14- 1

Risk Retention

• Retention is one of the two techniques of risk finance, the process whereby the risk manager arranges the availability of funds to replace property, meet obligations, and continue operations in the event of loss.

• It is an alternative to the other risk financing technique, insurance.

14- 2

Risk Retention

• Risk retention is the "residual" or "default" risk management technique, any exposures that are not avoided, reduced, or transferred are retained.

• When nothing is done about a particular exposure, the risk is retained.

14- 3

Risk Retention Techniques Classified

• Intentional / Unintentional

• Voluntary / Involuntary Retention

• Funded / Unfunded

14- 4

Intentional and Unintentional Retention

• Unintentional retention occurs when a risk is not recognized.

• The firm unwittingly and unintentionally retains the risk of loss arising out of the exposure.

• Unintentional retention can also occur when the risk is recognized, if measures designed to deal with it are improperly implemented.

• Unintentional risk retention is always undesirable.

14- 5

Voluntary - Involuntary Risk Retention

• Voluntary retention results from the judgment that retention is the most effective means of dealing with the risk.

• Involuntary retention occurs when it is not possible to avoid, reduce, or transfer the exposure to an insurance company.

• Some forms of retention are, in a sense, on the border between voluntary and involuntary retention.

14- 6

Funded Versus Unfunded Retention

• A final distinction that may be drawn is between funded retention and unfunded retention.

• In a funded retention program, the firm earmarks assets and holds them in some liquid or semi-liquid form against the possible losses that are retained.

• The need for segregated assets to fund the retention program will depend on the firm’s cash flow and the size of the losses that may result from the retained exposure

14- 7

Financing Losses Versus Financing Risk

• Not all losses involve risk, which is the possibility of a deviation from what is expected.

• If "expected" losses are $20,000 a year, but could be as much as $1,000,000, the risk is $980,000 ($1,000,000 minus $20,000).

• The $20,000 predictable loss may be treated by retention or by transfer to an insurer.

• The remaining $980,000 represents "risk," which may also be retained or transferred to an insurer.

14- 8

The Cost of Financing Risk

• The distinction between financing losses and financing risk raises an important principle in the decision to retain or transfer a particular exposure, the cost of financing risk.

• When insurance is purchased, the premium includes provision both for the cost of losses that will be funded by the coverage and for the cost of risk.

14- 9

The Cost of Financing Risk

• Consider a manufacturer that owns buildings worth $1,000,000.

• Insurance on the buildings will cost $30,000.

• Assuming a loss ratio of about 66 percent, the expected loss (that is, the average loss per insured) is roughly $20,000.

• In fact, let us assume that the manufacturer’s past losses have been about average, at roughly $20,000 per year.

14- 10

The Cost of Financing Risk

• If the firm could be certain that losses would not exceed $20,000 a year (actually $30,000 a year), it would save by retaining the entire risk.

• But losses could conceivably reach $1,000,000.

• If the firm decides to retain the entire risk of loss, it will presumably continue to incur $20,000 in losses annually.

• In addition, to protect against the possibility of a total $1,000,000 loss, it must maintain a liquid reserve of $980,000.

14- 11

Cost of Financing Risk

• This opportunity cost is measured as the difference that will be earned on the reserve, which must be kept in a semi-liquid form, and the return that could be realized if the $980,000 were applied to the firm’s operations.

• If the rate of return on funds applied to

operations is 15% and the interest that can be earned on the invested reserve is 6%, percent, the opportunity cost is $88,200 ($147,700 minus $58,800).

14- 12

Cost of Financing Risk

• Thus, the cost of insuring is $30,000, while the cost of retention is $108,200 ($20,000 in losses plus the $88,200 opportunity cost). A more complete analysis would consider the effect of taxes on both costs.

• Assuming a combined state and federal marginal tax rate of 50 percent, the cost of insurance would be $15,000 and the cost of retention would be $54,100.

14- 13

Determining Appropriate Retention Levels

• One common approach to determining risk retention levels is to measure the potential premium savings for a deductible of a given size against the risk retained.

• This oversimplified approach generally results in unnecessary costs and inconsistencies in the program.

• Other approaches are more productive.

14- 14

The Normal Loss

• The Normal (expected) loss can be calculated from past loss experience of the firm or it may be imputed from the insurance premium.

• Since a target loss ratio in many property and liability lines is about 65 percent, the average loss per insured (the normal loss) will be about 66 percent of the existing premium level.

• The normal loss is one possible retention level for consideration.

14- 15

Loss Retention Capacity

• Determining loss retention capacity requires measuring the resources that would be available to pay assumed losses in excess of the normal loss (that is, the ability to pay unexpected losses).

• In calculating the ability to retain losses, it is necessary to look at financial strength indicators.

14- 16

Tentative (Extremely) Guidelines

Working capitalTotal assets

Effect on earnings

Earnings per Share

Sales Budget

Cash flow

10% to 25%1% to 5%

1% to 3% of retained earnings+ 1% to 3% of 5-year average

10% of earnings per share 10% to 50% for public entity

0.5% to 2%

5% to 10% of nondedicated cash flow

14- 17

Setting Retention Level an Art, Not Science

• There is no hard and fast rule that permits easy computation of a risk retention level.

• Although the various factors discussed above cannot provide a precise and definite indication of the appropriate retention level, there are two measures that will always be of use.

14- 18

Credit Capacity and Cash Flow

What is the level of uninsured loss that would be beyond the credit capacity of the firm and would result in bankruptcy?

What is the level of uninsured loss that the firm could bear without being forced to borrow?

$__________

$__________

14- 19

Tax Considerations and Risk Retention

• Premiums for insurance are fully deductible by the insured.

• In general, Section 162 of the Internal Revenue Code provides a tax deduction for ordinary and necessary business expenses.

• Treasury Regulations Section 1.162.1(a) makes it clear that insurance premiums are deductible business expenses.

14- 20

Contributions to Self-Insurance Reserves

• Deductibility of contributions to self-insurance reserves has been sufficiently addressed by the court to allow the conclusion that contributions made by a corporation to a self-insurance fund are not deductible.

• Note that the tax law does not eliminate the tax deductibility of self-insurance—it only forces companies to wait until they actually pay a claim before taking the deduction.

14- 21

Net Operating Loss Deduction

• Although the taxable organization cannot deduct contributions to a loss reserve, the Internal Revenue Code provisions regarding net operating loss carryback and carryover provide some relief.

• Net operating losses may be carried back to each of the preceding 3 years, and carried forward to each of the following 15 years until used up.

14- 22

Financial Accounting Standards Board Rule 5

• One of the subjects relating to risk retention that has received attention is Financial Accounting Standards Board Rule No. 5 (FASB-5).

• With the adoption of FASB-5, essentially the same rules now apply to financial accounting as previously applied in tax law.

• FASB-5 is a rule for public accountants, to be followed if a financial statement issued by a publicly held corporation is certified.

14- 23

FASB-5

"An estimated loss from a contingency shall be accrued by a charge to income if both of the following conditions are met:

(a) Information available prior to the issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements.

It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.

(b) The amount of loss can be reasonably estimated.

14- 24

Self-Insurance

• Although the term self-insurance is a definitional impossibility, the term has found widespread acceptance in the business world.

• It is widely used (and understood) and there seems little sense in ignoring the widespread use of an established and accepted term.

• It is a convenient way of distinguishing retention programs that utilize insurance techniques from those that do not.

14- 25

Self Insurance

• Self-insurance programs are distinguished from other retention programs primarily in the formality of the arrangement.

• In some instances this means obtaining approval from a state regulatory agency to retain risks, under specifically defined conditions.

• It may mean the formal trappings of an insurance program, including funding measures based on actuarial calculations and the contractual definitions of the exposures are self-insured.

14- 26

Reasons for Self-Insurance

• Self-insurance—like any of the other risk management techniques—should be used when it is the most effective technique for dealing with a particular risk.

• The main reason that firms elect to self-insure certain exposures is that they believe it will be cheaper to do so in the long-run.

14- 27

Advantages of Self-Insurance

Reduction in Costs

• In addition to the losses that must be paid, the insurance premium must include a surcharge to cover the cost of operating the insurance company and its distribution system.

• In addition, commercial insurance is subject to state premium taxes, which represent a cost that must be paid by buyers.

14- 28

Commercial Insurance Expense Ratio

Acquisition expense 13.7State premium tax 3.6General administrative expense 7.5Loss adjustment expense 8.6Profit and contingency expense 2.5

35.9

14- 29

Potential Savings

• Several of these expenses can immediately be eliminated through self-insurance.

• These are the state premium tax and the allowance for profit and contingencies.

• In addition, many buyers would also eliminate acquisition expense.

• The remaining expenses--insurer overhead and loss adjustment expenses--represent an additional potential for saving.

14- 30

Claim Control

• Another major appeal of self-insurance for many organizations is the ability to control the claim process.

• Many insured firms have expressed dissatisfaction over the claim management process, and their lack of control in claims.

• Too often, they argue, workers comp or general liability claims are paid that should be contested and settlements are made that the employer does not believe are justified.

14- 31

Disadvantages of Self-Insurance

Exposure to Catastrophe Loss

• The greatest disadvantage of self-insurance is that it can leave the organization exposed to catastrophic loss.

• This disadvantage can be eliminated if the self-insurer purchases reinsurance for potentially catastrophic losses, much in the same way as do insurers.

14- 32

Disadvantages of Self-Insurance

Variation in Losses

• A second disadvantage of self-insurance is that there may be greater variation of costs from year to year.

• When the variation in costs from year to year is great, the firm may lose the tax deduction for the losses that occur in years when there are no profits from which to deduct the losses.

14- 33

Disadvantages of Self-Insurance

Possible Adverse Public Relations

• In addition, self-insurance of some exposures can create adverse employee and public relations.

• There may be advantages to the organization in having its employee benefit claims handled by an insurer (as opposed to the staff of the employer organization).

14- 34

Loss of Ancillary Services From Insurers

• Self-insurance may also involve the possible loss of ancillary services from insurance companies.

• Most of these relate to loss prevention and claims handling.

• These services can be purchased separately from an insurer (under an arrangement called “unbundling”) or from specialty firms.

14- 35

Analysis of Self-Insurance Proposals

Every organization can divide its insurance costs, whether fully insured or self-insured into three broad elements: (1) administrative costs, which include those

expenses other than loss costs; (2) average predictable losses, which are those

losses that occur regularly and, as a result, are reasonably predictable; and

(3) unpredictable losses, which are determined by chance and which individually can attain catastrophic proportions.

14- 36

Analysis of Self-Insurance Proposals

• In a fully insured program, these costs are grouped together in the premium charged by the insurance company.

• Under a self-insured program, the costs are separated and funded through discrete mechanisms.

• Proposals for self-insured programs universally address the first two components of cost (administrative costs and average predictable losses) but sometimes ignore the third.

14- 37

Analysis of Self-Insurance Proposals

• In a properly structured self-insurance program, unpredictable losses are not retained, but are insured by some form of excess insurance.

• The cost of protecting against unpredictable losses is sometimes so high that it eliminates the potential economies in a self-insurance plan.

• Under a self-insured program, the potential for deviations in actual experience is greater than for an insurer because the likelihood of abnormal deviations is greater.

14- 38

Aggregate Excess Insurance

• Because catastrophe losses—the deviations from expected or average losses—are by definition unpredictable, they are not an appropriate subject for retention.

• Aggregate excess (stop loss) coverage provides coverage when the sum of all losses falling within the self-insured retention exceeds a predetermined amount.

14- 39

Stop-Loss Insurance

• Normally the aggregate stop loss amount is a function of annual manual premium, such as 150 percent to 200 percent of manual premium.

• Under an aggregate excess stop-loss program, a maximum is imposed on the total losses that must be absorbed under the self insured retention.

• Occasionally, one encounters illustrations of the “cost advantages” of self-funded plans that ignore the cost of aggregate stop-loss insurance.

14- 40

Combining Retention and Transfer

• Historically, insurers developed the combination programs in order to complete with self-insurance programs.

• As large insureds began to recognize the advantages of retaining the insurance-related cash flow and the economies in segregating their own experience from that of other insureds, insurance companies responded with programs to facilitate this inclination.

14- 41

Deductibles

• Deductible coverage is available in virtually every form of insurance, and a variety of options are often offered.

• In the property insurance field, for example, coverage is available with a deductible applicable on a per-structure basis, per occurrence, and with an annual aggregate.

• Deductibles are also available in the workers compensation, general liability and automobile liability fields.

14- 42

Retrospectively Rated Insurance

• A retrospectively rated insurance policy is a self-rated plan under which the actual losses experienced during the policy period determine the final premium for the coverage, subject to a maximum and a minimum.

• A retrospective plan is a self-rating plan, in which the actual experience under the policy or policies involved determines the final premium.

14- 43

Retrospectively Rated Insurance

• In a sense, a retrospective program is much like a cost plus contract, the major difference being that the premium is subject to a maximum and a minimum.

• Viewed from a slightly different point of view, a retrospective program is like a self-insurance program up to the maximum premium.

14- 44

The Retrospective Formula

Retrospective Premium = (Basic Premium + Converted Losses) X Tax Multiplier

14- 45

Retrospective Rating Factors

1. Basic Premium. The basic premium is a charge for the insurance element in the retrospective plan---the fact that there is a maximum to the cost.

2. Ratable Losses. Ratable losses are the actual amounts paid out by the insurer, subject to the excess loss limitation, if any.

3. Loss Conversion Factor. The loss conversion factor adds a percentage surcharge to every dollar of loss to pay for the cost of claims administration.

4. The Tax Multiplier. The tax multiplier represents the charge required to pay the state premium tax.

14- 46

Evaluating Retrospective Plans

Rating DollarFactor Amount

Guaranteed Cost Premium $443,375Standard Premium 500,000Basic Premium .145 72,500Loss conversion factor 1.120Tax multiplier 1.07Minimum premium .60 300,000Maximum premium 1.30 650,000

14- 47

Retrospective Rating Illustration

(a) (b) (c) (d) (e) (f) If Losses Converted Basic Columns With Tax Final Are Losses Premium (b) + (c ) Multiplier Premium

$0 $0 $72,500 $72,500 $77,575 $300,000 Minimum40,000 44,800 72,500 117,300 125,511 300,000 Minimum

200,000 224,000 72,500 296,500 317,255 317,255240,000 268,800 72,500 341,300 365,191 365,191280,000 313,600 72,500 386,100 413,127 413,127305,240 341,869 72,500 414,369 443,375 443,375 Break-even

320,000 358,400 72,500 430,900 461,063 461,063440,000 492,800 72,500 565,300 604,871 604,871480,000 537,600 72,500 610,100 652,807 650,000 Maximum

14- 48

Casualty Cash Flow Plans

• Under traditional retrospectively rated plans, the retrospectively rated premium is based on total incurred claims (paid and reserved).

• The difference between paid claims and incurred claims represents a part of the cash-flow potential, and represents investible funds.

• The cash flow characteristics in prepayment of guaranteed cost programs and retrospectively rated programs brought about the concept of casualty cash-flow plans.

14- 49

Casualty Cash Flow Plans

• Although retrospective rating plans appeal to the insured who is inclined toward self-insurance because of better than average loss experience, it does not address another attraction of self-insurance, the investment income on policy reserves.

• To address this feature of self insurance, insurers developed cash flow plans. These plans include compensating balance plans and paid-loss retrospective plans.

14- 50

Compensating Balance Plan

• A compensating balance plan is a program in which premiums paid by the insured are deposited in a checking account in the insured’s bank and used to meet the compensating balance requirements the bank imposes on the insured.

• Insured losses and expenses are paid from this account.

• Because the deposited funds are available to meet the requirements of the insured’s bank, other funds are freed for use in operations.

14- 51

Paid-Loss Retro Plans

1. The special cash flow premium payment provisions are simply added to a standard retrospectively rated or guaranteed cost program.

2. Annual premiums are paid at approximately the same rate that claims are actually settled. Premiums are generally based on paid claims plus a servicing cost.

3. The insurance company requires an irrevocable bank letter of credit, based on the amount of reserved claims.

14- 52

Finite Risk Insurance

• Finite risk insurance is a financing tool used in connection with risk retention to smooth the effect of retained losses on the firm’s balance sheet.

• It is based on the premise that the insured will pay its own losses over time, but that fluctuations in loss experience will be smoothed by contractual transfers between the self-insurer and insurance company.

14- 53

Finite Risk Insurance Example

• Policy written excess of $1 million with a $50 million aggregate limit.

• Annual premium of $10 million, payable by cash premium of $500,000 plus $9.5 million note.

• Note becomes payable if required by the insurer to pay losses.

• If there are not losses, the insurer returns 99% of the $50 million premium to the insured.