Topic 6 Risk Management Alternatives

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

2. 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

3. 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

4. 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)

5. 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

6. 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”

7. 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

8. 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 entity’s responsibilities • Hiring a subcontractor • Outsourcing

9. 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

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

11. 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

12. 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

13. 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

14. 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 - Self-insurance

15. 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

16. 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 Self-Insurance versus Captive

17. Cash Flow – Self-Insurance Discount rate of 5% Present value of tax deduction = $3,046,117

18. Cash Flow - Captive Discount rate of 5% Present value of tax deduction = $3,333,333