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Finance of Risk Flashcards
Discuss the definitions of risk and the six general classes of risk. (p.2) Infrequent actuarial review and
Risk is uncertainty that may be either positive or negative, arising out of a given set of circumstances.
The six classes of risk are: Juridical Economic Legal Political Physical Social
What is risk?
Risk is uncertainty that may be either positive or negative, arising out of a given set of circumstances.
Discuss the definition of risk management and the five steps of the risk management process. (p. 6)
Risk Management is the process of managing uncertainty of exposures that affect an organization’s assets and financial statements using five steps: identification, analyis, control, financing, administration.
Five Steps of the Risk Management Process
- Risk Identification
- Risk Analysis
- Risk Control
- Risk Financing
- Risk Administration
What are the six general classes of risk?
6 classes of risk:
- Economic
- Judicial
- Legal
- Political
- Social
- Physical
What is the definition of Risk Management?
Risk Management is the process of managing uncertainty of exposures that affect an organization’s assets and financial statements using five steps: identification, analysis, control, financing, and administration.
What are the 5 steps of the risk management process?
The 5 steps of the risk management process:
- Identify the risk
- Analysis the risk.
- Control the risk.
- Finance the risk.
- Administration- implementatino and monitoring of the other 4 steps.
Discuss the components of the total cost of risk and how they are used as a key risk management tool. (p. 15)
TCOR = insurance costs + retained losses + risk management departmental costs + outside services fees + quantified indirect costs
Components of TCOR Insurance costs Retained losses (passive or active) Risk management departmental costs Outside services fees Indirect cost
What are the components of the total cost if risk?
Components of the total cost of risk: insurance costs retained losses risk management departmental costsoutside services fees indirect costs
How is total cost of risk used as a key risk management tool?
Assist with making effective risk management decisions.
Measure progress toward risk management objectives.
Focus and promote safety and loss control.
Provide management and employee incentives.
Assist with accurate pricing of products and services.
Assist with effective management of financial budgets.
Discuss the concepts of budgeted retention, tolerance corridor and retention-transfer diagrams. (p. 6)
Budgeted retention is planned retention based upon the portion of expected losses the organization is willing and able to retain.
Tolerance corridor is marginal retention beyond budgeted retention that the organization may also choose to retain.
retention-transfer diagram is a Graphic depiction of an organization’s financial ability and risk appetite. Includes budgeted losses, tolerance corridor, and retention.
What are the concepts of budgeted retention?
Budgeted retention is planned retention based upon the portion of expected losses the organization is willing and able to retain.
What are the concepts of tolerance corridor?
Tolerance corridor is marginal retention beyond budgeted retention that the organization may also choose to retain.
What are the concepts of retention-transfer diagrams?
Graphic depiction of an organization’s financial ability and risk appetite. Includes budgeted losses, tolerance corridor, and retention.
Describe the following analytical tools: measures of central tendency, measures of dispersion, loss distributions, trending and loss development. (p. 9) .
measures of central tendency:
- Mean/average
- Median - midpoint
- Mode most often
measures of dispersion:
Range - the difference between the highest value and the lowest value of an observation.
Variance - modified average of the squared deviation of each value from the mean of those values
loss distribution:
Normal distribution (also known as a bell curve) symmetrical
Non-normal distribution- Skewed to the left or right
trending and loss development:
Trending - indexing losses and exposures for inflation
· Development - how losses will ultimately payout over time because of the nature of the losses
Describe measures of central tendency.
mean= average
median= midpoint or middle value
Mode= most often or frequent
Describe measures of dispersion.
range= difference between highest and lowest
Variance= modified average of squared deviation of each value from the mean of those values
Describe loss distributions.
normal distributions-bell curve
non-normal distributions,
Describe trending.
indexing losses and exposures for inflation
Describe loss development.
how losses will ultimately pay out over time because of the nature of the losses.
Discuss the characteristics of simple financing options. (p.2)
Characteristics of SImple Financlng Options:
Rely heavily upon insurance policies to provide the source of external funds for financing risks.
Amount retained by the insured in the form of a deductible is relatively small.
In terms of the total cost of risk, the amount of risk financing provided by the insured organization consists of the premiums, the small amount of losses retained, and other expenses incurred for services.
Basic insurance terms for simple financing options
Written premium - total premiums on all Policies written by an insurer during a specified period of time, regardless of the portions that have been earned
Earned premium - amount of the premium that has been “used up” dUrIng the tenn of a policy; for example, if a oneyear policy has been in effect six months, half of the total premium has been earned
Unearned premium - amount of premium remaining after · deducting the earned premium from written premium; the portion of a premium representing the unexpired part of the policy period
Paid losses - the amount actually paid in losses during a specified period of time, not including estimates of amounts (i.e., reserves) that will be paid in the future for losses occuITlng In the specified period
Incurred losseS Total amount of paid claims and case reserves associated with a particular period of time (usually a policy year). Generally, incurred losses are the actual losseS paid and outstanding, interest on judgments, expenses incurred to obtain third-party recovenes, ana allocated loss adjustment expenses 2. Paid claims, case reserves, and IBNR reserves until ultimate incurred claims are reached, at which time .. there is no remaining IBNR.
unpaid c1aim~ “nt ?”al1~_ .. ,·1 ___ .~ ~,,+~1”"‘Io:Itpc;: for unpaid claims not reflected in the case reserve estimates fot individuallosses. The two components to IBNR reserves are pure IBNR and broad or bulk IBNR.
Pure IBNR - claims that have occurred but have not yet been reported as of the evaluation date. Since the claim has not been reported, there is no basis of establishing a reserve based upon the specific characteristics of the claim.
,;’ Broad or bulk IBNR - the additional development o e in reserve value as the ClaIm IS Investigated and settled.
Loss reserve - estimation of the liability for unpaid claims that have occurred as of a given date, including tbe IBNR t due. · claIms, claIms due but not yet paid, and amounts not yet due.
· Case reserve (claim reserve) - amount the claims adjuster : puts on an individual claim that has not yet been paid; there is no provision for development and IBNR
Allocated loss adjustment expense (ALAE) - an expense directly assigned to or that arises from a particular claim; examples of ALAE include court fees and outside legal counsel. Also known as allocated loss expense.
Unallocated loss adjustment expense (ULAE) - salaries, overhead, and other related adjustment expenses not specifically allocated or charged to a particular c1ajm. Some insurance carriers apply a nominal flat charge to each ClaIm reported to represent a portion of ULAE, but the amount is small relative to most types of ALAE
Discuss the basic types and forms of reinsurance and their uses. (p.6)
Types of reinsurance contracts
- Treaty reinsurance - accepts all risks
- Facultative reinsurance - each exposure accepted case by case only
C. Forms of reinsurance
- Pro rata reinsurance (proportional)
a. Quota share
b. Surplus share - Excess of loss reinsurance (non-proportional
a. Excess per occurrence
b. Aggregate excess of loss (stop loss or loss ratio)
What are the general uses of reinsurance?
General uses of reinsurance
- Risk shanng
- Stabilizing loss experience
- Increase capacity (premium volume and large lines)
- Surplus relief
- Catastrophe protection
- Retirement from a
a. Class of business
b. Territory
c. Book of business
d. Portfolio of claims
**Loss ratios and related terms
pure loss ratio=
losses incurred in the period (incurred, known claim reserves and IBNR reserves divided by earned premium during the period
Total loss ratio =
losses incurred in the period + allocated loss adjustment expenses divided by earned premium during the period
Expense ratio = underwriting expenses divided by earned premium
Combined ratio = total loss ratio + expense ratio
**Loss ratios and related terms
- pure loss ratio=
losses incurred in the period (incurred, known claim reserves and IBNR reserves divided by earned premium during the period
Total loss ratio =
losses incurred in the period + allocated loss adjustment expenses divided by earned premium during the period
Expense ratio = underwriting expenses divided by earned premium
Combined ratio = total loss ratio + expense ratio
What are the Dividend plan’s characteristics, advantages, an disadvantages. pg 19
Dividend Plan
Characteristics -Dividend options are applied to standard guaranteed cost plans Flat dividend - fixed amount regardless of losses Sliding scale Dividend based on insured’s incurred dividend credit Qlvldend credit I Dividend often based on insured’s audited premium (different scales based on premium) Dividends cannot be guaranteed by insurers as hoard of directors on entire book of business board of directors on entire book of business
Degree of retention - 100% external financing of r by insurer up to policy limits; subject to policy terms and condltlOns. A.ny aeaUctlble Imposed is a maIntenance deductible designed to handle very small ClaIms.
Premium certainty - insurance and retained loss component of total cost of risk is stable, with fixed llH1J1..HHUm anOlS reduced after payment of dividend.
Cash flow Limited cash flow through premium p, deferral Dividend can be considered a negative cash flow because of elimination of certain premium credits and the delay in receiving the dividends
Loss sensitivity No senSItIvIty to frequency Sensitive to severity, as one large claim can severely reduce or eliminate a dividend, even with a loss limit on anyone occurrence.
Service options - same as guaranteed cost
Program flexibility _ same as guaranteed cost except: Dividend factors are conservative and biased toward insurance carner
Accounting and tax impact - same as guaranteed cost plans except dividends are taxable as ordinary income
Advantages
Maximum premium is fixed; effective premium can be estimated with reasonable degree of certainty
· Depending on the plan, there is a chance that a reduction in losses will be rewarded
3. DIVldenas are normally calculated quickly after expiration (usually 6 to 18 months), so results are Known faIrly soon
Disadvantages Dividends are uncertain, even if entitlement occurs, as insurers do not guarantee dividends Insured is at the mercy of the claims (case) reserving l-Ila\;tlces or me Insurer
Since the plans are loss sensitive to severity, one large claim can eliminate a dividend; insured may have excellent risk control yet will not earn a dividend
What are the Guaranteed cost plan’s characteristics, advantages, an disadvantages. (pg 15)
Guaranteed Cost Plan Characteristics
Degree of retention - 100% external financing of risk by insurer up to policy limits, subject to policy terms and conditions. Any deductible imposed is a maintenance deductible designed to handle very small claims.
PremIUm certainty Rating is prospective; that is, rates are fixed or guaranteed and applied to estimated exposures known to msured Rating plan features (scheduled modifiers, discretionary modifiers, and experience modification) known in advance Insurance and retained loss components of the total cost of risk are very stable. Outside services expenses are largely stable.
Cash flow - none, except to the extent of premium deferral through installment payments
Degree of loss sensitivity No immediate sensitivity Sensitive to loss frequency and severity at renewals (increased premium or underwriting action)
Service options - insurer provided
Program flexibility Limited in contract language I. Limited in rating plan options
Accounting and tax impact Premiums are deductible when paid or when the expense IS Incurred under accrual accounting Losses under a maintenance deductible are deductible expenses when paid or incurred under accrual accounting. No recording issues since the insured has no responsibility for loss reserves
Advantages High budget predictability or certainty (subject to audit 01 exposures known to insured) Easy, one stop shopping and all services are provided by the insurer Certificates of insurance are provided by insurer or agent/broker Coverage is standardized and predictable ). Poor experience may go “unpunished” at renewal (deferred to later renewals)
Disadvantages (. Insurer’s expenses and profits are passed along Limited cash flow due to deferral of premium over maximum of 12 months (generally) 3, Good experience may go unrewarded at renewal (deferred to later renewal) . Services provided by the insurer may be inappropriate, inadequate or not needed options options · Long-tenn total cost of risk may be affected because mere are no short-term Incentives to reduce losses
What are the small deductible plan’s characteristics, advantages, an disadvantages. pg 24
Small Deductible Plan
Characteristics
· Degree of retentic · Deductible option is applied to a standan guaranteed cost plan
· Size of “small” is relative; the deductible wi larger than the maintenance deductible automatically included in the guaranteed cost plat and can be rather substantial.
The insurer pays all claims and bills the insured out under the deductible selected. out under the deductible selected.
Premium certainty Guaranteed rates and costs, based on estimated exposures, are negotiated and fixed in advance of the policy period and do not change. Premiums may be adjusted based on audits of exposures; however, the fixed rate is used.
Insurance component of the total cost of risk is stable, except for cost of collateral required under the deductible reimbursement plan. Retained losses will vary and the total cost of risk will be affected accordingly.
Cash flow possibilities Premium deferral options and deductible credits provIde some cash tlow benetits Loss payout lags (delay in deductible reimbursement) provide cash flow
Degree UI w::>::> ::>C;l1::>Hl v uy a. Frequency - potential for high loss sensitivity because of claim count and aggregation of losses
>. Severity - potential for high loss sensitivity because of size of deductible and aggregation of losses
Service options Insurance carrier provides all services Claims consultants may be involved (internal or external)
Program flexibility Contract language is generally standardized Rating plan has flexibility from deductible levels and credits
Accounting and tax impact Premiums are deductible when paid or when expense is incurred under accrual Losses are deductible when paid Loss reserves are maintained by the insurer. Deductible reimbursement obligations must be recorded as liabilities.
Advantages Can be structured with reasonable budget certainty Easy to implement, understand, and relatively easy to admInIster (depends on insurer) Insurance policy and certificates are standard (deductibles do not need to be shown on certificates) Direct savings and cash flow savings can be substantial, particularly if frequency is low and credits are reasonable , Real incentive to reduce frequency is introduced
Disadvantages Often inflexible related to coverage and pricing (class rated) (depends on cIrcumstances) (depends on circumstances) Services may be inadequate Insured haS a heightened incentive to be interested in the claims handling, but has little or no control over payments made to claimants or claim settlements (reserving is not a vested interest) · Insured may be required to offer a form of security, often in the fonn of escrow, which reduces cash flow advantages · Policy accounts may be held open for long periods of time before final cost is known for those claims with long development - depends on the plan and insurer
Differentiate between top-down and bottom-up pricing and when each is used in the pricing of insurance. (p. 3)
Top-down pricing
Commonly known as manual ratingJlf scheduled rating
Created on a state-by-state basis; broken down into territories within those states by a rather precise definition of the exposure, using a classification code
The underwriter Begins with a ~seFra!Z. established by the insurance carrier, regulator, or by a rale-maKIng organIzatIOn such as ISO or NCCI
The underwriter Applies an experience modification factor. scheduled credits or debits, premium discounts and/or deductible credits to achieve a net rate.
The underwriter Applies the net rate to the estimated exposure base to calculate the policy premium
Advantage - since underlying rates are usually based on a very large statistical sample, the premium will represent an actuarially sound initial pricing
Disadvantage - the data used to establish the base rates may not properly reflect the unique exposures of the insured or the effect of specific risk control enhancements made by the insured
_B~ottom-up pricing
Commonly known as loss rating
The underwriter Establishes credible loss data for a pre-set numbl of years and trends and develops the losses to ultimate values
1 ne unaerwnter Trends the unit of exposure (an independent variable, e.g., miles for a trucking company) for those same years, and the total ultimate loss is divided by the total number of exposures to create the loss rate; the rate of loss per exposure unit
The underwriter expense Grosses up the loss rate to include varia components, e.g., company underwriting expenses, brokerage commissions, loss control expenses, claims handling expenses, taxes, surcharges or assessments
The underwriter Generates the policy premium by multiplying the estimated exposure units for the policy period by the grossed up loss rate
bottom-up pricing Advantages
The loss rate will accurately represent the correct loss projection on which to build expenses if the data is large enough and credible
Claim charges and variation from the expected claims can be more accurately assessed since claim counts are more specific
Loss control will be specific to the insured and probably better suit the insured’s needs
Disadvantages of bottom-up pflclng
The premium will be inaccurate if the prediction of the losses is flawed, actuarially · unsound, or if the data is skewed by large · unpredictable or severe losses
Underwriters must be experienced and have the ability to use sound judgment to correctly project losses.
What are the Large Deductible plan’s characteristics, advantages, an disadvantages. pg 8
Large Deductible Plan Characteristics
Degree of retention can approach $100,000 and up
Premium certainty is high
retained losses vary
Cash flow possibilities are high,
Service options are widely available (“unbundling”) , Loss control options Claims service options Actuarial assistance in loss projections
Program flexibility is high
Appropriate attachment point. loss projection Loss stratificaltion Loss sensitivity
Complex accounting and tax impact Accounting treatment for liabilities (open reserves) , The economic performance test applies for premiums and loss reserves.
Advantages Positive cash flow pateReturn on loss control program investments are re, Coverages may be customized Services may be customized Claims can be better managed and controlle Policies and certificates are available from insurance carriers ranee Expense components can he negotiated with il carriers First step toward self insurance or captive programs
Disadvantages
Poor loss experience can cancel ad’ Accurate attachment point determination is required Insurer will require expensive security or collateral Lot be requirements with which the organizati willing or able to comply
· Aggregate protectIon may be cost prohibitive or may not be available
Management of claims and risk control
Describe sources of collateral. (p. 15)
sources: Collateral Letter of Credit (LOC)- most common Cash, certificates of deposit, or cash equivalents Custodial account- trust funds pre-funded deductible plans
Describe the issues related to collateral.
Issues with collateral requirements Collateral requirements are required at the onset of a new policy period and needed for subsequent expired policy periods until all claims are closed; this can take years.
This financial commitment limits cash flow, borroWIng capacity, and limits financial investments to promote · growth. Cost of collateral may outwetgh the benefit of premium savings compared to a standard insurance program.
:. Collateral requirements are based not only on the credit rating of an organization but also on the financial health of the organization. 1. Therefore, a heavily leveraged company may not qualify or may be required to pay higher collateral costs making a loss sensitive insurance program financially unattractive.
t The higher the level of projected ultimate losses subject to a deductible, Tetro, or self-insurance plan, the higher the level of required collateral
· Collateral may be “stacked”, e.g., each successive coverage period has its own required level of collateral related to the ultimate value of its open claims
Collateral requirements will likely increase based on any changes in exposures, e.g., payroll, vehicles, etc.
The insured should be proactive two-three months before renewal to ensure the “loss pick” is accurate since collateral is based on the estimated losses.
If the loss pick is too high, the insured will post too much; therefore, further limiting its cash How, credit line and investment opportunities.
If the loss pick is too low to cover the actual claims, the insured will need to post additional credit incurring an unexpected future expense.
· It is imperative that claims are properly managed and loss data is accurate, e.g., conduct periodic claims reviews to ensure reserves are accurate and settlements are occurring appropriately.
Discuss the characteristics, advantages and disadvantages of a retrospectively rated plan. (p. 22)
Retrospectively Rated Plans
Characteristics
Rates used to calculate the premium are fixed and premiums are adjusted retrospectively based upon losses
· All retrospectively rated plans are basically the same except for the types of loss used in adjusting the premiums retrospectively
Types of available plans
Incurred loss retro (ILR) plan
Modified ILR
Paid loss retro (PLR) plan
Advantages
, Can be the least expensive option
Widely available and offered by many insurance carriers
Flexible
Can create strong incentive for loss control
. Immediate advantage of turn-around in loss experienc
by timing of retro plan unplementatton
Cash flow possibilities (paid loss retro on]
Disadvantages
· Can be the most expensive option if alternatives are. limited or if loss experience is poor during retro penod
Can be used as a pricing weapon by insurance carriers
Retro adjustments are difficult to understand and often lead to accounting and budget problems
· Can lead to total cost of risk fluctuations
;. Potential collateral requirement for each year of retrospectively rated exposures that stacks or accumulates (paid loss retro only)
, Ultimate cost may be adversely affecttd if claims or loss control services are inadequat(
7. May have negative cash flow (incurred retro)
Retro premium formul
Indicated retro premium = [Basic Premium + Converted Losses) x Tax Multiplier Basic Premium = Standard Premium x Basic Factor Converted Losses = Losses x Loss Conversion Factor Tax Multiplier = 1.00 + Tax Factor
t. Subject to minimum and maximum premium factors · Losses may be subject to a loss limitation c. Subject to annual recalculation until all clain are closed, either by natural development or · capitation by insurance carner Annual premium adjustment may include an additional charge for non-subject premium or excess premium that is outside the calculation of the indicated retro premium 2. Formula is the same for both paid loss and incurred loss retro · plans except in a paid loss retro, only paid losses are considered. In an incurred loss retro, incurred losses are considered.
Analysis
Degree of retention _ retention varies greatly from plan to plan and is affected by maximum and min!mum premiums and by per occurrence loss limitations
· Premium certainty - premiums can vary greatly from plan to plan; a narrow minimum-maximum range defines a relatively predictable or certain premium, while a wIde range may be quite uncertam
Cash flow - can actually be worse than many other plans including guaranteed cost; somewhat better with a depressed exposure basis, or far better in earlier years · with a paid loss retro plan
Degree of loss sensitivity -loss sensitivity is high if there is a high maximum premium and no per occurrence loss limitation; loss sensitivity is low if there is a narrow minimum-maximum range and a low per occurrence loss limitation
· Services - same as underlying policy
Program flexibility - same as underlying poli<
7. Accounting and tax impact
a. Accounting treatment for liabilities
b. For premiums and loss reserves, the econorr : performance test applies
Retro plan terminology
Standard premium - determined on the basis of authorized rates, any experience modification rating, applicable loss constants and minimum premiums; specifically excludes premium discounts and expense constants
Basic premium - usually a percentage of the standard premium, often determined by multiplying the standard premium by a basic premium factor. It provides for insurance carrier expenses including loss control and commission, profit, contingencies, and an adjustment for limiting the retro premium between the minimum and the maximum retrospective premiums.
· Loss conversion factor - a factor used to cover clair adjustment expenses and the cost of the insurer’s or third-party claim administrator’s servlces
4. Tax multiplier - a factor applied to an insurance premium to cover licenses, fees, assessments, and premium taxes the insurance carrier must pay on the collected premium. It may also include an amount to subsidize residual market mechanisms or assigned risk markets.
). Loss limit - the maximum amount of anyone loss included in the retrospective rating plan. In effect, this lessens the impact of a severe loss on the retro premium and reduces variability of the loss sensitive retro premIUm.
Non-subject or excess premium - not a part of a loss sensitive rating formula. F or example, in a retro plan, the non-subject premium usually purchases the excess coverage for losses in excess of the loss limit (not to be confused with excess coverage for losses in excess of the primary coverage limits or the retention).
Maximum premIUm .’ The maximum that can be charged under a retro plan regardless of the losses J. The maximum paid by the insured under a retro plan
:;. Usually expressed as a percentage of the standard premium and is calculatal by multiplying the maximum premium factor hy the standard premium l.. It has the effect of placing a maximum dollar amount on the financial responsibility of the Insured
e. Once the maximum premium has been paid, all additional losses are the responsibtlity of th~ … insurance carrier, subject to the limit of liability of the insurance policles
The excess loss premium may be included in the maximum or in addition to the maximum, depending upon the retro agreement
Minimum premium The minimum amount of premIUm that can be charged under a retro plan regardless of the losses Least amount of premium (100% premium certainty) paid by the insured subject to a retro plan :. Usually stated as a percentage of the standard premium and is calculated by multiplying the minimum premium factor by the standard premlum
Indicated retro premium - the amount of premium . l calculated for anyone period using the retro formula
O. Retro adjustment - the amount of additional premium or return premium for each successive period determined by comparing the current period’s indicated retro premlum to the preceding period’s retro premium (either the deposit premium after audit or the indicated retro premium for subsequent perIods) .
What is the retro-premium formula?
Indicated retro premIum = [Basic Premium + Converted Losses) x Tax Multipli
Basic Premium = Standard Premium x Basic Factol
Converted Losses = Losses x Loss Conversion Fac~r
Tax Multiplier = 1.00 + Tax Factor
Discuss the characteristics, advantages and disadvantages of various self-insurance plans.
Various plans
- Qualified self-insurance - subject to state regulation
- Non-qualified self-insurance IS often combine generalliabilit) automobile liability, workers compensation and other miscellaneous lines with no per occurrence stop loss or loss limitation
- Fully self-insured Used by larger organizations
Characteristics
Self-insured retention (SIR)
Excess coverage is usually purchased
Services may be provided by outside vendors or internally by staff members of the organization
In the long run, self-insurance should be the most efficient and least expensive method of handling loss exposures if losses are reasonably predictable
Third-party requirements for rated insurance carriers and certificates of insurance are problematic for many se1finsured organizations
Advantages
Collateral is subject to negotiation and not statutory control
Loss control and claims management is vested solel with the organization using external providers or internal staff
Disadvantages
Insured is obligated to pay any claims beneath the SIR or pre-fund claim settlement
Few services, if any, are provided by excess insurers oftentimes, loss control and claims management is th sole responsibility of the organization
If the organization assumes responsibility for the claims management, organized and sophisticated claims handling procedures must be in place; otherwise, issues may occur with the insurance carrier .
Discuss the characteristics of a fronting program and how it is used by a captIve. . (p.24)
Characteristics of a fronting program
The captive is the reinsurer of the fronting carrier (the primary carrier).
The captive owner (insured) pays the premium to the fronting carrier (the pnmary carrier).
Fronting carrier cedes that portion of the premium designated to pay losses, predetermined based upon share of risk, to the ca0tive, the reinsurer. Generally, 100% of the losses are ceded, but the fronting carrier may, if negotiated retain a share of the risk and premium.
The fronting carrier issues a policy to the captive owner (insured) and pays insured losses to claimants.
Through a reinsurance treaty with the captive, the fronting carrier recovers these claim payments. The captive pays these losses. In effect, the captive owner has retained these losses.
The fronting carrier provides the use of its license, name, balance sheet, and services in exchange for a fronting fee and may provide contracted services (sud as underwriting and claims management).
The fronting carrier generally requires security in the form of an irrevocable letter of credit or similar mechanism.
In theory, the fronting carrier assumes no risk (except when what is agreed upon in the insurance agreement). However, there is always some degree of financial risk that the captive will become bankrupt or the letter of credit will not be sufficient. The greater the degree of risk perceived by the fronting carrier, the greater the security requirements.
Uses of a fronting prog ram
For workers compensation and automobile liability states require insurers be licensed and admitted to business. Since captives and other forms of alternative risk funding structures may not satisfy state capital and surplus requirements, a licensed, admitted fronting carrier must be used.
Several types of businesses, e.g., contractors, are required to provide evidence of insurance purchased from admitted insurers that hold acceptable claimspaying and financial strength ratings from A.M. Best or other financial rating agencies. Most captives do not apply to these rating agencies for rating because of the expense of obtaining the rating.
Discuss the characteristics, common features and the types ot of finite risk insurance contracts. (p. 40)
Characteristics of finite risk insurance
Spread of risk - Finite risk insurance is not dependent upon the spread of risk and its related contribution of loss funding among many insureds, as it is a program for only one insured. The law of large numbers does not apply.
Time value of money -1 In finite insurance, the time value of money is a central feature, as the insured receives credit for investment earnings that are added to the loss fund (experience account).
Annual vs. multi-year time frame:Finite risk insurance contracts are multi-year, with aggregate limits applying over the entire policy term. Finite risk insurance recognizes an event horizon of 5 to 10 years, as it is easier to predict that a given loss scenano will occur within a span of 5 to 10 years than within one specific year. The extended time frame facilitates high levels of loss funding for infrequent and unpredictable excess losses.
Insurable vs. uninsurable risks - . In finite risk insurance, nearly everything can be insured, barring a reinsurer’s exclusion, as long as the risk can be reasonably quantified with respect to frequency and severity on the extended policy term basis. Finite risk insurance contracts are designed to fund all losses within the aggregate limit of liability. Since finite risk insurance can be used as insurance, the program can be structured to include risks . unanticipated within the primary layer, thus providing coverage for the once-uninsurable risk.
Common applications of the finite risk insurance approach
1. Product-recall exposures 2. Warranty programs 3. Environmental impairment liability 4. Commodity price fluctuations 5. Credit risk 6. Earthquake or flood risk
Common Features of Finite Risk Insurance Contracts
r 1. Multi-year policy 2. Experience account 3, Cancellation provisions 4. Commutation 5. Reinsurer compensation 6. Blended risk/risk transfer 7. Interest rate risk 8. Credit risk
Types of finite risk insurance contracts
1. Retrospective Loss portfolic transfers Aggregate loss contracts
2. Prospective contracts Covers losses that have not yet occurred and that may never occur Covers losses that occur after the effective date of the contract
· Discuss the three methods of accounting for structured settlements. (p. 21)
Three methods of accounting for a structured settlement:
- . If annuity is in name of entity, the loss reserve liability should be carried on the balance sheet
- If annuity is in the name of the claimant, with no release of liability, no balance sheet entry is required; however, a foot note disclosing the outstanding amount is necessary
- If annuity is in the name of the claimant, with a release of liability, no entry or note is necessary
Discuss the implications of the Sarbanes-Oxley Act on the risk management function. (p.28)
:Sarbanes-OxIey Act Statement of management’s responsibility for establishing and maintaining an adeq.uate lntern control structure and procedUles for fmanda\ and Management’s assessment, as of year-end, of 1 effectiveness of the internal control structure procedures for financial reporting
Discuss tax issues relative to deductibility of paid losses, reserves, and premiums. (p.30)
GAAP vs SAP- when you can deduct losses expenses each program
39Discuss the characteristics, advantages and II disadvantages of the six types of captives.
Six types of captives 1. Single parent captive or pure captive 2. Group captive \:3. Association captive 4. Agency captive b. Rent-a-captive /6. Risk Retention Group
Reasons to [ann a captive
Availability of coverage
Pricing inequity
Need for improved existing products and service
Lack of flexibility
Inappropriate regulatior
Lack of value with conventional insurance transactiom
Characteristics of a captive
Degree of loss sensitivity is hif Degree of retention is_ 1000/1 Premium certainty is higb
Cash flow benefits abound due to the virtual 100% retention
Service options are flexibl Program flexibility is hig
Accounting and tax impact is very complex and requires knowledgeable tax counsel to avoid problem
Advantages of a captive
1. Reduction in the long-term cost of risk
2. Reduced operating costs
I 3. Investment income and operating pr )fofit
4. Broader coverage
5. Equitable rating
6. Coverage stability and availability
7. Direct reinsurer access
8. Improved services
9. Fewer regulatory restrictions
10. Enhanced risk management perspective
Disadvantages of a captive
- Internal administrative costs
- Long-term capitalization and commitment
- Dependence upon service providers
- Inadequate loss reserves and potential losses
- Complex taxation issues
- Increased cost or reduced availability of other insurance
42Discuss business decisions affected by reserves.
Business and Insurance Decisions Affected b rf by Reserves
Retention levels
Insurance and reinsurance pricing
Safety and loss control programs
PrDduct and services pricing
Forecasts of future results for budgetIng
Tax management
Merger and acquisition negotiation (pricing and terms)
Financial reporting
42Discuss contributing factors to reserve instability and/or stability.
Contributing Factors to Reserve Instability and/or Stabili1
Tort reform, economic and legal environment
Workers compensation !benefit structures
Procedures for adjustors
Claims staff and management
Rate of inflation for various costs
Capabilities of legal counsel
Volume of claims
Litigious nature of venue
The SEC Staff Accounting Bulletin 99 identifies factors defining materiality in reporting financial transactions
a.
b. Masks a change in earnings or other
c. Hides a failure to meet amlysts’ expectations
d. Changes a losiinto a gain or vice versa
e. Complicnce with regulatory requiremen
f. Compliance with l~2Ilcovenants
Accounting Audit Findings that Trigger Risk Concerns
Self-insurance plan existence Captive insurance company existence Past decision not to purchase nsurance Cash flow plans Increased deductible/ oetention level Reduced liability limits )rganization is member of 'isk pooling program Unchanged property values from prior years Solvency of insurance carriers
