CHAPTER 11 AND 12

CORPORATE RISK FINANCING

INTRODUCTION Risk financing is a planning process to

arrange for funds that are reliable and cost-effective to finance for losses that might happen.

Risk financing and risk control are not mutually exclusive and are in fact, complementary to one another.

RISK FINANCING OBJECTIVES

The major goal is to maximizing of the value of the organization to its shareholders.

Plays a significant role in attaining the pre-loss objectives risk management by removing uncertainty created by the existence of risk by arranging funds which will be available when losses occur.

Risk financing support post-loss objectives of risk management by utilizing the funds made available through risk financing to pay for losses.

RISK FINANCING TECHNIQUES Can be broadly divided into three categories:

Risk Transfer√ Enables an organization to transfer its financial

responsibility to pay for potential loss to the insurers.

Risk Retention√ Use of organization internal funds or funds from its

group of companies to finance the loss. Includes:√ Paying losses as current expenses√ Establishing a reserve √ Payment of loss from organization captive insurance

management Hybrid Technique√ Involves the combination of internal and external

sources of funds to pay for the loss.

RISK TRANSFER:COMMERCIAL INSURANCE

Commercial insurance is the oldest, most established and reliable risk management technique.

Insurance is a risk transfer mechanism where the financial consequences of losses are transferred to an insurer which agrees to pay for the loss.

Insurance promotes business activities and increases overall productivity of an economy by proving financial protection to organization.

Figure above shows the insurance mechanism. The right of insured to indemnity payment is subject to

fulfillment of certain requirements and insurer may refuse to pay compensation due to breach of these requirements.

Effective and economical use of commercial insurance is a key risk management responsibility which in the long run enables the organization to manage its risks effectively.

Premium (Small & Certain)

Claim (Large & Uncertain)

INSURERINSURED

NATURE & ECONOMIC FUNCTION OF INSURANCE

Insurance has two fundamental characteristics:

The transfer of risk of financial loss from individual to the group.

Sharing of losses on some equitable basis among the members through the risk pool created by the insurance mechanism.

ECONOMIC DEFINITION OF INSURANCE

Insurance is an economic device whereby the individual/organization substitutes a small certain cost (the premium) for a large uncertain future financial loss by transferring the risk of financial loss to a risk pool.

‘Risk Pool’(Insurance Fund)

Premium Manage

Claim Profit/loss (risk)

ILLUSTRATION

Assuming 1,000 owners of identical double-storey house, each pay a premium of RM250 per year to an insurer to insure their houses against fire loss. The value of each house is RM100,000. the probability of fire destroying the building in a year is 0.002 as predicted from the past fire loss experience.

TOTAL PREMIUM AT THE BEGINNING OF THE POOL = RM250 X 1000 = RM250,000

Actual number of houses destroyed by fire = 2 (0.002 x 1000)

Amount of claim payable = 200,000 (2 x 100,000)Amount of premium collected = RM250,000 (250x1,000)

Outcome = Total premium – Total claims = RM250,000 – RM200,000 = RM50,000

(surplus available to pay for the profit and expenses of the insurer)

SCENARIO 1

Actual number of houses destroyed by fire = 3 (deviation from predicted)

Amount of claim payable = 300,000 (3 x 100,000)Amount of premium collected = RM250,000

(250x100,000)

Outcome = Total premium – Total claims = RM250,000 – RM300,000 = (RM50,000)

(trading loss and is financed by the capital of insurer)

SCENARIO 2

BENEFITS OF INSURANCE

CHARACTERISTICS OF INSURABLE RISKS

INSURANCE PRICING Premium is the price payable by the insured for the

financial protection provided by the insurance. Understanding how insurers determine the premium

has two important applications: Information used as a basis for selection of the

most cost effective risk financing tool, insurance, risk retention/hybrid.

Risk manager may use such information to structure his risk management strategy.

The main components that made up the Insurance premium are: Expected claim costs Administrative and marketing loading Profit loading to compensate for the cost of insurers’

capital.

Gross Premium Rate/ Cost of Insurance= Expected loss + Loading factor (expenses, profit and

contingency reserve)

Commercial insurance expenses ratio (%)Acquisition expenses 13.7%State premium tax 3.6%General administrative expense 7.5%Loss adjustment fees 8.6%Profit & contingencies expenses 2.5%

35.9%

Premium is always higher than the expected loss sustained by the insured’s in long-run.

Insurance is always more costly than the cost of losses actually occurred.

In this respect, risk retention is apparently more cost efficient than insurance and therefore organization should retain most of the loss exposures on cost reasons.

If the magnitude of MPL is beyond the financial capacity of the organization, it may become bankrupt after the loss has occurred.

TYPES OF INSURANCE

Can be broadly divided into two major categories: Life insurance – provides financial protection

against premature deaths of the insured's and it also provides a means of long-term saving for retirement

General insurance – annual insurance contracts that provide financial protection to individuals or organization against property and liability risks.

TYPES OF INSURANCE

USE OF INSURANCE IN RISK MANAGEMENT STRATEGY

In risk management philosophy, insurance is viewed as simple one of the approaches in for dealing with pure risks in the organization.

Under the risk management philosophy, the use of insurance over other risk management techniques, the use of insurance over other risk management techniques must be justified on cost factors.

The insurance needs of an organization may be according the following terms:

“Essential” Insurance

“Important "Insurance

“Optional” Insurance

COMMON ERRORS IN BUYING INSURANCE

Buying too little insurance. Failure to buy enough essential insurance to cover

critical risks. Buying too much insurance.

Buying too much optional insurance covering unimportant risk.

Buying too much and too little insurance at the same time. Buying too much optional insurance and at the

same time buying not enough essential insurance.

RISK RETENTION

Used when: Severity of loss is low (high F, low S or low F low S) Losses which can be predicted relatively Insurance on certain risks are not available

General advantages are: Exercise greater administrative and loss control

than insurer. Encourage better loss control through allocation of

losses operating units Greater flexibility in cash flow management.

CLASSIFICATION OF RISK RETENTION TECHNIQUES

COST FUNDED RISK RETENTION Cost of Risk Retention

= Cost of financing loss + Cost of financing risk

Cost of financing loss (expected loss) Long run average loss occurred in a given year. Cost of financing loss = cost of paying expected loss

Cost of financing Risk Risk is defined as the potential deviation the future loss from the

expected loss. The cost of providing fund to pay for future potential large losses that

are above the expected loss predicted is the cost of financing risk. Cost of financing risk = (company’s rate of return – interest rate) X

Reserve

COMPARISON Which one to use??

Cost of Risk Retention = Cost of financing loss + Cost of financing

risk

Gross Premium Rate/ Cost of Insurance= Expected loss + Loading factor (expenses, profit and

contingency reserve

RULE: choose the most cost effective options

SELF INSURANCE Use of actuarial technique to estimate

expected loss, loss reserve based on loss experience and amount of annual contributions to fund losses.

Advantages: Reduction in costs Potential saving Stronger control of risk management program Better cash flow control Capture investment income from loss reserve

Disadvantages: Exposure to catastrophe loss Variation in losses

It is a combination of insurance and risk retention

The insurers developed combination programs to complete with self-insurance programs.

HYBRID RISK FINANCING

RETENTION (CAPTIVE INSURANCE CO’)

Explores the reasons why an organization set up a captive insurance company.

It is wholly owned insurance subsidiary of an organization which has its primary function of insuring the risks of its parent company.

Reasons for formation of captives: Dissatisfaction with conventional insurance market Advantages of Captives

Dissatisfaction with conventional insurance market may due to: Market volatility Rating structure Unavailability of cover and Unacceptable rating

Benefits from Captive Insurance Company Saving in insurance costs Selection or risks Improved risk control Access to reinsurance market Taxation advantage over contribution Benefits of offshore insurance location Develop into a profit center for parent

organization

THANK YOU..