Risk Management Exam 2 Study Guide Topic 6 Risk Financing Options Part II of Step 3 in RM Process Sources of Funds 1 External Funds someone else pays Risk Transfer 2 Internal Funds we pay Risk Retention a Either have to borrow money or issue debt bonds etc 3 Alternative Risk Financing Strategies a Lie outside insurance or similar contract ex Hedging with Derivatives Risk Transfer of the Financing Type o Firm seeks funds from unrelated 3rd parties to pay for losses o Still have that activity asset exposed to loss just transferring financial responsibility o Ex INSURANCE transfer the financial responsibility of a loss to the insurer In only exchange insurer earns premium o Ex Non Insurance Risk Transfer Lease with loss to property while tenant is occupying both landlord and tenant may be financially responsible The lease contract transfers risk to tenant Hold Harmless Agreements portion of a contract that states if a 3rd party sues both contract parties only one party assumes financial responsibility Risk Retention o A firm or individual assumes financial responsibility for losses that occur o Ex NOT buying insurance being underinsured having insurance with a deductible o 2 ways to classify 1 Active Risk Retention knowingly retaining financial responsibility 2 Passive Risk Retention unaware about retaining financial responsibility a Results from failing to identify loss exposures o Retention is also classified as 1 Funded Retention firm sets aside funds each time period to pay for losses a Used for high severity low frequency situations b Used for predictable losses 2 Unfunded Retention when losses do occur we pay for it out of current revenue or borrowed funds a Used for low severity low or high frequency Risk Retention Self Insurance o Self Insurance is Active and Funded Retention o For firms with many loss exposures and potential large losses o Common self insurance programs Health insurance Worker s Compensation o Self Insured Retention SIR Characteristics Ideal for Self Insurance 1 Fairly predictable losses 2 Long Payout Period Larger firms with many loss exposures If large enough it s better to self insure than to pay a Risk Charge Admin Cost Ex Firm self insures worker s compensation it pays out payments for a long time Advantages of Self Insurance 1 Potential Cost Savings reduces the Cost of Risk a Cost of Self Insurance premium p Admin costs b Cost of Market Insurance Gross premium p Risk Charge Admin costs 2 Time Value of Money a Insurers get interest free loan premium and earn interest between premium payout inflow and claim payment outflow b With Self Insurance money could earn higher rate of return than the value of insurance 3 Firm could retain the full benefits of loss control reduction prevention a Ex Worker s Compensation safety training rehab decreases claims by 100 000 but insurance company only decreases premium by 50 000 b With Self Insurance there s a dollar for dollar benefit c Moral hazard Self Insurance Market Insurance 4 Flexibility in the design of insurance programs a Ex Health insurance Affordable Care Act small income firms don t have to provide contraceptives b Mandated benefits may be required of insurers but NOT for self insurance Disadvantages of Self Insurance 1 Possibility of Catastrophic Loss a Ex company self insures health insurance benefits b Firm may buy stop loss insurance i Specific individual stop loss retain the first X of any ONE claim ii Aggregate stop loss retain the first X of all claims together 2 Firm misses services available from insurer a Ex Claims settlement return to work programs wellness programs other stuff b Administrative Services Only ASO contract with insurer c Third Party Administrator TPA contract without insurer 3 Potential for employee public relations problems a Employee isn t happy with benefits and causes public harm to the company Captives and Risk Retention Groups o Came about during the hard markets in the 1980s 1990s for liability and medical malpractice insurance o Take risk out of the market and retain instead o Captives a wholly owned insurance subsidiary of a non insurance firm Primary purpose is to insure risk of parent firm Parent provides capital to start the captive o Single Parent Captive one company owns subsidiary and they pay the parent company o Association Captive captive sponsored by association of firms Advantages of a Captive o Helps firms during hard market conditions o Location advantages where it is domiciled Tax benefits premiums paid to captives are tax deductible Regulatory requirements capital Proximity Best places for captives internationally Luxembourg Caymans Bermuda Domestically best places for captives Delaware and Vermont o Able to access the reinsurance market insurance for insurance companies wholesale insurance Ex buy 10M policy for 100K from AIG AIG keeps the first 2M and reinsures the next 8M for 50K Firm cannot go directly to Reinsurance Company Instead the firm creates a captive who can then go to a Reinsurance Company Risk Retention Groups RRGs o Captive owned by multiple firms in the same industry o Engaged in collective risk sharing o ONLY for liability insurance as established by a 1986 law Topic 7 Selecting from RM Options Step 4 of RM Process Loss Matrix decision making tool to help figure out which RM option to use o Indicates the possible values of expenditures associated with combinations of RM alternatives Future possible states of the world o Assume two possible states Loss or No Loss o Ex A building with a replacement cost of 424 000 and a potential fire loss total loss of 424 000 No fire 0 loss 3 possible RM options 1 Retention alone ignore it 2 Retention with safety measures safety costs 12 000 decreases freq 3 Full insurance with Face Amount limit of 424 000 no deductible and a premium of 20 000 Assume a tax rate of 40 and MAKE LOSS MATRIX RM Options Retention After Tax After Tax Full Insurance After Tax Fire 424 000 254 400 261 600 20 000 12 000 Retention with Safety 12K 424K 436 000 No Fire 0 0 12 000 7 200 20 000 12 000 Types of Expenditures o Cost of Safety Measures 12 000 o Cost of Insurance Premiums 20 000 o Cost of uninsured losses 424 000 All of these are tax deductible How to calculate tax deductible amount Probabilities Retention Fire 3 1 No Fire 97 99 Retention with Safety After tax expected cost of each option Retention only 03 254 400 97 0 7 632 p Retention w safety 01 261 600 99 0 9 744 p Full Insurance 12 000 with Probability of 1 12 000 p