MHSA 7750 – RISK MANAGEMENT AND INSURANCE
RISK FINANCING AND INSURANCE
TR-5-28
RISK FINANCING
Concentrates on arranging the availability of funds to meet
losses arising from the risks that remain after the application of risk control.
Includes the tools of
• Retention
• Transfer
RISK FINANCING: GENERAL CONSIDERATIONS
TR-5-29
Choice between retention and transfer is sometimes dictated by
the first rule of risk management.
• When a risk exceeds organization’s risk-bearing capacity, it must be
reduced or transferred.
• In some cases where the organization could afford the loss, there may still
be advantages in transfer.
FINANCING LOSSES VERSUS FINANCING RISK
TR-5-30
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.
TR-5-31
THE COST OF FINANCING RISK
Assuming a loss ratio of about 66 percent, if expected loss (that is,
the average loss per insured) is $20,000, the premium will be about $30,000.
• If the firm could be certain that losses would not exceed $30,000
a year, it would save by retaining the entire risk.
• But losses could conceivably reach $1,000,000.
• To protect against the possibility of a total $1,000,000 loss, it must maintain
a liquid reserve of $980,000.
137
TR-5-32
COST OF FINANCING RISK
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.
TAX CONSIDERATIONS AND RISK RETENTION
TR-5-33
Premiums for insurance are fully deductible by the insured.
Contributions made by a corporation to a self-insurance fund are not deductible.
Tax law does not eliminate the tax deductibility of self-insurance—it only forces
companies to wait until they actually pay a claim before taking the deduction.
TAX TREATMENT OF PROPERTY LOSS RECOVERIES
TR-5-34
If the insurance recovery exceeds the book value of a destroyed
asset. there is a taxable gain, to the extent the recovery exceeds book value.
• This type of loss and recovery is termed an involuntary conversion and is
subject special tax treatment under Internal Revenue Code Section 1033(a).
• the taxpayer has the option of recognizing (and paying taxes on) the gain,
or deferring taxation of the gain.
TR-5-35
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.
• 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.
TR-5-36
FUNDING THE RETENTION PROGRAM
Funding refers to the measures taken to ensuring availability of funds
to meet the losses that occur.
• When an organization elects to retain some of its risks it may be logical to
budget for the uninsured losses that will probably take place.
138
• Whether the retention program should be supported by segregation of
specific assets to cover losses depends on
♦
the size of the potential losses
♦
the variability in losses from year to year
♦
the availability of assets in the absence of a fund9
TR-5-37
REASONS FOR SELF-INSURANCE
The main reason that firms elect to self-insure certain exposures
is that they believe it will be cheaper to do so in the long run. Self insurance
• avoids certain expenses associated with traditional commercial insurance
• the organization’s loss experience may be better than average
• investment income may be earned on loss reserves
• Self-insurance can avoid the “social load” in insurance rates.
TR-5-38
DISADVANTAGES OF SELF-INSURANCE
Self insurance may
• leave the organization exposed to catastrophic loss.
• result in greater variation of costs from year to year and possible loss of tax
deduction
• create adverse employee and public relations in some areas.
•
involve the possible loss of ancillary services from insurance companies.
TR-5-39
CAPTIVE INSURANCE COMPANIES
A captive insurance company is an entity created and controlled by a
parent, whose main purpose is to provide insurance to that parent.
Two types of organizations may be considered.
1.
2.
Pure captives
Association or group captives
TR-5-40
CAPTIVE DOMICILES
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.
•
Usually, foreign captives operate under the surplus line laws of the states.
139
TR-5-41
GROWTH OF CAPTIVES
From a hundred or so in the late 1950s, the number of captives
licensed worldwide by 2000 was over 4,000.
By 2000, it was estimated also that over half of the Fortune 500 companies have
established captives.
TR-5-42
TAX TREATMENT OF CAPTIVES
Some captives were formed in the belief that a tax deduction not
available for self-insurance would be granted for payments to a captive.
The IRS position since 1972 has been:
• A captive is an insurance company in form only, not substance.
•
Since there is no shifting of risk, the premiums paid by the parent to a
captive are self-insurance reserves and not deductible.
• The captive has been formed primarily for the purpose of tax avoidance and
therefore premiums to it are not deductible.
TR-5-43
THE RISK RETENTION ACT OF 1986
The Risk Retention Act of 1986 amended the Product Liability Risk
Retention Act of 1981, which was limited to product liability exposures.
•
The 1986 law expanded the provisions of the law to apply to most liability
coverages.
Like its predecessor, the Risk Retention Act of 1986 authorized two
mechanisms for group treatment of liability risks:
• Risk retention groups for self-funding (pooling) and
• Purchasing groups for joint purchase of insurance
TR-5-44
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, regularly licensed in the state of domicile, and
owned by their policyholders who, in effect, double as shareholders
Members must have a community of interest (i.e., similar risks) and
once organized, they can offer "memberships" to others with similar needs on a
nationwide basis.
• A risk retention group 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 the group insurer.
140
• Risk retention groups are prohibited from joining the state insolvency
guaranty fund.
TR-5-46
PURCHASING GROUPS
A "purchasing group" is an entity that buys insurance 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 from insurance companies for its
members.
TR-5-47
POOLS
A risk sharing pool represents a 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.
Many authorities believe that pooling is appropriately classified
as either transfer or retention, depending on the situation.
•
In one sense, pooling is a form of transfer, in the sense that risks of the
pooling members are transferred from the individuals to the group.
•
In another sense, it is a form of retention, in which the organization's risks
are retained, along with those of the other pooling members.
TR-5-49
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.
TR-3-1
NATURE & FUNCTIONS OF INSURANCE
In its simplest aspect, insurance has two fundamental
characteristics:
1. Transfer of risk from the individual to the group
2. Sharing of losses on some equitable basis
141
OPERATION OF INSURANCE ILLUSTRATED
1.
2.
3.
4.
5.
6.
7.
8.
9.
TR-3-2
1,000 dwellings valued at $100,000 each.
Each owner faces risk of a $100,000 loss.
Owners agree to share losses that occur.
If a house burns (total loss) each owner pays $100 ($100 X 1,000 = $100,000).
This is a pure assessment mutual insurance plan.
Potential difficulty: some members might refuse to pay their assessment.
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 is $200.
If we add $100 for a cushion and for operating expenses, the cost is $300.
INSURANCE DEFINED: INDIVIDUAL VIEWPOINT
TR-3-4
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.
TR-3-5
RISK REDUCTION THROUGH POOLING
1.
2.
3.
4.
The risk an insurer faces is not merely a summation of risks
transferred to it by individuals.
Insurer can predict within narrow limits the amount of losses that will occur.
If the insurer could predict future losses with absolute precision, it would
have no risk.
Accuracy of insurer’s prediction is based on the law of large numbers.
PROBABILITY THEORY AND LAW OF LARGE NUMBERS
TR-3-6
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
1.
2.
3.
4.
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.
TR-3-8
TWO INTERPRETATIONS OF PROBABILITY
1.
TR-3-7
Relative frequency interpretation:
signifies the relative frequency of occurrence that would be
expected, given a large number of separate independent trials.
142
2.
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).
TR-3-9
DETERMINING THE PROBABILITY OF AN EVENT
1.
2.
A priori estimates determined from the underlying conditions
♦
probability of flipping a “head” is .5
♦
probability of drawing Ace of Spades is 1/52
A priori estimates not significant for us except in illustrating Law of Large
Numbers
TR-3-10
LAW OF LARGE NUMBERS
1.
Even though we know the probability of “head” is .5, we
know we cannot predict whether a given flip will be a head or a tail.
2.
Given a sufficient number of “flips,” we would expect the result to approach
one-half “heads” and one-half “tails.”
3.
This common sense notion that probability is meaningful only over a large
number of trials is recognition of the 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.
TR-3-12
A POSTERIORI PROBABILITIES
1.
When probability cannot be determined by underlying
conditions (i.e., a priori), it can be estimated based on past experience.
2.
A posteriori probabilities are based on observed frequencies of past events.
3.
After observing proportion of the time that various outcomes occur, we
construct an index of relative frequencies of occurrence called a probability
distribution.
TR-3-13
PROBABILITY DISTRIBUTION
1.
Probability distribution is an index of the relative frequency
of all outcomes.
2.
The probability assigned to the event is the average rate at which the
outcome is expected to occur.
3.
Probability distributions generally constructed on basis of a sample.
143
TR-3-14
ILLUSTRATION OF SAMPLING OF LOSSES
Year
Houses
that Burn
1
2
3
4
5
Total
7
11
10
9
13
50
Average
10
Year
Houses
that Burn
1
2
3
4
5
Total
16
4
10
12
8
50
Average
10
TR-3-16
STANDARD DEVIATION
Year
1
2
3
4
5
Average
Losses
10
10
10
10
10
Actual
Losses
7
11
10
9
13
Summation of Differences Squared
Number of Years
Difference
Squared
9
1
0
1
9
20
Difference
3
1
0
1
3
=
20
5
= 5
Variance = 4, Standard Deviation = 2
Year
1
2
3
4
5
Average
Losses
10
10
10
10
10
Actual
Losses
16
4
10
12
8
144
Difference
6
6
0
2
2
Difference
Squared
36
36
0
4
4
80
Summation of Differences Squared
Number of Years
=
80
5
= 16
Variance = 16, Standard Deviation = 4
TR-3-18
SIGNIFICANCE OF STANDARD DEVIATION
1.
2.
3.
4.
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, 10 + 2.
For the second set, 10 + 4.
DUAL APPLICATION OF LAW OF LARGE NUMBERS
TR-3-19
1.
To estimate the underlying probability accurately, insurer
must have a large sample of experience.
2.
Once an estimate of probability has been made, it must be applied to a large
number of exposures to permit the underlying probability “to work itself out.”
TR-3-20
INSURANCE DEFINED SOCIAL VIEWPOINT
Insurance is an economic device for reducing and eliminating risk
through the process of combining a sufficient number of homogeneous
exposures to make the losses predictable for the group as a whole.
ECONOMIC CONTRIBUTION OF INSURANCE
1.
2.
3.
TR-3-21
Creates certainty about burden of loss
Spreading losses that do occur
Provides for an optimal utilization of capital
TR-3-22
INSURANCE: TRANSFER OR POOLING?
1.
The view that the essence of insurance is risk transfer
emphasizes the individual’s substitution of a small certain cost for large
uncertain loss.
2.
Emphasis on pooling or risk sharing emphasizes the role of reducing risk in
the aggregate.
3.
Insurance can exist without pooling, but not without transfer.
145
TR-3-23
INSURANCE AND GAMBLING
1.
In gambling, there is no chance of loss (and therefore no risk)
prior to the wager.
2.
In the case of insurance, the chance of loss exists whether or not insurance
is purchased.
3. Gambling creates risk, while insurance provides for the transfer of existing
risk.
TR-3-24
ELEMENTS OF AN INSURABLE RISK
1.
2.
3.
4.
Large numbers of exposure units
Definite and measurable loss
The loss must be fortuitous
The loss must not be catastrophic
TR-3-25
OTHER FACETS OF INSURABLE RISK
1.
2.
Randomness-adverse selection
Economic feasibility
TR-3-26
SELF-INSURANCE
1.
2.
3.
Definitional impossibility: cannot transfer to or pool with oneself.
Nevertheless, the term has found widespread acceptance and we
should construct an acceptable operational definition.
Acceptable operational definition
♦
enough exposures for predictability
♦
financially dependable
♦
geographic dispersion
TR-3-27
THE FIELDS OF INSURANCE
1.
Private insurance
2.
voluntary programs designed to protect against financial loss
Social insurance
3.
compulsory insurance programs generally operated by
government
Public benefit guarantee programs
quasi-social coverages usually associated with regulation
TR-3-28
PRIVATE (VOLUNTARY) INSURANCE
1.
2.
Usually (but not always) voluntary
Usually (but not always) offered by private insurers
146
TR-3-29
CLASSIFICATION OF PRIVATE INSURANCE
1.
2.
3.
Life insurance
Accident and health insurance
Property and liability
♦
fire
♦
marine
♦
casualty
♦
fidelity and surety bonds
TR-3-30
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, the surety will be
responsible to the oblige.
In a sense, the surety is analogous to the cosigner of a note and like a cosigner, is
responsible for the obligation if the principal defaults.
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.
TR-3-32
SOCIAL INSURANCE
Based on the notion that there are some people in society
who face fundamental risks that they cannot deal with themselves.
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.
TR-3-33
SOCIAL INSURANCE DEFINITION
1.
2.
Coverage is compulsory
Eligibility derived from contributions:
no requirement to demonstrate need
3. Method of determining benefits prescribed by law
4. Benefits not directly related to contributions
147
5. Definite long-range plan for financing
6. Cost borne primarily by contributions
7. Plan administered or supervised by government
8. Plan not established solely for government employees
SOCIAL INSURANCE PROGRAMS IN THE U.S.
1.
2.
3.
4.
5.
TR-3-35
Old-Age, Survivors and Disability Insurance
Railroad Retirement, Disability and Unemployment Insurance
Unemployment Insurance
Medicare
State Compulsory Temporary Disability
PUBLIC GUARANTEE INSURANCE PROGRAMS
TR-3-36
1.
Quasi social insurance programs, mainly in connection with
regulation of financial institutions.
2.
Insurance principle is used to protect lenders, depositors, or investors
against loss resulting from failure of a financial institution
FEDERAL PUBLIC GUARANTEE PROGRAMS
1.
2.
3.
4.
TR-3-37
Federal Deposit Insurance Corporation
National Credit Union Administration
Securities Investor Protection Corporation
Pension Benefit Guarantee Corporation
SIMILARITIES IN VARIOUS FIELDS OF INSURANCE
TR-3-38
1.
Although details of operation may vary, the programs
discussed all use some form of pooling of exposure units.
2.
The possibility of loss is transferred from the individual to the group where
losses are shared on some prescribed basis.
3.
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.
TR-5-50
COMMON ERRORS IN BUYING INSURANCE
1.
2.
3.
Buying too much
Buying too little
Buying too much and too little at the same time
148
PRIORITY RANKING FOR INSURANCE COVERAGES
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
TR-5-51
TR-5-52
LARGE LOSS PRINCIPLE
1.
Probability that a loss may or may not occur is less important
than potential severity of the loss.
2.
Important question is not “can I afford the insurance?” but “can I afford to be
without it?”
3.
When available dollars cannot provide all the essential and important
coverages required, a part of the loss may be assumed through deductibles.
TR-5-53
INSURANCE AS A LAST RESORT
1.
Insurance always costs more than the expected value of the loss.
2.
People who purchase coverage against small loss exposures are trying to
beat the insurance company at its own game.
3.
Insurance should be used as a last resort.
TR-5-54
SELECTING THE AGENT
1.
Most important service provided by the agent is probably advice.
2.
Primary consideration in selecting an agent should be knowledge of the
insurance field and interest in the needs of the client.
3. One indicator of a knowledgeable and professional agent is a professional
designation (CPCU, CLU).
TR-5-55
SELECTING THE INSURER
1.
2.
3.
Major consideration should be financial stability
Cost
Other considerations include attitude toward claims and cancellation
149