ARM 56 Part C

Characteristics used to measure a loss exposure for hazard cost allocation purposes include

size, nature of operations, and territory.

Forward contract

A contract that obligates one party to buy and another party to sell a specific financial instrument or physical commodity at a specified future date and price.

Insurance-linked security

A financial instrument whose value is primarily driven by insurance and/or reinsurance loss events.

Objective trigger

A measurement that determines the value of an insurance-related capital market based on a parameter that is not within the control of the organization transferring the risk.

Catastrophe equity put option

A right to sell equity (stock) at a predetermined price in the event of a catastrophic loss.

Risk-sharing system

A risk management cost allocation system that allocates losses among all of an organization's departments.

Risk-bearing system

A risk management cost allocation system that allocates losses to the individual department that generates them.

Insurance option

A specialized type of option that derives its value from insurable losses - either an organization's actual insurable losses or an insurance industry index of losses.

Experience-based system

A system that allocates costs to departments according to their pro rata portion of past losses.

Exposure-based system

A system that allocates costs to departments on the basis of their exposures, regardless of their loss experience.

Surplus note

A type of unsecured debt instrument, issued only by insurers, that has characteristics of both conventional equity and debt securities and is classified as policyholder's surplus rather than as a liability on the insurer's statutory balance sheet.

Option contract

An agreement to keep an offer open for a stated period, supported by consideration.

Standby credit facility

An arrangement in which a bank or another financial institution agrees to provide a loan to an organization in the event the organization suffers a loss.

Put option

An option giving the holder the right to sell a set amount of the underlying security at any time within a specified period.

Call option

An option to buy a set amount of the underlying security at any time within a specified time period.

Swaps

Are frequently structured so that no money is paid up front between counterparties for the contract. Instead, cash flows are exchanged back and forth between the organizations throughout the term of the swap.

The organizations that use insurance-linked securities and insurance derivatives to transfer risk are concerned with

Cost, the financial security (credit risk) of the parties supplying the risk capital, and the risk that the amount received may not match the amount of their loss (basis risk).

Insurance derivative

Financial contract whose value is based on the level of insurable losses that occur during a specific time period.

A forward contract that is exchange-traded, or a futures contract

Has the benefits of being standardized, openly available, and transferable.

A financial instrument

Is a check, a bond, a share of stock, or another document with monetary value. A financial instrument could also be a binding agreement between parties for payment of money.

A call option

Is an option that gives the holder the right to buy an asset. A put option is an option that gives the holder the right to sell an asset.

An effective cost allocation system serves these purposes

Promote risk control Motivates personnel to reduce the frequency and/or severity of the organization's losses because each department is held accountable or rewarded for its risk control efforts. Facilitate risk control retention Allows the entire organization to benefit from an optimal risk retention level while not unduly exposing individual departments to excessive fluctuations in their cost of risk. Prioritize risk management expenditures Departments that pay for risk control measures carefully scrutinize the measure's cost effectiveness and prioritize measures that provide the greatest return on investment. Reduce costs lowering claim frequency and severity through risk control allows an organization to retain risk at an optimal level, resulting in a lower cost of risk. Distribute cost fairly Assigned amounts should have a direct correlation between departmental losses and the amount of risk management costs allocated to the unit. Balance risk bearing and risk sharing A proper balance distributes risk management costs across the organization while also allowing departments to benefit from their own loss experience and other changing conditions. Provide managers with hazard risk management cost information Accurate allocation and reporting of cost of risk compels managers to focus on areas in which the cost of risk can be reduced.

Contingent surplus notes

Surplus notes that have been designed so that an insurer, at its option, can immediately obtain funds by issuing the notes at a pre-agreed rate of interest.

Experience period

The length of time available to collect loss costs.

Price risk

The potential for a change in revenue or cost because of an increase or a decrease in the price of a product or input.

Strike price

The price at which the stock or commodity underlying a call option (such as a warrant) or a put option can be purchased (called) or sold (put) during a specific period.

Liquidity risk

The risk than an asset cannot be sold on short notice without incurring a loss.

Interest rate risk

The risk that a security's future value will decline because of changes in interest rates.

Credit risk

The risk that customers or other creditors will fail to make promised payments as they come due.

Market risk

Uncertainty about an investment's future value because of potential changes in the market for that type of investment.

Exchange risk

Uncertainty about an investment's value because of potential changes in the exchange rate between currencies.

These answers identify commonly used bases for measuring and allocating costs for these corresponding loss exposures

a. Commonly used bases for general liability include square footage of floor space, annual budget, payroll, full-time-equivalent workers, and sales. b. The commonly used basis for automobile liability is the number of vehicles used, with some adjustments for the difference in types of vehicles. c. Commonly used bases for workers compensation include payroll and full-time equivalent number of employees, with adjustments made for differences in exposure by job classification. d. Commonly used bases for property include square footage and property values (either replacement cost or actual cash value). The exposure base is often modified to accurately reflect the associated exposure.

These are the advantages of each hazard risk management cost allocation approach

a. Costs are assumed to be known before the beginning of the accounting period and are not changed. b. Costs are more accurately attributed to the period and department with which they are associated. However, final allocated costs are not determined until well after the end of the period during which the losses were incurred, which complicates risk management budgeting.

These are the two general approaches to hazard risk management cost allocation

a. Estimated costs are allocated at the beginning of the accounting period during which they are expected to be incurred. But once allocated, costs are not changed for the period, regardless of actual losses incurred. b. Estimated costs are allocated at the beginning of the accounting period during which they are expected to be incurred, but they can be reallocated one or more times during or after the close of the period, with payments or returns made retrospectively according to changes in loss experience.

These answers describe an insurance option holder's potential gain in these situations

a.When the value of an option's underlying asset exceeds the strike price, the buyer can exercise (sell) and realize a gain. b. When the value of an option's underlying asset is less than the strike price, the buyer cannot realize a gain by exercising the option.

Structured options, like traditional insurance

are usually tailored to the organization. However, structured options have slightly higher basis risk than traditional insurance, as options normally settle to an index or are based on a parameter that is not within the control of the organization transferring the risk.

The amount of the capital commitment fee is influenced by several factors

including likelihood of loss event, interest rates of alternative investments, and credit risk of the organization trying to arrange for the contingent capital.

An insurance derivative

is a financial contract whose value is based on the level of insurable losses that occur during a specific time period. An insurance derivative increases in value as specified insurable losses increase, and, therefore, the purchaser of the derivative can use this gain to offset its insurable losses.

A contingent capital arrangement

is a pre-loss agreement that establishes terms for an organization to raise cash in the wake of a major loss. The entity that agrees to provide the contingent capital receives a commitment fee in exchange for its promise to reimburse the partner organization for its loss costs. Under a contingent capital arrangement, the organization does not transfer its risk of loss to investors. Instead, after a loss occurs, it receives a capital injection in the form of debt or equity to help pay for the loss. Because the terms of then capital injection are agreed upon in advance, the organization generally receives more favorable terms than it would receive if it were forced to raise capital after a large loss, when the organization is likely to be in a weakened financial condition.

A major benefit of involving an SPV in a securitization transaction

is that investors can decide whether to invest in the securities based solely on the risk presented by the income-producing assets, or accounts receivable, held as collateral by the SPV. If FPS directly securitized its income-producing assets without using an SPV as an intermediary, investors would need to consider not only the risks presented by the income-producing assets, but also the overall credit risk of FPS. Analyzing overall credit risk is complex because FPS may hold many different types of assets and incur many different types of liabilities. Even expert investors have difficulty accurately analyzing such credit risk. An SPV reduces this associated credit risk; conversely, not having an SPV increases this associated credit risk

A major benefit of involving an SPV in a securitization transaction

is that investors can decide whether to invest the securities based solely on the risk presented by the income-producing assets held as collateral by the SPV.

Output price risk

is the uncertainty of what price the organization can charge for its product.

Investors in insurance-linked securities and insurance derivatives that are not determined to be insurance

must comply with the requirements of the various regulators of securities and derivatives. An organization is not able to deduct for tax purposes the amount it pays to transfer risk, and it must record on its balance sheet outstanding losses that are meant to be covered by proceeds from the insurance-linked security or insurance derivative. The organization can show a corresponding asset on its balance sheet for the fair value of the insurance-linked security or insurance derivative.

An organization transferring its risk of loss through SPV

receives tax and accounting advantages because the transaction will be treated as insurance or reinsurance if the SPV qualifies as an insurer or reinsurer under US state regulations.

With catastrophic bonds, a special purpose vehicle (SPV) "reinsures" the insurer for

specific catastrophe losses and in turn funds the coverage by selling bonds in the regular capital markets. The interest and principal on these bonds does not need to be repaid to the capital market investors if the specified losses take place. If the losses do not take place, the SPV pays interest and repays the principal on a schedule, as with most other bonds.

Liquidity risk involves

the uncertainty over an organization having enough cash or other assets that can be converted to cash and maintain value should there be an immediate demand for cash.

Insurance-linked securities are considered to provide a high level of financial security because

they are usually fully collateralized.

Costs most appropriately allocated to a department include

those that are clearly incurred by and beneficial to the department and that are wholly within its control.

SPV's

were established for the purpose of purchasing income-producing assets from an organization, holding title to them, and then using those assets to collateralize securities that will be sold to investors.

Regulatory and accounting treatment for insurance-linked securities (ILSs) and insurance derivatives that are determined to be insurance must comply

with insurance regulations. State premium taxes need to be paid; however, an organization can deduct these taxes and is not required to record the outstanding losses that are covered by the insurance on the liability section of the balance sheet.

Issues relevant to an organization that is selecting a hazard risk management cost allocation basis include these

• Accounting system • Tax system • Minimum amount charge for each department • Whether cost allocation is significant • Penalties or rewards for department managers • Inclusion of managers in development of the risk management cost allocation plan • The risk management information system (RMIS) used • Consistency of cost allocation • Changes in organizational structure

Advantages associated with insurance derivatives include these

• Additional risk capacity • Lower in cost than insurance-linked securities • Transparent pricing • Opportunities for investors to exit during its term • Standardized contracts • Efficient claims and contract settlement

These three primary criteria are used to project a department's losses and related costs

• Changes in claims paid • Changes in payments plus loss reserves • Changes in projected ultimate incurred losses

These are four types of hazard risk management costs that constitute an organization's cost of risk

• Cost of accidental losses not reimbursed by insurance or other outside sources • Insurance premiums • Cost of risk control techniques • Costs of administering risk management activities

The disadvantages of contingent capital arrangements are these

• Funds received from a standby credit facility or contingent surplus note for losses are paid in the form of loans, not equity, and must be paid back to the lender with interest. • The amount of an organization's equity increases when a catastrophe equity put option is exercised, thereby reducing the existing shareholders' percentage of ownership. This dilution may also come at a crucial time in the management of the organization (that is, after a catastrophe)

An organization may use these methods to allocate hazard risk management overhead

• In proportion to the total of other risk management department costs allocated for particular loss exposures. • As a fixed percentage of some other basis, such as sales. • As a combination of al flat fee per department (to cover fixed costs) and a percentage of some base, such as sales (to cover variable costs).

An organization calculates loss costs on one of these bases

• Incurred loss basis - Amounts paid for losses are added to reserves for pending claims, to the additions to those reserves, and to the estimated amount of incurred but not reported losses. • Claims-made basis - Actual loss payments are added to reserves for pending claims, to the additions to those reserves, and to the estimated amount of incurred but not reported losses. • Claims-paid basis - Amount paid on losses during the accounting period, regardless of when the losses were incurred.

Internal and external manipulation of cost information can be avoided in these ways

• Internal manipulation of cost information can be discouraged or prevented by requiring losses to be reviewed or audited to confirm that they were reported in a timely fashion and that subsequent changes to reserve amounts are not attributed to facts that should have been revealed at the time of loss. • External manipulation may be prevented if the system is designed to reflect the organization's overall objectives and has been approved by senior management.

These situations typically trigger cost allocation system changes

• Material shifts in the organization's operations • Change in expected losses because of change in legal climate, inflation, or some other factor, which can create a need to change the per occurrence limit. • Restructuring of the organization's departments or lines of authority

These costs are associated with administering risk management activities

• Operating budget of the risk management department • Cost of executives' time from other departments • Other resources from other departments devoted to hazard risk management.

An effective cost allocation system serves these purposes

• Promote risk control - Motivates personnel to reduce the frequency and/or severity of the organization's losses because each department is held accountable or rewarded for its risk control efforts. • Facilitate risk control retention - Allows the entire organization to benefit from an optimal risk retention level while not unduly exposing individual departments to excessive fluctuations in their cost of risk. • Prioritize risk management expenditures - Departments that pay for risk control measures carefully scrutinize the measure's cost effectiveness and prioritize measures that provide the greatest return on investment. • Reduce costs - lowering claim frequency and severity through risk control allows an organization to retain risk at an optimal level, resulting in a lower cost of risk. • Distribute cost fairly - Assigned amounts should have a direct correlation between departmental losses and the amount of risk management costs allocated to the unit. • Balance risk bearing and risk sharing - A proper balance distributes risk management costs across the organization while also allowing departments to benefit from their own loss experience and other changing conditions. • Provide managers with hazard risk management cost information - Accurate allocation and reporting of cost of risk compels managers to focus on areas in which the cost of risk can be reduced.

The ease of evaluating the effectiveness of a risk control program differs in these ways, depending on the cost allocation approach selected

• Prospective cost allocation - An increase (or decrease) in risk control activity can be separated by several accounting periods from the corresponding reduction (or increase) in allocated costs and are not always reflective of risk control expense outputs of the period to which they are charged. • Retrospective cost allocation - Hazard control program effectiveness is facilitated because the decrease (or increase) in loss costs is immediately recognized in terms of allocated costs.

An effectively designed hazard risk management cost allocation system should focus on these costs of risk

• Retained losses • Insurance premiums • Risk control costs • Administrative expenses for the risk management function

A contingent capital agreement generally falls into one of these categories

• Standby credit facility • Contingent surplus note • Catastrophe equity put option

These criteria are used to determine whether an insurance securitization or insurance derivative can be considered insurance and regulated as insurance

• The contract must indemnify an organization for its actual losses. • The insured organization must have an insurable interest that is the subject of an insurance contract. Insurance securitizations and insurance derivatives whose values are based on an objective trigger may not be considered insurance and should not be regulated as insurance

The advantages of contingent capital arrangements are these

• The funds they make available to an organization cost less than funds made available by insurance. • They allow an organization to obtain capital infusion at a predetermined price.

Disadvantages associated with insurance derivatives include these

• Underdeveloped markets • Basis risk • Credit risk • Uncertain regulatory and accounting treatment