Risk Financing / Transfer Options
The following are some of the alternatives to traditional guaranteed cost insurance:
- Fund from Cash-Flow (Self Insure / Large Deductible or Self Insured Retention / Internal Fund / Sinking Fund / Lending Agreement)
- Retrospective Rating Program
- Finite Risk / Financial Reinsurance / Chronological Loss Stabilization Program / Multi-Line Integrated Program / Multi Year / Multi Trigger / Blended Risk Contracts (Operational Risk Only) / Blended Risk Contracts (Operational & Financial Risks)
- Wholly Owned Captive / Rent-a-Captive / Protected Cell Company / Association Captive / Agent Owned Captive
- Risk Retention Group / Purchasing Group / Pooling Arrangements
- Reciprocal Insurance Exchange (Canada – except Quebec)
- Industry Focused Insurance Companies
- Insurance Linked Securities (Catastrophe Bond / Securitization) / Non-Catastrophic Securitization / Future Flow Transactions / Financial Guarantee / Loan Guarantee / Derivatives / Futures / Options / Swaps
- Insuritization – Using an insurance contract to hedge against financial risks (e.g. currency/portfolio risks)
- Loss Portfolio Transfer
Many large organizations will structure their risk financing program to incorporate two or more of these options, and usually the optional choice will be different for each layer of coverage.
The merits of each option should be evaluated individually, however, it is important to reach an overall conclusion that considers the most effective combination of alternative options.
With risk financing it is common to consider an organization’s risk and / or insurance arrangements in terms of various layers of cover. These layers are generally defined as follows:
- Primary Layer – This layer contains the high frequency / low severity losses which are essentially predictable. It is unlikely that any single loss in this layer could seriously impact a large organization although an accumulation of claims in any one financial period may create a problem. This layer generally falls within local deductibles with claims paid by Operating Companies.
- Working Layer – This layer contains the medium frequency / medium severity losses where there are only a few losses a year expected. An individual loss may seriously distort the budget / financial performance of any operating unit although it is not likely to present a major problem for the Group as a whole. The decision to insure or self-insure this layer of risk depends upon the appetite for risk-taking that the management of the organization has and sometimes is influenced by the terms offered by insurers.
- Catastrophe Layer – This layer contains the low frequency / high severity losses. An individual loss of this magnitude can seriously distort the financial results of the organization in any one financial year and, may even threaten the whole organization. It is essential that insurance or an alternative method of risk transfer is used to deal with these risks.
Depending on the size of the organization, the definition of these layers will vary based on its financial strength and the historical claims experience. The next step is to evaluate the most effective risk financing option for each one.
The following decision criteria have been identified as common standards for evaluating risk financing alternatives:
Ensure Continuity of Operations
For most companies the objective of insurance / risk transfer is to ensure continuity of operations following a catastrophic loss. This may often be referred to as providing ‘peace of mind’.
Ensure Preservation of Assets
Key assets should be protected by insurance or other methods of risk transfer to ensure restoration / rebuild in the event of a loss.
Minimize Long-Term Costs
The objective of an insurance program and the selection and position of appropriate risk financing vehicles is to minimize cost over the long-term. Except in very soft market conditions it is not usually cost-effective for a large organization to buy full ground-up insurance because the smaller, predictable claims can be self-insured more efficiently.
Smooth Profits or Losses Over Time
From a financial budgeting point of view, it is much easier to work with costs that do not vary wildly from one year to another, as can often be the case when relying on traditional insurance markets.
Availability of Capital
The organization may already be committed to a significant capital investment program. This may influence decision-makers against options that involve short-term and significant capital outlay e.g. a captive insurance company.
Plan for the future
Most large commercial organizations restructure operations on a regular basis. It is important that any risk financing strategy including the selection of a vehicle, should be flexible enough to respond to the future structure of the company.
The risk financing vehicle selected must allow the organization to maintain and develop control over risk exposures. When assuming responsibility for the cost of retained losses and uninsured losses it will naturally require the promotion of risk management, better communication, motivation and awareness. The risk financing method selected should enhance the level of these various aspects of the organization thereby aiding in control.
Be Practical and Achievable Within a Reasonable Timeframe
The risk financing vehicle selected should be practical and there should be reasonable expectation on implementation to an agreed, acceptable timeframe e.g. within a year.
Weighting of Criteria
An insurance / risk retention program for a large organization normally involves a mixture of risk financing alternatives. In finding the optimal risk financing option, it is necessary to take into account that some of the criteria identified above are more important than others. The weightings applied to each of the criteria are therefore selected and refined following discussions with management of the organization.
For the working and catastrophe layers a much higher weight is usually assigned to the availability of capital. For the primary and working layers the first three criteria (i.e. continuity of operations / preservation of assets / minimize long-term costs) have been allocated zero weight because they have little relevance.
- Canadian Petroleum Insurance Exchange
- Canadian Universities Reciprocal Insurance Exchange
- Community Newspapers Reciprocal Insurance Exchange
- Dion Durrell
- Governmental Interinsurance Exchange
- MEARIE – Municipal Electric Association Reciprocal Insurance Exchange.
- Municipal Insurance Association of B.C.
- Barbados Exempt Insurance Companies
- Bermuda Insurance Market
- Bermuda Laws On-Line
- Bermuda Stock Exchange
- Canadian Captive Insurance Association
- Captive Insurance Companies Association (CICA)
- Captive Insurance Company Domiciles – From IRMI
- Captive Insurance Council of the District of Columbia
- Conyers Dill & Pearman – Bermuda law firm.
- Dublin International Insurance & Management Association
- Financial Action Task Force on Money Laundering
- Guernsey Financial Services Commission
- Incisive Media Plc
- Insurance Taxation and Regulation Publications
- International Compliance Association
- Internal Revenue Service
- KPMG Bermuda
- Offshore Alert
- Ruchelman Law Firm – International Tax Lawyers
- Self-Insurance Institute of America, Inc.
- The Bermuda Foundation for Insurance Studies
- Vermont Captive Insurance Association
- WWWoods & Co
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