Assignment 3: Risk Financing Flashcards
Common Risk Financing Goals
- Pay for losses (including transfer costs)
- Manage the cost of risk
- Manage cash flow variability
- Maintain an appropriate level of liquidity (balance between long-term returns in less liquid investments and the liquidity needs of retained losses)
- Comply with legal requirements
Transfer Costs
Costs paid to transfer the responsibility for losses to another party
Ex. For financial risks, transfer costs could be the price of buying options to hedge the costs associated with currency exchange risk
Ex. For hazard risks, transfer costs are often insurance premiums
Retention
A risk financing technique by which losses are retained by generating funds within the organization to pay for losses
It can be the most economical form of risk financing, but it exposes the individual or organization to high cash flow uncertainty
Planned Retention
An intentional form of risk financing which allows the risk professional to choose the most appropriate retention funding measure
This includes
1. Current expensing of losses
2. Using an unfunded reserve
3. Using a funded reserve
4. Borrowing funds
Unplanned Retention
This occurs when either losses cannot be insured or otherwise transferred or an individual or organization fails to correctly identify or assess a loss exposure
Advantages of Retention
- Cost savings (avoiding administrative, premium, moral hazard, social loading, and adverse selection costs)
- Control of claims process
- Timing of cash flows
- Incentives for risk control
Transfer
In the context of risk management, a risk financing technique by which the financial responsibility for losses and variability in cash flows is shifted to another party
Limitations on Risk Transfer Measures
- Most, if not all, risk transfer measures involve some type of limitation on the potential loss amounts that are being transferred
- Risk financing does not eliminate the transferor’s legal responsibility for the loss if the transferee fails to pay
Advantages of Transfer
- Reducing exposure to large losses
- Reducing cash flow uncertainty
- Providing ancillary services
- Avoiding adverse employee and public relations
Major Factors of Using Risk Financing Measures to Meet Goals
- The mix of retention and transfer
- Loss exposure characteristics (transfer if losses are low frequency and high severity, avoid if high frequency and high severity, retain if low severity)
- Characteristics of the individual or organization
Characteristics Affecting Risk Financing Measures
- Risk tolerance
- Financial condition
- Core operations
- Ability to diversify
- Ability to control losses
- Ability to administer the retention plan
Guaranteed Cost Insurance
Insurance policies in which the premium and limits are specified in advance
Primary Layer
The first level of insurance coverage above any deductible
Excess Layer
A level of insurance coverage above the primary layer
Excess coverage
Insurance that covers losses above an attachment point, below which there is usually another insurance policy or a self-insured retention
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
Buffer Layer
A level of excess insurance coverage between a primary layer and an umbrella policy
Alternative Risk Transfer (ART)
A term widely used to refer to risk financing measures other than guaranteed cost insurance
Self-Insurance
A form of retention under which an organization records its losses and maintains a formal system to pay for them (often used for high-frequency loss exposures)
Large Deductible Plan
An insurance policy with a per occurrence or per accident deductible of $100,000 or more. The insurer adjusts and pays for all claims, even those below the deductible, then seeks reimbursement for claims below the deductible
Captive Insurer (or Captive)
A subsidiary formed to insure the loss exposures of its parent company and the parent’s affiliates
Considerations for How a Captive Will Operate
- What types of losses exposures the captive will insure
- Where the captive will be domiciled
- Whether the captive will accept unaffiliated business
Considerations for Selecting the Domicile for a Captive
- Initial capital requirements, taxes, and annual fees
- Reputation and regulatory environment
- Premium and investment restrictions
- Support of infrastructure in terms of accountants, bankers, lawyers, captive managers, and other third-party service providers within the domicile
Risk Retention Group (RRG)
A group captive formed under the requirements of the Liability Risk Retention Act of 1986 to insure the parent organizations
Rent-A-Captive
An arrangement under which an organization rents capital from a captive, to which it pays premiums and receives reimbursement for its losses. However, in this format it is possible for capital rented to be diminished by losses of another insured
Protected Cell Company (PCC)
A corporate entity separated into cells so that each participating company owns an entire cell but only a portion of the overall company. In this format, capital cannot be diminished by losses of another insured
Finite Risk Insurance Plan
A risk financing plan that transfers a limited (finite) amount of risk to an insurer
Pool
A group of organizations that band together to insure each other’s loss exposures
Retrospective Rating Plan
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. A company must have a large premium to benefit from this
If premium due is more (less) than the original deposit, the insurer will collect additional premium from (issue a refund to) the insured
Loss Limit
The level at which a loss occurrence is limited for the purpose of calculating a retrospectively rated premium
Hold-Harmless Agreement (or Indemnity Agreement)
A contractual provision that obligates one of the parties to assume the legal liability of another party (common for manufacturers to enter these agreements with distributors)
Capital Market
A financial market in which long-term securities are traded
Securitization
The process of creating a marketable investment security based on a financial transaction’s expected cash flows
Insurance Securitization
The process of creating a marketable insurance-linked security based on the cash flows that arise from the transfer of insurable risks (most common type is a catastrophe bond)
Special Purpose Vehicle (SPV)
Acts as an intermediary from a bank/insurance company/other entity to investors
Hedging
A financial transaction in which one asset is held to offset the risk associated with another asset
Derivative
A financial contract that derives its value from the value of another asset
Contingent Capital Arrangement
An agreement, entered into before any losses occur, that enables an organization to raise cash by selling stock or issuing debt at prearranged terms after a loss occurs that exceeds a certain threshold
