Topic 5Risk Management Alternatives

BUS 200Introduction to Risk Management and Insurance

Jin Park

Overview All risk management alternatives are

either risk control options or risk financing options. Risk Control Options

Deal with risk itself Risk Financing Options

Deal with financial arrangement

Risk Control Options Avoidance Loss control

Loss prevention - frequency Loss reduction - severity

Others Separation of exposure unit Duplication of exposure unit Risk transfers of the control type

Goals Reduce the frequency of the loss (probability of the loss) Reduce the severity of losses that do occur Make losses more predicable

make losses less variable reduces objective risk

Risk Control Options - Avoidance Never engage in the activity causing the loss Stop engaging in the activity causing the loss Avoidance is mutually exclusive with respect to

other risk management options Problems

May not be feasible or desirable May create another loss exposures Some loss exposures are not avoidable

Benefit If practiced successfully, then there is no loss (zero

frequency)

Risk Control Options - Avoidance When is avoidance a valid consideration?

A risk that is associated with potentially severe loss and severe frequency. Withdrawal from the auto liability insurance

market in a state where loss is so severe. Medical malpractice insurance especially for

gynecologists since these doctors are frequently sued by their patients, which makes their annual insurance premium so high that they cannot maintain their office.

Asbestos producers, lead contained paint producers.

Risk Control Options – Loss Control Loss prevention

Reduce the frequency or the probability of the loss

Similar with avoidance in terms of reducing the frequency, but it does not reduce the frequency to zero as avoidance does.

Some may also reduce severity Interrupt or break the chain of events leading to

a loss Activities that take place prior to a loss

Risk Control Options – Loss Control Loss reduction

Given a loss has occurred, what can be done either before or after the loss to reduce severity of the loss.

Pre-loss, loss reduction activities does not prevent a loss from occurring

Post-loss, loss reduction activities Salvage operations Legal defense Rehabilitation of injured workers

Extreme form of loss reduction - crisis management In case of an worst possible scenario

Command and control center – a replicated office located remotely from an original office and it will be used when the original office is not functional due to various types of losses

Risk Control Options – Others Separation of exposure units

Exposure unit – person, item, thing exposed to loss

Limits the severe of the loss from any one occurrence One storage facility vs two Two suppliers of raw materials Cross-training or job-sharing Old Chinese merchants

Risk Control Options – Others Duplication of exposure units

Back-ups and reserves spare tires, spare parts, Back-up of data, copy of important

paper/record (title, deed, etc). back-up suppliers. back-up office

Risk Control Options – Others Risk transfers of the control type

Exposure becomes another entity’s responsibilities Loss exposure cannot return to you -

ultimate responsibility is shifted Hiring subcontractor for a part of

construction project

Risk Financing Options Risk transfer of the financing type

not the same as risk transfer of control type Shift financial responsibility for payment of

losses to a third party Assume a loss has occurred, then what are

sources of funds to pay for the loss? Internal funds

Retention, Self-insurance External funds

Insurance, Line of credit, Issuance of debts

Risk Financing Options Distinctions among the various options

Risk retained vs. Risk transferred Timing of the cash flows Tax treatment Legal obligation to bear risks

Insurance RetroRatedPlan

Captive Self-Insurance

Insurance RetroRatedPlan

Captive Self-Insurance

Retention

Risk Financing Options - Retention Assumption of a financial responsibility for

losses Retain the loss exposure units Not buying insurance (auto physical damage

insurance) Less than full insurance

low coverage limit deductible

What determines the retention decision? Costs, self-confidence, failure to identify, etc

Risk Financing Options - Retention Active vs passive retention

Active: aware of this decision. Passive: decision without awareness.

Usually result from failure to identify the loss exposures

Funded vs Unfunded retention Funded: a firm sets aside funds to pay for losses as

they occur Better for losses that are less predictable

Unfunded: if a loss occurs, it is paid for out of current operating revenue For more predicable and lower severity losses

Risk Financing Options - Self-insurance Planned, funded retention

Retention program for firms with many exposure units and potentially large overall losses

Formal program Healthcare benefits for employees, W/C

Ideal characteristics for self-insurance Losses can be predicted with high degree of

accuracy Loss payment can be internally financed Long payout period

Risk Financing Options - Self-insurance Advantages

Use of funds set aside to pay for future losses

Potentially less expensive

Can retain full benefit of any successful loss prevention/reduction program

Flexibility in the design of insurance program

Disadvantages Possibility of a

catastrophic loss Need to perform the

administrative tasks associated with insurance

Difficult to jump back into the insurance market once a firm has left

Deniable claims may not be denied since it is managed by employer

Risk Financing Options - Captive Definition of captive

A form of self-insurance Wholly owned subsidiaries created to provide

insurance to the parent companies (from AICPA Audit and Accounting Guide)

Pure captive, Group captive, Risk Retention Group

Coverage General liabilities, product liabilities, and W/C are the

most common types Automobile and auto physical damages

Self-Insurance versus Captive Self-insurance

Premium payments are not tax deductible

No other income No tax deduction

for loss reserves Claims are tax

deductible when paid

Captive insurance Premium payments

are tax deductible Other incomes Captive Has

deduction for loss reserves on discounted Basis

Cash Flow – Self-InsuranceYear Payout Loss Payments Value of Tax

Deduction1 18 % $1.8 mil $630 K2 25 % $2.5 mil $875 K3 23 % $2.3 mil $805 K4 18 % $1.8 mil $630 K5 16 % $1.6 mil $560 K

100% $10.0 mil $3.5 mil

Discount rate of 5%Present value of tax deduction = $3,046,117

Cash Flow - CaptiveYear Payout Loss

PaymentsPremium Value of Tax

Deduction1 18 % $1.8 mil $10 mil $3.5 mil2 25 % $2.5 mil3 23 % $2.3 mil4 18 % $1.8 mil5 16 % $1.6 mil

100% $10.0 mil

Discount rate of 5%Present value of tax deduction = $3,333,333

1986 Liability Risk Retention Act 1981 Product Liability Risk Retention Act. Outcry from businesses and municipalities across the

U. S. who were unable to obtain or afford liability insurance during the mid 1980's

Amendments to the 1981 Product Liability Risk Retention Act - Liability Risk Retention Act of 1986 (or The Federal Liability Risk Retention Act of 1986)

Under the 1986 Act, two new vehicles by which insurance buyers could more readily avail themselves of liability insurance. risk retention groups (RRGs) purchasing groups (PGs)

RRG versus PG Risk Retention Group

A liability insurance company.

The owners of the RRG must be its insureds.

Membership in the RRG is limited to persons engaged in similar businesses or activities with respect to the liability to which they are exposed.

A RRG must file annual financial statement

Purchasing Group Not an insurance

company.

Could be a member of a RRG.

Any group of persons with similar or related liability risks who form an organization to purchase liability insurance on a group basis.

No specific requirements regarding the legal structure of the PG.

RRG vs. PG

RRG vs. PG