Topic 6 Risk Management Alternatives BUS 200 Introduction to Risk Management and Insurance Jin Park

Overview All risk management alternatives are either risk control or risk financing options. Risk Control Options Avoidance Loss Control Others Risk Financing Options Funded Retention Self-Insurance Captive Traditional Insurance

Risk Control Options Goals Reduce the frequency of a loss Reduce the severity of a loss Make a loss more predicable make losses less variable reduces objective risk

Risk Control Options - Avoidance Never engage (or Stop engaging) in the activity causing the loss Avoidance is mutually exclusive with respect to other risk management alternatives 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. Physicians specialized in neurosurgery, orthopedic surgery, and obstetrics in eastern states State Farm Insurance Company in New Jersey. Asbestos, Lead contained paints

Risk Control Options – Loss Control 1. Loss prevention Pre-loss risk management programs Reduce the frequency or the probability of the loss Interrupt or break the chain of events leading to a loss Recent arsons highlight churches exposures... Up-Front risk analysis helps control losses

Risk Control Options – Loss Control 2. Loss reduction Pre-loss, loss reduction activities Where no business is good business Recent arsons highlight churches exposures... Post-loss, loss reduction activities Salvage operations Legal defense Rehabilitation of injured workers Crisis management Extreme form of loss reduction management Command and control center a replicated office located remotely from an original office, which will be used when the original office is not functional due to various types of losses

Risk Control Options – Others 1. Separation of exposure units To limit (reduce) the severity of a loss One storage facility vs two Cross-training or job-sharing Old Chinese merchants 2. Duplication of exposure units Back-ups and reserves Spare tires, spare parts Data Back-up More than one supplier Command and control center 3. Risk transfers of the control type Exposure becomes another entitys responsibilities Hiring a subcontractor Outsourcing

Risk Financing Options Deal with sources and uses of funds to finance the recovery from a loss Sources of funds Internal funds External funds Insurance, Line of credit, Issuance of financial securities Types of risk financing Risk transfer of the financing type Shift financial responsibility for payment of losses to a third party Risk Retention

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 Retro Rated Plan Captive Self- Insurance Retro Rated Plan Captive Funded self- Insurance Retention or unfunded self-insurance

Risk Financing Options - Retention Assumption of a financial responsibility for losses No purchase of insurance auto physical damage insurance Less than full insurance low coverage limit deductible What determines the retention decision? Frequency & severity of expected losses Costs and availability of insurance MMP, Health care insurance Self-confidence or degree of risk aversion Failure to identify

Risk Financing Options - Retention Active vs passive retention Active: aware of this decision. Passive: decision without awareness. Funded vs Unfunded retention Funded: a firm sets aside funds to pay for losses as they occur Unfunded: if a loss occurs, it is paid for out of current operating revenue

Risk Financing Options - Self-insurance Planned, funded retention Formal retention program for firms with many exposure units and potentially large overall losses Ex: 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 Potentially less expensive 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 Deniable claims may be covered since the program is managed by employer

Risk Financing Options - Captive Definition of captive A form of self-insurance through an insurance company Wholly owned subsidiary (insurance company) created to provide insurance to the parent companies Pure captive, Group captive, Risk Retention Group

Self-Insurance versus Captive Self-insurance Premium payments are not tax deductible No other income No tax deduction for loss reserves, but claims are tax deductible when paid Captive insurance Premium payments are tax deductible Other incomes Captive Has deduction for loss reserves

Cash Flow – Self-Insurance YearPayoutLoss PaymentsValue of Tax Deduction 118 % $1.8 mil$630 K 225 % $2.5 mil$875 K 323 % $2.3 mil$805 K 418 % $1.8 mil$630 K 516 % $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 - Captive YearPayoutLoss Payments PremiumValue of Tax Deduction 118 % $1.8 mil$10 mil$3.5 mil 225 % $2.5 mil 323 % $2.3 mil 418 % $1.8 mil 516 % $1.6 mil 100%$10.0 mil Discount rate of 5% Present value of tax deduction = $3,333,333