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FIL 250 Chapter 4

Risk financing

QuestionAnswer
What are the goals of risk financing? Availability/Pay for losses, Manage the cost of risk (admin, risk control/financing), Manage cash flow variability, Maintain appropriate liquidity, Comply with legal/contractual requirements
Retention One extreme of risk financing where the organization that suffers losses are financially responsible and use internal funds to pay for them
Risk transfer One extreme of risk financing where the financial responsibility for paying losses of an organization are shifted to another party
When compared with risk transfer (insurance), what are the advantages of retention? cost savings (insurer overhead/admin/commissions), control of the claims process, timing of the cash flows, strong incentive for risk control
When compared with retention, what are the advantages of risk transfer (insurance)? Reduced exposure to large losses, reduced cash flow / earnings volatility, professional loss control and claims administration services
What are some organization specific characteristics that affect the selection of risk financing measures? Risk tolerance of stakeholders (managers, investors), financial strength, core operations (knowledge of risk), ability to diversity, ability to control losses, ability to administer retention
Primary insurance layer First level of insurance that begins payment after satisfaction of a deductible
Excess insurance layer(s) Begins payment for loss after the limit on the primary layer of insurance has been exhausted.
Self insurance A risk financing technique that is a carefully designed form of retention where the organization evaluates loss exposures and develops internal systems to track losses and fund them with payments that look like premiums.
Large deductible plan A risk financing technique where an insurer provides administrative/claims services and the organization reimburses insurer for losses under a large deductible
Captive insurer A risk financing technique where a parent company forms a subsidiary to insure its own loss exposures
risk retention group (RRG) Similar to a group captive, where an insurer is formed to provide liability insurance for several parent companies' loss exposures.
finite risk insurance plan A multi-year risk financing technique that involves very large premiums and only transfers a small portion of the risk of an organization to an insurer.
pools A risk financing technique where a group of organizations come together to provide protection in the event of a loss.
Retrospective rating plan A risk financing technique where the premium for an insured is based on the actual loss experience during the policy period subject to a minimum and maximum
hold harmless agreement A type of risk transfer that does not involve insurance. It is a contractual arrangement to assign financial responsibility when there is a relationship between organizations
What capital market solutions exist as risk financing techniques? securitization, hedging with derivatives, and contingent capital
(insurance) securitization instead of absorbing the losses directly, securitization involves the creation of a financial security sold directly to investors whose underlying cash flows are tied to losses.
hedging using a financial asset, such as options and futures contracts, in a way to offset the underlying loss exposure of an organization
contingent capital arrangement A risk financing technique that allows an organization to raise capital by entering into an agreement with another party who agrees to buy securities at prearranged terms if losses exceed some amount.
What are methods of retention? ad hoc, reserves (unfunded or funded), self-insurance, borrowing (line of credit), captive insurer
active retention a conscious decision of an organization that recognizes a loss exposure and decides to pay subsequent losses directly
passive retention unplanned retention, where a business does not recognize its exposure to a loss and by default must pay for losses if they occur
guaranteed cost insurance a type of risk financing where an organization pays a fixed price ahead of time and an insurer pays for specified losses. some retention remains due to deductibles and a policy limit (plus uninsured losses)
pure captive an insurance subsidiary that is owned by only the parent company
group captive an insurance company formed and owned by several companies, often from the same industry, who are looking to insure their own losses
catastrophe (cat) bonds a type of debt instrument sold to investors where interest and principal repayments are tied to losses or other type of trigger (such as an external index)
Created by: isufil250