Risk Financing. Risk Financing: General Considerations

Transcription

1 Retention Transfer Risk Financing Risk Financing: General Considerations Choice between retention and transfer is sometimes dictated by the first rule of risk management. (i.e. don t risk more than you can afford to lose) When a risk exceeds organization s riskbearing capacity, it must be reduced or transferred. In some cases where the organization could afford the loss, there may still be advantages in transfer. Page 1

2 Risk Financing vs. Loss Financing Not all losses involve risk, which is the possibility of a deviation from what is expected. If "expected" losses are $20,000 a year, but could be as much as $1,000,000, the risk is $980,000 ($1,000,000 minus $20,000). The $20,000 predictable loss may be retained or transferred to an insurer. The remaining $980,000 represents "risk," which may also be retained or transferred to an insurer. The Cost of Risk Financing Transferring some / all of the risk associated with the potential $980,000 loss imputes a cost to the organization Cost of risk transfer to an insurer Assuming an insurer loss ratio (expected loss as a percentage of total premium) of about 66 percent, if average expected loss is $20,000, the premium will be about $30,000. Cost of risk transfer is difference between average expected loss and total premium Page 2

3 The Cost of Risk Financing Cost of risk retention to the organization If the firm could be certain (which it can t know, a priori) that losses would not exceed $30,000 a year, it could save by retaining the entire risk. But losses could conceivably reach $1,000,000. To protect against the non-zero probability of a total $1,000,000 loss, it must maintain a liquid reserve of $980,000 (planned retention). Cost of retention estimated as opportunity cost of retained assets Retention Cost Example The cost of risk is the difference in earnings on a $980,000 reserve kept in a semi-liquid form, and the return if the $980,000 were applied to the firm s operations. If the return on funds applied to operations is 15% and the earnings on the invested reserve is 6%, the opportunity cost is $88,200 ($147,700 minus $58,800). A more complete analysis would consider the effect of taxes on both costs. Page 3

4 Choice of Risk Financing Often, the choice of retention vs. transfer is based on a comparison of the costs of the two alternatives. Cost of transfer $30,000 Cost of retention $88,200 The optimal risk financing option is typically the least costly option Choice of Risk Financing Variables that affect choice of risk financing (transfer vs. retention): Cost of insurance (transfer cost) Opportunity costs of capital (retention cost) Severity of potential loss(es) Amount of risk (uncertainty) associated with expected losses Risk preferences of the organization Taxation issues Page 4

5 Tax Considerations and Risk Financing Premiums for insurance (risk transfer) are fully deductible by the insured as a legitimate cost of business in the year when premiums are paid. Contributions made by a corporation to a self-insurance fund are not deductible Actual paid losses ARE deductible in the year when they are actually paid from whatever retention fund the organization has established. Risk Retention Risk retention encompasses a variety of risk financing techniques. In its simplest form, retained losses are simply paid as an operating expense like any other costs. (un-funded retention) At the most complex level, it can involve the formation of a captive insurance company to serve as a vehicle for funding the retained losses. (funded retention) Page 5

6 Funding the Retention Program Retention funding refers to specific mechanisms used to ensure the availability of funds to meet losses that MAY occur in the future. Options for retention funding Use of available operating revenues to fund risk retention (e.g. deductibles) Establishment of loss reserve account(s) with dedicated assets to cover the expected liability associated with a particular risk exposure Use of borrowed funds (not recommended) Funding the Retention Program The choice of approach with regard to retention funding is based on: Size of the potential losses The larger the potential loss, the greater the need for the establishment of loss reserves Variability in losses from year to year The greater the loss variability (higher risk), the greater the need for the establishment of loss reserves Availability of assets in the absence of a fund Balance sheet considerations Net assets vs. net liabilities Opportunity cost issues Page 6

7 Rationale for Risk Retention The main reason that firms elect to retain some of the costs of their risk exposures is the belief that it will be cheaper Avoids certain expenses associated with traditional commercial insurance Organization s loss experience may be better than average (insurance premiums based on average loss among large group) Investment income can be earned on reserves Self-insurance can avoid the social load in insurance rates ( mutualization of rates) Disadvantages to Risk Retention Inappropriate risk retention has the potential to: Leaves the organization exposed to catastrophic loss(es) Results in greater variation of costs from year to year and possible loss of tax deduction May involve the possible loss of ancillary services from insurance companies Page 7

8 Formal Risk Retention Mechanisms - Captives A captive insurance company is an entity created and controlled by a parent organization whose main purpose is to provide insurance to the parent Two types of captive organizations exist: 1. Pure captives 2. Association or group captives Captive Location Captives have traditionally been classified as onshore or offshore. An onshore captive is incorporated domestically and conducts business in the United States. An offshore captive is incorporated in a foreign jurisdiction and operates from that location, but it may still primarily insure U.S. risks. Choice of location often based on taxation issues in specific jurisdictions Page 8

9 Growth of Captives Increased from around 100 total in the late 1950s to over 4,000 by the year 2000 Over half of the Fortune 500 companies had established captive insurance arrangements to selfinsure various risk exposures by the year 2000 Tax Treatment of Captives Early on, captives were formed based on the belief that a tax deduction not available for self-insurance would be granted for payments to a captive The IRS position on captives since 1972 has been as follows: A captive is an insurance company in form only, not substance. There is no shifting of risk, and premiums paid by the parent are thus not deductible as a cost of doing business Page 9

10 The Risk Retention Act of 1986 Amended the Product Liability RRA of 1981, which was limited in scope to product liability exposures. The 1986 law expanded the provisions of the law to apply to most liability coverages. The RRA of 1986 authorized two mechanisms for group retention/treatment of various liability risks: Risk retention groups for self-funding (RRG) Purchasing groups for joint purchase of insurance. Risk Retention Groups A risk retention group is a group-owned insurer whose primary activity consists of assuming and spreading the liability risks of its members. They are insurance companies, regulated/ licensed in their state of incorporation, and owned by their policyholders who, in effect, double as shareholders. Page 10

11 Risk Retention Groups Members must have a community of interest (i.e. must face similar risks) Once organized, they can offer "memberships" to other organizations with similar risks on a nationwide basis. A RRG need be licensed in only one state, but may insure members of the group in any state. The jurisdiction in which it is chartered regulates the formation and operation of RRG RRGs are prohibited from joining a state insolvency guaranty fund Purchasing Groups A "purchasing group" is an entity that buys insurance from third party insurers for its members. Like participants in risk retention groups, members of purchasing groups must be in similar or related businesses which exposure them to similar liability risks. Unlike a risk retention group, a purchasing group does not retain risk It purchases group liability insurance coverage from insurance companies for its members. Serves as a bulk purchaser to obtain group discounts Page 11

12 Risk Sharing Pools A risk sharing pool represents a type of mechanism that is closely related to association or group captives, but which is actually a separate technique A group of entities may elect to pool their exposures, sharing the losses that occur, without creating a formal corporate insurance structure In this case, a separate corporate insurer is not created, but the risks are nevertheless "insured" by the pooling mechanism Risk Transfer: Buying Insurance Although insurance is only one of the techniques available for dealing with the pure risks, many of the risk management decisions culminate in a choice between insurance and non-insurance. It is therefore useful to examine the application of some basic principles of risk management to the area of insurance buying. Page 12

13 Insurance Defined: Individual Perspective Insurance is an economic device whereby the individual substitutes a small certain cost (the premium) for a large uncertain financial loss (the contingency insured against) which would exist if it were not for the insurance (transfer of risk from individual to other entity) Nature & Functions of Insurance All types of insurance have two fundamental characteristics: Transfer of risk from the individual to a larger group Sharing of losses among members of the insured group on some equitable basis Page 13

14 The Insurance Function An Illustration 1,000 homes valued at $100,000 each Each owner faces an unknown risk of a potential $100,000 loss All owners agree to share equally in any losses that actually occur If one house burns each owner agrees to pays $100 ($100 X 1,000 = $100,000). This is a pure assessment mutual insurance plan. Insurance Illustration (continued) Potential difficulty some members might refuse to pay their designated share of the losses that occur This problem can be overcome by requiring advance payment for predicted future losses based on past experience If 2 total losses are predicted, each owner s cost would be $200. If we add $100 to cover the cost of offering insurance, the cost is $300. Page 14

15 Insurance Illustration (continued) For a $300 premium, an insurer is willing to assume the risk that 2 houses will be destroyed at a total loss of $200,000 over a defined period of time. (risk transfer from individual homeowners) Why is it better for an insurer to assume this risk compared to individual homeowners? Risk Reduction Through Pooling For many types of risk exposures, insurers can predict, within fairly narrow limits, the magnitude of losses that will likely occur. If insurer could predict future losses with absolute precision, it would assume no risk and its rationale for existence would be tenuous Accuracy of insurer s prediction with regard to expected losses is based on the law of large numbers Page 15

16 Probability Theory and Law of Large Numbers Probability theory is the body of knowledge concerned with measuring the likelihood that something will happen and making predictions based on this likelihood Probability Theory and Law of Large Numbers Likelihood of an event is assigned a numerical value between 0 and 1. Impossible events assigned a value of 0. Inevitable events assigned value of 1. Events that may or may not happen are assigned a value between 0 and 1, with higher values assigned to those with greater likelihood. Page 16

17 Two Interpretations of Probability Relative frequency interpretation signifies the relative frequency of occurrence that would be expected, given a large number of separate independent trials. Subjective interpretation probability is measured by the degree of belief (e.g., student says she has a 50:50 chance of getting a B in the course). Determining the Probability of an Event A Priori Estimates A priori probability estimates are determined from known conditions the probability of flipping a head is.5 the probability of drawing the Ace of Spades is 1/52 A priori estimates not useful except for illustrating Law of Large Numbers Page 17

18 Law of Large Numbers Even though we know the probability of heads is.5, we cannot perfectly predict whether a given flip will be heads or tails Given a sufficient number of flips, however, we would expect the result to approach one-half heads and one-half tails. This notion that probability is meaningful as a predictor of future events only over a large number of trials is recognition of the Law of Large Numbers Law of Large Numbers The observed frequency of an event more nearly approaches the underlying probability of the population as the number of trials approaches infinity and/or as the size of the sample increases relative to the population as a whole. Page 18

19 A Posteriori Probabilities When probability cannot be determined by underlying conditions (i.e., a priori), it may be estimated based on past experiences A posteriori probabilities are based on observed frequencies of past events After observing proportion of the time that various outcomes occur, we construct an index of relative frequencies of occurrence called a probability distribution. Probability Distribution Probability distribution is an index of the relative frequency of all outcomes The probability assigned to the event is the average rate at which the outcome is expected to occur Probability distributions generally constructed on basis of a sample Page 19

20 Illustration of Sampling of Losses (1) Year Houses that Burn Total 50 Average 10 Illustration of Sampling of Losses (2) Year Houses that Burn Total 50 Average 10 Page 20

21 Standard Deviation (1) Year Avg. Actual Diff. Diff Loss Loss Squared Sum of Differences Squared = 20 Variance = 4, Std Deviation = 2 Standard Deviation (2) Year Avg. Actual Diff. Diff Loss Loss Squared Sum of Differences Squared = 80 Variance = 16, Std Deviation = 4 Page 21

22 Significance of Standard Deviation The smaller the standard deviation relative to the mean, the less the dispersion of the values in the population In our example, if a large number of samples were taken, 68.27% of the means (of the samples) would fall between 10 + the standard deviation. For the first set of data, For the second set, Dual Application of Law of Large Numbers To estimate the underlying probability accurately, insurer must have a large sample of experience Once the estimate of probability has been made, it must be applied to a large number of exposure units to permit the underlying probability to work itself out. Page 22

23 Insurance Defined: Social Perspective Insurance is an economic device for reducing or eliminating risk through the process of combining a sufficient number of homogeneous exposures to make the losses predictable for the group as a whole. (pooling of risks) Economic Contribution of Insurance Creates increased certainty about the burden of loss Spreads losses that do occur across large groups, reducing the individual burden of such losses Provides for a more optimal utilization of capital Page 23

24 Insurance Value Transfer vs. Pooling The view that the essence of insurance is risk transfer emphasizes the individual s substitution of a small small certain cost for large uncertain loss Emphasis on pooling or risk sharing emphasizes the role of reducing risk in the aggregate Insurance can exist without pooling, but not without transfer Characteristics of an Insurable Risk Ideally, an insurable risk should be associated with: Large numbers of exposure units Definite and measurable loss Losses that are fortuitous (unanticipated) Losses that are not catastrophic Losses that occur randomly Economic feasibility of coverage The more of these characteristics a risk possesses, the more insurable the risk Page 24

25 Categories of Insurance Private insurance Voluntary programs designed to protect individual against financial loss Social Insurance Compulsory (mandatory) insurance programs generally operated by government Public Benefit Guarantee Programs Quasi-social coverages usually associated with regulation Private (Voluntary) Insurance Usually (but not always) voluntary. Usually (but not always) offered by private insurers. Page 25

26 Classification of Private Insurance Coverages Life Insurance Accident and Health Insurance Property and Liability insurance Fire Marine Casualty Fidelity and surety bonds Surety Bonds Surety bonds represent a special class of risk transfer device, and strictly speaking are not contracts of insurance. A surety bond is an agreement by one party, the surety, to answer to a third person, called the obligee, for the obligation of a party called the principal. If the principal fails to perform in the manner guaranteed, surety is responsible to the obligee. The surety is analogous to the cosigner of a note and like a cosigner, is responsible for the obligation if the principal defaults. Page 26

27 Surety Bonds The primary obligation to perform rests with the principal, but if the principal is unable to meet the commitment, the surety must pay for the loss. In this event, the surety may take possession of the principal s assets and convert them into cash to reimburse itself for the loss paid. Most surety bonds are issued for persons doing contract construction, those connected with court actions, and those seeking licenses and permits. Social Insurance Based on the notion that there are some people in society who face fundamental risks that they cannot deal with themselves and cannot feasibly transfer to another entity on a voluntary basis Social insurance programs rest on the premise that if an individual cannot provide for a reasonable standard of living through personal efforts, society should assist Page 27

28 Social Insurance Characteristics Coverage is compulsory Eligibility derived from contributions no requirement to demonstrate need Method of determining benefits prescribed by law Benefits not directly related to contributions Social Insurance Programs in the U.S. Old-Age, Survivors and Disability Insurance (Social Security) Railroad Retirement, Disability and Unemployment Insurance Unemployment Insurance Medicare State Compulsory Temporary Disability Page 28

29 Similarities in Various Fields of Insurance Although details of operation may vary, the programs discussed all use some form of pooling of exposure units The possibility of loss is transferred from the individual to the group where losses are shared on some prescribed basis Basic concepts of pooling and sharing of losses and individual s substitution of small, certain cost for large uncertain loss are fundamental to all the programs Common Organizational Errors in Buying Insurance Buying too much insurance Risking too much for too little Buying too little Exposure to potentially catastrophic losses Buying too much and too little at the same time Page 29

30 Priority Ranking for Insurance Coverage Essential -- insures against losses that could cause bankruptcy Important -- insures against losses that would require resort to credit Optional -- Insures against losses that could be met from assets or cash flow Large Loss Principle Probability that a loss may or may not occur is often less important than potential severity of the loss. Important question is not can I afford the insurance? but can I afford to be without it? When available dollars cannot provide all the essential and important coverages required, a part of the loss may be assumed through deductibles. Page 30

31 Insurance as a Last Resort Insurance always costs more than the expected value of the loss. People who purchase coverage against small loss exposures are trying to beat the insurance company at its own game. Insurance should be used as a last resort. Selecting the Insurer Major consideration should be financial stability of the insurer Cost of insurance Other considerations include insurer policies toward claims adjudication and coverage cancellation (the role of underwriting) Page 31