1. Self insurance Chapter 5

2. Comparing insurance and retention Exposure of 1 million dollar loss Probability of loss =0.02 Expected loss = 20,000 Assume loss will occur at the end of the year Net cost of capital (net of interest earned on reserve funds) = 9%

3. Insure Load = $10,000 and premium = $30,000 Premium paid today (FV = $32,700)

4. Retain Set up $1 million in reserve funds Net cost of capital = $90,000 With probability 0.02 the loss will occur Expected loss = $20,000 Total cost =$110,00 (FV)

5. Tax treatment Premiums are tax deductible expense Funding of losses (self insurance) does not get the tax break unless loss occurs If there is a loss, the book value of the asset becomes a decutible expense If insured, the difference between indemnity and book value becomes taxable income (involuntary conversion)

6. Types of self insurance Simple retention Funding the losses (some times externally imposed standards) Setting up a captive insurance company

7. Tax treatment of captive premiums If captive does business with parent exclusively (pure captive), premiums cannot be deducted for tax purposes Not so if it is a group of association captive (test is how much business is done outside (min 30%) Captives usually set up in off shore tax havens

8. Advantages of self insurance Insurers overhead, morale hazard eliminated Insurance premiums may be viewed as overpriced –subjective estimates of probabilities –social load –premiums do not reflect investment income

9. Disadvantages Exposure to large losses (earnings variability, survival) Assurance to others (employees, community) Ancilliary servicees

10. Innovations cash-flow plans experience rating claims processing services

11. Risk retention alternatives risk retention group (a group owned insurer) risk-sharing pool (not an insurer) insurance purchasing groups