are considered in calculating a major portion of the premium. Premium is adjusted and insured issue a refund or invoice. Min and max premiums used. Advantages: Require only a moderate amount of admin by insured. One important expense saved is insurer risk charges which are extra charges an insurer includes as part of its risk transfer premium to cover the change that losses will be higher than expected. Encourages risk control. Provides financial stability. Can meet risk financing goals by providing appropriate balance between retention and transfer. Because premium is adjusted up or down depending on losses, the insured is retaining a portion of its own losses.

Finite Risk Insurance Plans

A risk financing plan that transfers a limited amount of risk to an insurer. Used for especially hazardous loss exposures for which insurance capacity is limited or unavailable. Differs from guaranteed cost because a large party of the insured's premium creates an experience fund for the insured's own losses. The remaining amount of premium is used to transfer a limits portion of risk to the insurer. Insurer shares a large portion of profits with insured. Premium is a high percentage of policy limits. Advantages: Insured that can control losses receives profit sharing, investment income, protected by a limited amount of risk transfer, obtain higher limits than available with guaranteed cost insurance.

Retention

A risk financing technique by which losses are retained by generating funds within the org to pay for the losses. Most risk financing measures are risk sharing mechanisms, and involve both retention and transfer. Can be the most economical form of risk financing but exposes insured to most cash flow variability. Planned: An intention form of risk financing. Allows risk mgmt professional to choose the most appropriate retention funding measure. Unplanned: Occurs when either losses cannot be insured or otherwise transferred or if loss exposures are incorrectly identified. Retention is the default financing technique in these cases.

Excess Coverage

Insurance that covers losses above an attachment point, below which there is usually another insurance policy or a self-insured retention.

Capital Market Solutions

Involve significant time and cost to implement, so only a few large corporations use them. Used mainly for catastrophe risks, but could be used for any type of insurable risk. Securitization Derivatives Contingent Capital Arrangements

Alternative Risk Transfer ART

Refers to risk financing measures other than guaranteed cost insurance.

Manage the Cost of Risk

These expenses form part of the cost of risk, regardless of whether losses are retained or transferred: -Admin expenses: cost of internal admin, claim admin or risk mgmt consulting. Mostly unavoidable but can save on them by modifying procedures or eliminating unnecessary tasks. -Risk control expenses: incurred to reduce frequency, severity or predictability of future losses. Conduct a cost-benefit analysis: benefit should exceed the cost. -Risk financing expenses: Transaction costs, commissions, fees. Org should be wary of sacrificing effectiveness for efficiency because many of these costs are unavoidable and necessary.

Large Deductible Plan

An insurance policy with a per occurrence or per accident deductible of $100,000 or more. WC, BA, GL. Similar to self insurance with excess coverage because it exposes the org to a large amount of loss, but there is a premium reduction from guaranteed cost insurance. Insurer adjusts and pays for all claims, even those under the deductible. Then seeks reimbursement from the insured. So the insurer is guaranteeing payment of all claims.

Advantages of Retention

-Cost Savings: Primary advantage. Saves costs that are included in an insurance premium including admin costs, premium taxes, moral hazard costs, social loading costs and adverse selection costs. -Control of Claims Process: allows greater flexibility in investigating and negotiating claims -Timing of Cash Flows: Avoid upfront insurance premium payments and can shorten delay between time of loss and the payment by the other party. -Incentives for risk control: When orgs pay for their own losses, the have a strong incentive to prevent and reduce losses.

Advantages of Transfer

-Reduce Exposure to Large Loss: Primary advantage because retaining large losses can cause financial distress. -Reducing Cash Flow Variability: By reducing the effect of losses associated with retaining large losses. Can increase attractiveness to investors. -Providing Ancillary Services: Risk assessment and control services. -Avoiding Adverse Employee and Public Relations: The claims admin process is also transferred, so any issues with them would not hurt the org's reputation.

Protected Cell Company

A corporate entity separated into cells so that each participating company owns an entire cell but only a portion of the overall company. Org pays premiums and receives reimbursement for losses while receiving credit for underwriting profit and investment income. Required by statute to be separated into cells, so each member is assured that other members and third parties cannot access its assets in the event another member becomes insolvent.

Derivative

A financial contract that derives its value from the value of another asset, such as a price or financial value that is uncertain in the future (stock market index, common stock price, commodity price).

Captive Insurers

A subsidiary formed to insure the loss exposures of its parent company and the parents affiliates. WC, BA, GL because they can drain cash flow. If significant portion of captive's revenues are generated by underwriting third party orgs (unaffiliated business), they operate more as a transfer measure than as a retention measure. Requires additional underwriting, actuarial, marketing expertise and adds additional risk to the captive. Can transfer the financial consequences of some of the insured loss exposures through reinsurance. Requires an investment of capital by its parent to pay losses and admin costs. Collects premium, issues policies, invests assets, and pays losses. Advantage: Captive can earn investment income on substantial loss reserves needed for WC, BA, GL exposures.

Contingent Capital Arrangements

An agreement, entered into before any losses occur, that enables an org to raise cash by selling stock or issuing debt at prearranged terms after a loss occurs that exceeds a certain threshold. Org does not transfer risk of loss to investors. It receives a capital injection in the form of debt or equity after a loss occurs to help it pay for the loss. ie a mfg may have a contingent capital arrangement with an investment bank that requires the bank to purchase a specified number of mfg shares at a predetermined price if the mfg suffers a significant property loss . mfg pays fee up front and if a loss occurs, the purchase of the shares allows mfg to rebuild. If no loss occurs, the agreement expires.

Rent-a-captive

An arrangement under which an org rents capital from a captive to which it pays premiums and receives reimbursement for its losses. Org can benefit from using a captive without having to supple its own capital to establish such a company. Each insured keeps its own premium and loss account, so no risk transfer occurs among the members. There is no statutory separation of capital and assets so it is possible that the capital rented by the insured could be diminished by losses of another insured in the structure.

Mix of Retention and Transfer

Balance of retention and transfer. How Retention and Transfer Meet Risk Financing Goals: Pay for losses: Retention is the most economical risk financing measure. Primary benefit for transfer. Ability to pay for losses depends on the structure of the retention measure implemented and relative strength of the insured's cash flows. Manage Cost of Risk: Primary benefit of retention. Transfer is rarely the most cost-effective option. Manage Cash Flow Variability: Retention generates the highest level of cash flow variability and may threaten liquidity. This is an important benefit of transfer. Maintain Liquidity: Transfer reduces the level of liquidity needed. For retention, it depends on the magnitude of loss and structure and mgmt of retention measure and the relative strength of cash flows. Comply with Legal Requirements: For retention, it depends on structure and mgmt of retention measure. This is a secondary benefit of transfer. ie states require mortgages are insured. Transfer measures offer the greatest certainty regarding the ability to pay losses, offer the greatest cash flow certainty, and are useful in preventing liquidity problems but they are costly to arrange.

Risk Financing Measures

Guaranteed Cost Insurance Self-insurance Large Deductible Plans Captive Insurers Finite Risk Insurance Plans Pools Retrospective Rating Plans Hold-harmless Agreements Capital Market Solutions

Loss Exposure Characteristics

High frequency, high severity: Avoid because neither retention or transfer is designed to cover these types of losses. Low frequency, low severity: Retain High frequency, low severity: Retain Low frequency, high severity: Transfer

Transfer

In the context of risk mgmt, a risk financing technique by which the financial responsibility for losses and variability in cash flows is shifted to another party. Pure transfer shifts the entire loss from one party to another. Limitations: Not typically pure transfers but are some combination of retention and transfer and the ultimate responsibility for paying for loss remains with insured. Transferor is reliant on good faith and financial strength of transferee and the judicial enforceability of the transfer agreement.

Guaranteed Cost Insurance

Insurance policies in which premiums and limits are specified in advance. Premium is guaranteed because it does not depend on the losses incurred during the period of coverage. Funded risk transfer method. Property, liability, personnel and net income loss exposures can be covered. Orgs with large loss exposures typcially purchase multiple guaranteed cost insurance policies as part of an overall program. Program is divided into two or more layers. Premium for higher layers is usually less the higher they get because they are not used as often.

Selecting Appropriate Risk Financing Measures

Must evaluate the relative advantages of all available measures and consider ability of each to meet the risk financing goals. Factors: -Mix of retention and transfer -Loss Exposure Analysis -Individual or org specific characteristics.

Single Parent Captive/Pure Captive

Operate as a formalized retention plan and only provide insurance coverage for their parent or sibling organizations, known as affiliated business.

Group Captive

Operate as formalized pools in which several orgs group together to share the financial consequences associated with their collective loss exposures. Because of their sharing, they act more like transfer measures. Risk Retention Group RRG Rent-a-captive Protected Cell Company PCC

Individual or Organizations Specific Characteristics

Optimal balance of retention and transfer depends on these: Risk Tolerance: Level of risk an org is willing to assume. The higher the willingness to accept risk, the higher the likelihood more risk will be retained. Financial Condition: The more financially secure a individual org is, the more loss exposures can be retained without causing liquidity or cash flow variability problems. Core Operations: Org is better able to retain the loss exposures directly related to its core ops because it is info advantage. Ability to Diversify: Ability to diversify allows org to gain advantage of offsetting losses, which means they are better able to accurately forecast future losses, and allow org to retain more loss exposures. Ability to Control Losses: The more risk control an org undertakes, the more loss exposures it is able to retain. Ability to Administer the Retention Plan: Requires more admin than transfer.

Ability of Guaranteed Cost Insurance to Meet Risk Financing Goals

Pay for Losses: Can meet this goal as long as loss exposures are covered under policy. Manage the Cost of Risk: Can meet this goal but it is not idea because premiums are designed to cover losses and additional costs incurred by insurer. Manage Cash Flow Variability: Can meet this goal because much of the uncertainty of future losses is transferred to the carrier. Maintain Appropriate Level of Liquidity: Can meet this goal because org requires less liquidity compared to retention or other risk financing measures. Comply with Legal Requirements: Can meet this goal, especially by loss exposures required by law to be transferred.

Ability of Captive Plan to Meet Risk Financing Goals

Pay for Losses: Can meet this goal because if properly capitalized and managed. Manage the Cost of Risk: Can reduce an org's cost over time if properly funded and managed, despite large start-up costs. Manage Cash Flow Variability: Can meet this goal by charging level premiums and retaining earnings in the years with lower losses to pay for higher losses in other years. Maintain Appropriate Level of Liquidity: Can meet this goal if it is properly capitalized. Comply with Legal Requirements: Can meet legal requirements, though there are rarely licensed to operate as a primary insurer in the US.

Ability of Finite Risk Insurance Plan to Meet Risk Financing Goals

Pay for Losses: Can meet this goal because insurer pays for losses as they come due, but because of the limited transfer, the insured pays for most losses. Manage the Cost of Risk: Can meet this goal because of profit sharing. Manage Cash Flow Variability: Can meet this goal because cash flows are smoothed over multiple periods; however, large premiums may be due at outset. Maintain Appropriate Level of Liquidity: Cannot meet this goal because premium payments are paid upfront. Comply with Legal Requirements: Can meet this requirement because insurer issues a policy guaranteeing all covered claims will be paid.

Ability of Large Deductible Plan to Meet Risk Financing Goals

Pay for Losses: Can meet this goal because insurer pays losses as they become due. Manage the Cost of Risk: May meet this goal because insurer administers claim process. Not as good as guaranteed cost plans, but better than retention plans. Manage Cash Flow Variability: Can meet this goal because org can effectively manage cash flow uncertainty if deductible is chosen carefully. Better than self insurance but not as good as guaranteed cost. Maintain Appropriate Level of Liquidity: Can meet this goal because liquidity is maintained if deductible is carefully selected. Lower liquidity than required with retention, but higher than guaranteed cost. Comply with Legal Requirements: Can meet goal.

Ability of Capital Markets to Meet Risk Financing Goals

Pay for Losses: Can meet this goal because some of the financial consequences of the losses are transferred to investors. Manage the Cost of Risk: Cannot typically meet this goal. They are expensive relative to other risk financing measures. Manage Cash Flow Variability: Can meet this goal because some of the financial consequences of the losses are transferred to investors. Maintain Appropriate Level of Liquidity: Can meet this goal because they can reduce the necessary level of liquidity that an org needs to maintain. Comply with Legal Requirements: Can meet this goal if correctly structured.

Ability of a Pool to Meet Risk Financing Goal

Pay for Losses: Can meet this goal because there is some risk transfer to other members of the pool, but the pool must pay for its own losses. Manage the Cost of Risk: Can meet this goal through economies of scale in administration. Manage Cash Flow Variability: Can meet this goal through risk sharing with other members. Risk sharing is a major benefit if there are enough loss exposures to benefit from the law of large numbers. Maintain Appropriate Level of Liquidity: Can meet this goal if adequately funded and managed, reducing an org's necessary level of liquidity. Comply with Legal Requirements: Can meet this goal if organized and managed within state regulations.

Ability of a Retrospective Rating Plan to Meet Risk Financing Goals.

Pay for Losses: Can meet this goal because, insurer pays for losses as they become due. Manage the Cost of Risk: Can meet this goal because it includes a significant amount of retention and can reduce an org's cost of risk over the long run. Manage Cash Flow Variability: Can meet this goal because it helps manage some cash flow uncertainty, but some uncertainty remains. Maintain Appropriate Level of Liquidity: Can meet this goal if loss limit and max premium are chosen carefully. Comply with Legal Requirements: Can meet this requirement because insurer issues a policy guaranteeing all covered claims will be paid.

Ability of Self Insurance to Meet Risk Financing Goals

Pay for Losses: Can meet this goal if correct retention level and excess coverage is chosen and there is a sufficient cash flow or liquid assets. Manage the Cost of Risk: Org must administer its own claims but can save insurer operating expenses. Primary benefit to self insurance. Manage Cash Flow Variability: Retained loss outcomes are uncertain. The higher the retention, the higher the degree of uncertainty of retained loss outcomes. Maintain Appropriate Level of Liquidity: Can meet this goal if retention level and excess coverage is chosen and paid amounts for retained losses are forecasted accurately. Comply with Legal Requirements: Must meet certain legal requirements to operate.

Ability of Hold Harmless Agreement to Meet Risk Financing Goals

Pay for Losses: Can meet this goal provided the loss exposures are covered by the agreement and the other party has the financial ability to pay losses subject to the agreement. Manage the Cost of Risk: Can meet this goal subject to any other contractual demands the other party requires before accepting the hold-harmless agreement. Manage Cash Flow Variability: Can meet this goal subject to the extent of the agreement. Maintain Appropriate Level of Liquidity: Can meet this goal because the org requires less liquidity with a hold-harmless agreement compared with other ART measures. Comply with Legal Requirements: Can meet this goal especially regarding loss exposures that are required by law to be transferred.

Pay for Losses

Paying for losses does not only entail paying for the actual losses or portions of losses retained, it also covers transfer costs, which are costs paid in order to transfer responsibility for losses to another party ie the price of buying options to hedge costs associated with a currency exchange risk or insurance premium. Paying for losses and paying for transfer costs are separate goals.

Retention Funding Measures

Rely on funds that originate within the org. Four types by increasing complexity: -Current Expensing of Losses: Least formal and expensive funding measure but provides the least assurance that funds will be available. Ok for low value losses, but the larger the value of the loss, the more formal and better funded the retention should be. -Using an Unfunded Reserve: Appears as an accounting entry denoting a potential liability to pay for a loss. Loss is not supported with any specific assets. ie uncollectible accounts -Using a Funded Reserve: Supported with cash, securities, or other liquid assets allocated to meet the obligations that the reserve represents. Can be informal or complex such as creating a captive. -Borrowing Funds: Results in a reduction of line of credit or ability to borrow for other purposes, which can deplete resources. In the short term, external source of capital is paying for loss and in the long term the insured pays entire loss.

Risk Financing Goals

Support risk mgmt goals, which support org goals. Pay for Losses Manage the Cost of Risk Manage Cash Flow Variability Maintain an Appropriate Level of Liquidity Comply with Legal Requirements

Primary Layer

The fist level of insurance coverage above any deductible. Referred to as working layer but it is used most often to pay losses.

Comply with Legal Requirements

The goal of complying with legal requirements is a fundamental requirement of all risk financing goals. Legal requirements can affect the specific risk financing measures and how they are implemented.

Loss Limit

The level at which a loss occurrence is limited for the purpose of calculating a retrospectively rated premium.

Manage Cost Flow Variability

The level of cash flow variability depends on the the tolerance of risk. Must determine max cash flow variability and organize risk mgmt programs within those parameters. Individual: Risk tolerance depends on financial strength, family obligations and aversion to risk. Organization: Risk tolerance depends on size, financial strength, risk tolerance, degree to which shareholders, suppliers, customers are willing to accept risk.

Insurance Securitization

The process of creating a marketable insurance-linked security based on the cash flows that arise from the transfer of insurable risks, which are similar to premium and loss payments under an insurance policy. Catastrophe Bond -Insurance policies may cover catastrophic events, but insurers/reinsurers have difficulty using pooling and the law of large numbers to mitigate cost of risk. So they transfer the risk to the capital markets where investors holding diversified portfolios have a larger pool of assets to absorb catastrophic losses. An SPV will use premiums to sell a catastrophe bond to investors. If there has been no catastrophe by the end of the bond term, the investor receives the principal and interest from the SPV, but if there was a catastrophe the investor receives the principal or a portion of the principal

Securitization

The process of creating a marketable investment security based on a financial transaction's expected cash flows. Insurer benefit: Risk is passed to investors. Investor benefit: Diversified portfolio because the risk embedded in insurance-linked securities is not closely correlated with the risks normally involved in other investments. Special Purpose Vehicle: ie a bank sells its mortgage receivables to investors -Bank lends money to purchase real property -Mortgagors make a promise to repay (mortgage receivables) -Bank sells a mortgage-backed security through an SPV -Bank collects money from investors and transfers mortgage receivables to investors. Removes risk of nonpayment of mortgagors for the bank.