Topic 6 Risk Management Alternatives Loss Financing Techniques 1 Individuals and organizations need to ensure that funds are available to pay for losses when they occur I Risk Financing Goals A Pay For Losses 2 Can be internal or external B Manage the Cost of Risk 1 Administrative Expenses a The cost of internal administration and the cost of purchased services such as claim administration or risk management consulting 2 Risk Control Expenses a Incurred to reduce frequency reduce the severity of losses that do occur and in crease the predictability of future losses b Best analyze risk control expenses by conducting a cost benefit analysis benefit of a risk control measure exceeds its cost 3 Risk Financing Expenses a Incurred to manage the risk financing measures used to meet risk financing goals 1 Transaction costs including commissions paid to brokers fees paid to banks or other investment institutions C Manage Cash Flow Variability 1 The level of cash flow variability that an individual or organization is able to or willing to accept depends on the individual s or organization s tolerance for risk D Maintain an Appropriate Level of Liquidity Related to C 1 A certain level of cash liquidity liquid assets is required to pay for retained losses 2 A liquid asset is one that can be easily converted into cash such as marketable securi 3 As an individual s retention level increases so does the level of liquidity required a Liquidity can be increased by 1 Selling assets 2 Retaining cash flow instead of using it to fund capital projects or to pay divi ties dends 3 Externally an organization can increase liquidity by borrowing issuing a debt instrument a bond or issuing stock for a publicly traded organization E Comply with Legal Requirements II Risk Financing Techniques Transfer and Retention A Risk Financing losses and risk control measures or to offset variability in cash flows A conscious act or decision not to act that generates the funds to pay for B Risk financing techniques are not necessarily used in isolated Many techniques involve ele ments of both retention and transfer deductible insurance comprises retention of the de ductible and transfer of losses above the deductible 1 Transfer external includes insurance and non insurance techniques to shift the fi nancial consequences of loss to another party a Non insurance Risk Transfer transfers all or part of the financial consequences of loss to another party other than an insurer 1 Leases 2 Hedging a financial transaction in which one asset is held to offset the risk as sociated with another asset 3 Futures Contract an exchange traded agreement to buy or sell a commodity or security at a future date at a price that if fixed at the time of the agreement b Insurance risk financing technique that transfers the potential financial conse quences of certain specified loss exposures from the insured to the insurer 1 By accepting the risk premium the insurer agrees to pay for all the organiza tion s losses that are covered by the insurance contract 2 Retention internal involves absorbing the loss by generating funds within the organi zation to pay for the loss generates the highest level of cash flow variability a Planned active deliberate assumption of a loss exposure that has been identified and analyzed b Unplanned passive failure to identify a loss exposure c Funded pre loss arrangement to ensure that funding is available post loss to pay for losses that do occur 1 The ideal loss exposure for funded retention is severe and predictable 2 Pre Loss Funding money to fund losses is set aside in advance 3 Current Loss Funding money to fund retained losses is provided at the time of the loss or immediately after 4 Post Loss Funding the organization pays for its retained losses sometime after the losses occur using borrowing in the meantime d Unfunded lack of advanced funding for losses that do occur III Selecting Appropriate Risk Financing Measures A The mix of retention and transfer B Loss exposure characteristics 1 The frequency and severity of losses associated with each loss exposure are vital to de termining whether a loss exposure should be fully retained or whether some form of transfer is appropriate a Low Severity Low Frequency Retain b Low Severity High Frequency Retain c High Severity Low Frequency Transfer d High Severity High Frequency Avoid if possible Retain last resort C Individual or Organization specific Characteristics 1 Risk tolerance ance between retention and transfer 2 Financial condition a The level of risk an organization is willing to assume directly affects it optimal bal a The more financially secure an individual or organization is the more loss expo sures can be retained without causing liquidity or cash flow variability problems Fi nancially secure organizations must still be careful though 3 Core operations a An organization is often better able to retain the loss exposures directly related to its core operations because it has an information advantage regarding those opera tions The org knows and understand its core operations better than any third party including insurers 4 Ability to diversify a If an org can diversify its loss exposures it can gain the advantage of offsetting losses associated with the other loss exposures and will then be better able to accu rately forecast future losses 5 Ability to control losses a The reductions in frequency severity make it more likely that the organization will have the ability to fund the retention of that particular loss exposure 6 Ability to administer the retention plan a Organizations that have a better ability to fulfill administrative requirements claim administration RM consulting retention fund accounting are able to use retention more efficiently IV Types of Contractual Risk Transfer A Contractual Risk Transfer an agreement in which one party accepts another party s expo sure to loss or the financial consequences of the transferrer s loss exposures as an inciden tal aspect of another business transition 1 Non insurance Risk Control Transfer Transfer of risk control responsibilities to a party that is not an insurer becomes effective only when the transferee performs the action that rids the transferor of risk a Incorporation a corporation is a legal entity distinct from its shareholders and b Leasing A tenant is responsible for any damage because they signed a lease stating solely responsible for its own wrongs it is their financial responsibility c