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
