Assignment 3: Risk Financing

Question 1

Common Risk Financing Goals

Answer 1

1. Pay for losses (including transfer costs)
2. Manage the cost of risk
3. Manage cash flow variability
4. Maintain an appropriate level of liquidity (balance between long-term returns in less liquid investments and the liquidity needs of retained losses)
5. Comply with legal requirements

Question 2

Transfer Costs

Answer 2

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

Question 3

Retention

Answer 3

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

Question 4

Planned Retention

Answer 4

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

Question 5

Unplanned Retention

Answer 5

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

Question 6

Advantages of Retention

Answer 6

1. Cost savings (avoiding administrative, premium, moral hazard, social loading, and adverse selection costs)
2. Control of claims process
3. Timing of cash flows
4. Incentives for risk control

Question 7

Transfer

Answer 7

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

Question 8

Limitations on Risk Transfer Measures

Answer 8

1. Most, if not all, risk transfer measures involve some type of limitation on the potential loss amounts that are being transferred
2. Risk financing does not eliminate the transferor’s legal responsibility for the loss if the transferee fails to pay

Question 9

Advantages of Transfer

Answer 9

1. Reducing exposure to large losses
2. Reducing cash flow uncertainty
3. Providing ancillary services
4. Avoiding adverse employee and public relations

Question 10

Major Factors of Using Risk Financing Measures to Meet Goals

Answer 10

1. The mix of retention and transfer
2. Loss exposure characteristics (transfer if losses are low frequency and high severity, avoid if high frequency and high severity, retain if low severity)
3. Characteristics of the individual or organization

Question 11

Characteristics Affecting Risk Financing Measures

Answer 11

• Risk tolerance
• Financial condition
• Core operations
• Ability to diversify
• Ability to control losses
• Ability to administer the retention plan

Question 12

Guaranteed Cost Insurance

Answer 12

Insurance policies in which the premium and limits are specified in advance

Question 13

Primary Layer

Answer 13

The first level of insurance coverage above any deductible

Question 14

Excess Layer

Answer 14

A level of insurance coverage above the primary layer

Question 15

Excess coverage

Answer 15

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

Question 16

Umbrella Policy

Answer 16

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

Question 17

Buffer Layer

Answer 17

A level of excess insurance coverage between a primary layer and an umbrella policy

Question 18

Alternative Risk Transfer (ART)

Answer 18

A term widely used to refer to risk financing measures other than guaranteed cost insurance

Question 19

Self-Insurance

Answer 19

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)

Question 20

Large Deductible Plan

Answer 20

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

Question 21

Captive Insurer (or Captive)

Answer 21

A subsidiary formed to insure the loss exposures of its parent company and the parent’s affiliates

Question 22

Considerations for How a Captive Will Operate

Answer 22

1. What types of losses exposures the captive will insure
2. Where the captive will be domiciled
3. Whether the captive will accept unaffiliated business

Question 23

Considerations for Selecting the Domicile for a Captive

Answer 23

1. Initial capital requirements, taxes, and annual fees
2. Reputation and regulatory environment
3. Premium and investment restrictions
4. Support of infrastructure in terms of accountants, bankers, lawyers, captive managers, and other third-party service providers within the domicile

Question 24

Risk Retention Group (RRG)

Answer 24

A group captive formed under the requirements of the Liability Risk Retention Act of 1986 to insure the parent organizations

Question 25

Rent-A-Captive

Answer 25

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

Question 26

Protected Cell Company (PCC)

Answer 26

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

Question 27

Finite Risk Insurance Plan

Answer 27

A risk financing plan that transfers a limited (finite) amount of risk to an insurer

Question 28

Pool

Answer 28

A group of organizations that band together to insure each other’s loss exposures

Question 29

Retrospective Rating Plan

Answer 29

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

Question 30

Loss Limit

Answer 30

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

Question 31

Hold-Harmless Agreement (or Indemnity Agreement)

Answer 31

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)

Question 32

Capital Market

Answer 32

A financial market in which long-term securities are traded

Question 33

Securitization

Answer 33

The process of creating a marketable investment security based on a financial transaction’s expected cash flows

Question 34

Insurance Securitization

Answer 34

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)

Question 35

Special Purpose Vehicle (SPV)

Answer 35

Acts as an intermediary from a bank/insurance company/other entity to investors

Question 36

Hedging

Answer 36

A financial transaction in which one asset is held to offset the risk associated with another asset

Question 37

Derivative

Answer 37

A financial contract that derives its value from the value of another asset

Question 38

Contingent Capital Arrangement

Answer 38

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