Topic 5 - Managing Enterprise Risk: Risk Financing

Risk Financing

Seeks funds to pay for losses

External Funds / Transfers

Involves transferring the risk to an outside party

Internal Funds / Retention

Involves using internal funds to pay for losses

• Borrow money

• Issue debt

Risk Transfers of the Financing Type

Seek external sources from third parties to cover financial losses. You still have the asset but transfer the financial responsibilities

Insurance

Transfers the financial responsibility of the loss to the insurer, but not the asset or activity itself

Leases

The tenant is responsible for all property losses while occupying the property. If the tenant fails, the owner is ultimately responsible

Hold Harmless Agreement

Someone contractually accepts risk for you.

ex. Contractor does a project but if a loss occurs, the firm will take full responsibility

Retention

A firm or individual assumes the financial responsibility for losses that occur

• Not buying insurance

Funded Retention

A firm sets aside money regularly to pay for future, predictable losses. Used for high-frequency, low-severity losses

Unfunded Retention

A firm decides to pay for losses as they happen, without setting aside money in advance. Used for low-frequency and low-severity

Active Retention

The intentional decision to assume a risk

Passive Retention

The exposure to risk is unintentional and also unaware

Self-Insurance

A form of active and funded retention. Instead of buying a policy, a business or person sets aside their own money to pay for potential losses

Ideal Characteristics for Self-Insurance: Fairly Predictable Losses

Risks that have a predictable pattern or can be reasonably estimated

ex. Medical Plan for Employees

Ideal Characteristics for Self-Insurance: Long Payout Period

Risks where the losses are paid out over a long time

ex. Workers Compensation

Advantages of Self-Insurance - Flexibility

Allows a firm to design a plan that meets its specific needs and avoids state-mandated benefit laws

Advantages of Self-Insurance - No Loading

Avoid expenses such as administrative costs, marketing expenses, and premium taxes

Advantages of Self-Insurance - Time Value of Money

When a firm self-insures, it can invest the funds it would have paid for premiums. This can produce a higher ROI

Disadvantage of Self-Insurance - Catastrophic Loss Possibility

A single large loss could financially wipe out the company

Disadvantage of Self-Insurance - Administrative Costs

Must handle all administrative functions, such as claim settlement, return-to-work programs, and wellness programs

Catastrophic Loss Solutions

• Stop self-insurance

• Use an insurance contract with a high deductible

Disadvantage of Self-Insurance - Financial Instability Perception

May give the perception that the company is financially unstable, and it’s hard to return to the insurance market once you leave

Disadvantage of Self-Insurance - Income Tax Treatment

Firms can’t deduct the premium cost until a loss actually happens and is paid

Captive

An insurance company owned by another business

Hard Market for Captives

When the cost of commercial insurance rose tremendously after 9/11

Single Parent Captive

Owned by one company

Group Captive

Owned by more than one company. These owners can be similar companies like hospitals

Captive Insurer Advantage - Hard Market Relief

They provide coverage when commercial insurance is too expensive

Captive Insurer Advantage - Regulatory Freedom

Captives are often located outside the U.S. to take advantage of more favorable regulatory environments

Captive Insurer Advantage - Tax Treatment

Can write off premiums and gain tax advantages if they meet the criteria for a true risk transfer

• Save money on premium

Third-Party Administrator (TPA)

An outside organization (often an independent firm) that a self-insured company hires to handle all or part of the administrative functions of its risk management plan, such as claims processing, record-keeping, and legal defense

Administrative Services Only (ASO) Contract

A formal agreement where a self-insured firm contracts with a commercial insurer (or sometimes a TPA) to provide only administrative services, such as claims handling and plan management, while the self-insured firm retains the full financial risk of the losses.