Cpcu 500 Ch.4

Front 1

Risk financing goals

Back 1

Common risk financing goals include: paying for losses, managing the cost of risk, managing variability (fluctuations) of cash flow, maintaining liquidity, and complying with legal requirements.

Risk financing goals should be effective and efficient.

Front 2

Paying for losses

Back 2

Organizations need to ensure funds are available to pay for losses that occur (some organizations choose to retain losses by not insuring them). Availability of funds is particularly important for losses that disrupt operations.

Paying for losses includes paying for actual losses as well as transfer costs. Transfer costs are costs to transfer risks to another, such as the purchase of options or insurance premiums. E.x. if you purchase a stock you can also purchase a "put option" to help you in case the stock declines but there is an added cost for that "put option".

Front 3

Managing the cost of risk

Back 3

Expenses associated with the cost of risk: administrative expenses - cost of internal administration and claim administration (e.x. if you retain losses within org. instead of purchasing insurance then you are responsible for the admin costs associated with processing the claims). Risk control expenses - reduce frequency and severity of losses (sprinklers, burglar bars). Risk financing expenses - transaction costs, such as bank fees.

Managing cost of risk does not necessarily mean minimizing these expenses. Many of these costs are necessary (don't minimize these costs, make sure they are efficient and effective).

Insurance premiums represent two goals of risk financing, paying for losses (goal 1) and managing the cost of risk (goal 2) b/c insurance pays for losses if one is incurred and there are also transaction costs associated with the policy itself which focuses on managing the cost of risk.

Front 4

Managing cash flow variability

Back 4

Some orgs can tolerate more cash flow fluctuation than others. Maximum acceptable cash flow variability depends on financial strength and risk tolerance. For organization cash flow fluctuations are affected by organization's financial strength and risk tolerance of managers and stakeholders. For individuals, affected by family obligations and individual's risk tolerance (for an individual who is married w/ children, they may not be able to tolerate a wide fluctuation in cash flow).

The maximum cash flow variability an organization will accept is highest for risk tolerant organizations (the more risk you can accept, the more cash flow variability you can accept).

Front 5

Maintaining liquidity

Back 5

Liquidity (cash and marketable securities) is required to pay for retained losses. Real estate and requirement is not liquid. Liquid assets typically have low return.

As an organization's retention level increases, the amount of required liquidity for the organization increases. Liquidity can be increased by borrowing, issuing stock or not paying a dividend.

Front 6

Complying with legal requirements

Back 6

Law and regulations may require specific risk financing measures (e.x. state that require drivers to purchase auto insurance, or workers comp for orgs).

Legal requirements affect how risk financing measures are implemented.

Front 7

Retention

Back 7

Most risk financing measures involve a mix of retention and transfers. E.x. insurance is considered a risk transfer measure however the may be a deductible that represents risk retention. Orgs that are better able to fulfill admin requirements are able to use risk retention more effectively.

Advantages of retention include: cost savings (primary advantage), control of claims process (allows greater flexibility of investigating settlements), timing of cash flows (avoids up-front payment of premiums), and risk control incentive (if org pays for own losses, there is incentive to prevent losses (risk control)).

Front 8

Retention pt.2

Back 8

Retention can be the most economical form of risk financing. Exposes organization to most variability of cash flow.

Planned retention is an intentional form of risk financing (purchasing an insurance policy that has a ded). Unplanned retention occurs when insurance is unavailable or losses are not identified.

Front 9

Planned retention funding

Back 9

Retention funding measures include:

Current expensing of losses - least formal and least expensive funding measure (hope you have enough cash on hand). Current cash flow used to cover losses. Becomes less appropriate as expected value of losses increases.

Unfunded reserve - accounting entry reflecting potential liability for losses. Specific assets are not used to support the potential loss. E.x. balance sheet includes reserve that offset assets (no specific assets that back it up, unfunded). Recognizes in advance the potential for loss, but does not support the potential for loss with any specific assets.

Front 10

Retention funding pt.2

Back 10

Retention funding measures include:

Funded reserve - supported with liquid assets to meet potential obligations. Can be informally funded or complex such as forming a captive insurer.

Borrowing funds - considered retention measure because borrowed funds reduce lines of credit available for other purposes (if you are using credit to fund losses, there won't be as much left to grow your business).

Front 11

Transfer

Back 11

Transfer is the opposite of retention. Risk transferred to third party.

Limitations on risk transfer: Deductibles or other limits forcing organization to pay for some part of loss (policy might have limits). Organization is still legally responsible for paying for loss.

Most risk transfer measures limit the potential amount of loss being transferred. In the real world there is usually a mix between transfer and retention. Most risk transfers shift the transferor's financial (not legal) responsibility for paying a loss to the transferee.

Front 12

Advantages of transfer

Back 12

Risk transfer offers the following advantages: reducing exposure to large losses (most important overall advantage), reducing cash flow variability (if you're making steady payments on a policy, that's more manageable and less fluctuating, advantage that is valued by investors), providing ancillary services (includes risk assessment services offered by insurer), and avoiding adverse employee/public relations (by having insurance pay for the damage and organization can avoid bad PR that might occur if they handled the claim).

Front 13

Mixing retention and transfer

Back 13

A mix of risk financing measures can help an organization balance retention and transfer. Retention helps manage the cost of risk b/c you're not paying premiums. Deductibles are a type of partial risk retention. Self-insurance is a form of risk retention, usually only appropriate for larger companies.

Transfer generally reduces the level of liquidity needed.

Front 14

Loss exposure characteristics

Back 14

The characteristics of the loss exposure can help determine the mix of retention and transfer. Frequency and severity of losses are critical characteristics. Insurance is typically designed around frequency and severity. If something is frequent, it's not appropriate for insurance, insurance is meant for low frequency/high severity. Regardless of frequency, losses that are considered low severity should usually be retained.

Front 15

Organization characteristics

Back 15

Characteristics of an organization can affect selection of risk financing measure: risk tolerance (the higher the risk tolerance, the more likely the org will retain risk), financial position (the more financially secure (the more assets, the more risk can be retained), ability to diversify (more diversification allows for better ability to predict losses (increases accuracy of loss estimates and reduces uncertainty regarding future losses, allows organization to retain more exposures).

Front 16

Organization characteristics pt.2

Back 16

Characteristics of an organization: ability to control losses (the greater the risk control undertaken, the more loss exposures that can be retained), ability to administer retention plan (the better the ability to fulfill admin requirements, the better to use retention more effectively (retention requires more administration than transfer)).

Front 17

Risk financing measures

Back 17

Types of risk financing measures: guaranteed cost of insurance, self-insurance, large deductible plans, captive insurers, finite risk insurance plans, pools, retrospective rating plans, hold-harmless agreements and capital market solutions.

Front 18

Risk financing measures pt.2

Back 18

Guaranteed cost insurance - premiums and limits are specified in advance. Premium does not depend on losses incurred (basic insurance policy).

Self insurance - Retention measure, organization maintains a formal system of paying for its own losses. Well-suited for high frequency loss exposures and losses paid out over time as it allows for cash flow management. Workers compensation, generally liability and auto liability loss exposures are typically paid out over time. Often combined with risk financing measure like excess coverage policy for losses that are high severity. The insured adjusts and pays its own losses up to the point of excess coverage insurance attachment.

Front 19

Risk financing measures pt.3

Back 19

Large deductible plans - similar to self-ins plan combined with excess coverage policy. Difference is insurer adjusts and pays all claims, even those below deductible. Insurer then is reimbursed for deductible.

Captive insurers - subsidiary formed by org to insure losses of parent and unrelated companies (subsidiary is basically insurance company). Used to insure property loss exposures that are difficult to insure in the primary market. Requires significant capital investment by parent.

Front 20

Risk financing measures pt.4

Back 20

Finite risk insurance plans - transfers limited amount of risk to insurer. Org pays large premium to insurer. Large part of premium creates a fund for insured's losses, with remaining amount used for insurance. Premium is a very high percentage of the policy limits. Often used for hazardous loss exposures for which insurance is limited or unavailable. Premium is high percentage of policy limits. Enables insured to receive higher limits than under basic guaranteed cost insurance.

Front 21

Risk financing measures pt.5

Back 21

Pools - a group of organizations coming together to insure each other. Well-suited for insureds too small to form captive insurance (won't have to make large capital investment). Achieves savings through economies of scale in administration.

Front 22

Risk financing measures pt.6

Back 22

Retrospective rating plans - adjusts insured's premium based on actual losses during period. Used for low-medium severity losses. Often combines with other risk financing plans to cover high severity losses. Organization must have substantial premium to benefit from retrospective rating plans. Premiums are determined using loss limit negotiated by insurer and insured. Loss limit is level at which a loss occurrence is limited for purposes of calculating premium.

Front 23

Risk financing measure pt.7

Back 23

Hold harmless agreement - noninsurance risk transfer measure. Agreement where one party agrees in advance not to hold the other party responsible for a loss.

Capital market solutions - solutions to cover loss exposures relating to long-term securities (noninsurance). Securitization - creating a security based on expected cash flows of transaction, e.x. a bank can sell it's mortgage receivables to investors and investors will collect the funds. Hedging - purchase/sale of asset to offset risk associated with another asset e.x. can use stock options to hedge other stocks you own.