Posted at 10.11.2018
Generally, the goal of risk management is value maximization for a for-profit firm. In other words, risk management aspires to maximize value by reducing the price tag on risk. Total costs of real risk include costs of control and costs of funding. This essay targets risk financing. You can find two broad methods of risk funding: risk retention and risk copy. Risk transfer includes insurance and other contractual risk exchanges. At the start of the assay, I will introduce the concept of retention, insurance, and contractual risk transfers, and their benefits and drawbacks. Then I will discuss how a firm should make a decision between risk retention and risk transfer, if a captive insurance provider is not to be employed. Finally, I am going to discuss how a firm, getting a captive insurer, should financing its clean risk loss.
"With retention, an enterprise retains the responsibility to pay for part or all the losses. When in conjunction with a formal intend to fund losses for medium-to-large businesses, retention often is called self-insurance. " (Harrington and Niehaus 1999 Site 12)
Retention can be financed with a captive insurance company (an insurance provider owned by way of a non-insurance company which is also its customer), a risk retention group, cash moves from ongoing activities, and basic working capital (the surplus of the firm's liquid resources over its short-term liabilities). Furthermore, businesses can also obtain cash by borrowing, lending options, issuing new stock and offering other business asset, such as complexes and cars. Funds to pay maintained losses should be large so that there surely is enough money to pay maintained losses. In addition, the retained deficits are unpredictable, and they may be large or small. However, there can be an opportunity cost for a finance. The chance cost is the difference between your come back on the finance and the firm's normal rate of return. Because of this, if money are large, the chance costs will be large; if funds are small, they may neglect to pay all loss. In addition, there can also be costs incurred in transforming non-liquid resources into cash for settling losses. (Dr. David Ayling 2009)
Risk transfer includes insurance and contractual risk exchanges. Insurance is a form of risk management mainly. A company could purchase insurance associates to repay risk deficits. "Insurance is defined as the equitable copy of the chance of a loss, in one entity to some other, in trade for reduced, and can be regarded as a guaranteed and known small damage to prevent a big, possibly devastating reduction. An insurer is a company selling the insurance; an insured or policyholder is the individual or entity buying the insurance. " (Web 1) Businesses can transfer a few of risk loss to insurance provider by insurance contracts. According to Dr. David Ayling (2009), the benefits associated with insurance include reduced amount of uncertainty, reduction control advice, liquidity of company protected, long-term planning mire possible, and access to large risk mixture services. On the other hands, insurance does not cover loss of goodwill, loss of market show, lost customers and suppliers, and so no. Furthermore, some risks are not insurable, such as risk deficits are too big, risks are not measurable, risks are not predictable, etc.
Firms can also use some contractual risk transfers to copy risk to another party. For example, if a company wants to create a house, and employ the service of a development company to generate the house, it might perform some process routinely into contracts, such as though workers or pedestrians are injured by accidence when the house is building, the building company pay for these losses; if the house accidents after it is completed, the engineering company will be in charge of it.
Having introduced risk retention and risk transfer, the next will discuss how a firm should decide between risk retention and risk copy, if a captive insurance company is not to be employed.
Both risk retention and risk copy is important and primary options for risk funding. How should a company decide the techniques of risk management? The severity and frequency probability of risk loss determine which method should be used to finance risk losses. Corresponding to Dr. David Ayling (2009), when the occurrence probabilities of pure dangers are low and their severities are high, then your method of risk transfer would be better to finance the chance losses, because the severities are high, this means the risk losses may be large. If using risk retention, they need large money to finance the risk losses so that the chance costs of the funds will be large. As a result, the potential risks could be used in insurer or another party by buying insurance or making deals. However, risk retention may be better, if the frequency probabilities of pure risks are low and their severities are low. Because they want only small money to cover the potential risks as both frequency probabilities and severities are low. In addition, the insurance may be expensive; commonly the price of the insurance is high than the ability cost of retention. Even more, the risk losses might not exactly be covered by insurance. When the regularity probabilities of risk losses are high, both retention and insurance are not better methods, because the chance losses will continuously happen. As a result, if the severities of the risk loss are high, we have to avoid these hazards. In the other words, we have to abandon these lenders, because they're too dangerous; if the severities of the risk losses are low, we should control it by increasing safeguards and limitations on risk activity designed to reduce the frequency and severeness of damages. (Harrington and Niehaus 1999 Site 23)
There can be an important factor that could affect organizations' decision between retention and insurance. The factor is taxes. "When determining its taxable income, a noninsurance company can only deduct losses which were paid during the year. In contrast, an insurance company can deduct the marked down value of incurred losses, which equals deficits paid during the year plus the change through the season in the marked down value of its liability for unpaid claims. This difference essentially allows insurers to deduct deficits sooner than noninsurance companies, which everything else equal escalates the present value of expected tax deductions in case a loss coverage is insured. But the tax respite is awarded to insurers, competition among insurers for business may cause most or even the whole tax break in the action to be given to policyholders through lower prices. " (Harrington and Niehaus 1999 Webpage 218)
In practice, many large companies established captive insurance firms. These companies make payment with their captive insurers, which then pay deficits to the top companies. It is an important approach to financing loss for large organizations, and can be viewed as a special kind of retention and self-insurance. If a company has a captive insurance company, the organization should finance risk losses by buy insurance from its captive insurance company. A company could advantage a whole lot by utilizing a captive insurer. To begin with, the parent or guardian company could reduce expected duty payments relative to retention. As I've talked about before, insurance has a tax advantage compared with retention. Furthermore, Dr. David Ayling (2009) stated that the father or mother company could usage of the reinsurance markets through its captive. The father or mother first purchases insurance through its captive, which then expenses reinsurance. Finally, Harrington and Niehaus (1999) said captive can also be used to lessen risk. The parent's risk exposures will be pooled with other unrelated companies' exposures, if its captive markets insurance or reinsurance to other unrelated companies. Subsequently, a large company will benefit from its captive insurance company in lowering expected tax obligations, accessing to the reinsurance marketplaces, and lowering risk through the captive's deal.
In bottom line, as retention and insurance have their own advantages and disadvantages, the frequency probabilities and severities of risks determine which methods of risk funding should be used. Insurance is a good risk financing method for a low regularity and high severeness risk; on the other hand, retention is an excellent risk financing way for a low frequency and low severeness risk. For many large companies, utilizing a captive insurance company becomes an important method of financing deficits. Captives could gain their father or mother company from reducing expected tax obligations, accessing to the reinsurance markets, and lowering risk through the captive's transfer. However, regarding to Dr. David Ayling (2009), if risk losses could be used in someone apart from an insurance company at a cheaper cost, or can be prevented or reduced at a cost cheaper than insurance, insurance and retention are not the best ways of risk losses financing, because risk management aims to maximize value by reducing the price of risk.
Dr. David Ayling (2009) Corporate Risk Management's handout,
Bangor University or college.
Harrington, S. E, Niehaus, G. R, (1999) Risk Management and Insurance, Boston: Irwin/McGraw-Hill.
Web 1: Wikipedia (2009) Insurance (Online) Wikimedia Foundations, Inc: USA. Available from: http://en. wikipedia. org/wiki/Insurance