1. Topic 5 Risk Management Alternatives BUS 200 Introduction to Risk Management and Insurance Jin Park

2. Overview  All risk management alternatives are either risk control options or risk financing options. Risk Control Options  Deal with risk itself Risk Financing Options  Deal with financial arrangement

3. Risk Control Options  Avoidance  Loss control Loss prevention - frequency Loss reduction - severity  Others Separation of exposure unit Duplication of exposure unit Risk transfers of the control type  Goals Reduce the frequency of the loss (probability of the loss) Reduce the severity of losses that do occur Make losses more predicable  make losses less variable  reduces objective risk

4. Risk Control Options - Avoidance  Never engage in the activity causing the loss  Stop engaging in the activity causing the loss  Avoidance is mutually exclusive with respect to other risk management options  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.  Withdrawal from the auto liability insurance market in a state where loss is so severe.  Medical malpractice insurance especially for gynecologists since these doctors are frequently sued by their patients, which makes their annual insurance premium so high that they cannot maintain their office.  Asbestos producers, lead contained paint producers.

6. Risk Control Options – Loss Control  Loss prevention Reduce the frequency or the probability of the loss Similar with avoidance in terms of reducing the frequency, but it does not reduce the frequency to zero as avoidance does. Some may also reduce severity Interrupt or break the chain of events leading to a loss Activities that take place prior to a loss

7. Risk Control Options – Loss Control  Loss reduction Given a loss has occurred, what can be done either before or after the loss to reduce severity of the loss. Pre-loss, loss reduction activities  does not prevent a loss from occurring Post-loss, loss reduction activities  Salvage operations  Legal defense  Rehabilitation of injured workers  Extreme form of loss reduction - crisis management In case of an worst possible scenario  Command and control center – a replicated office located remotely from an original office and it will be used when the original office is not functional due to various types of losses

8. Risk Control Options – Others  Separation of exposure units Exposure unit – person, item, thing exposed to loss Limits the severe of the loss from any one occurrence  One storage facility vs two  Two suppliers of raw materials  Cross-training or job-sharing  Old Chinese merchants

9. Risk Control Options – Others  Duplication of exposure units Back-ups and reserves  spare tires, spare parts,  Back-up of data, copy of important paper/record (title, deed, etc).  back-up suppliers.  back-up office

10. Risk Control Options – Others  Risk transfers of the control type Exposure becomes another entity’s responsibilities  Loss exposure cannot return to you - ultimate responsibility is shifted  Hiring subcontractor for a part of construction project

11. Risk Financing Options  Risk transfer of the financing type not the same as risk transfer of control type Shift financial responsibility for payment of losses to a third party  Assume a loss has occurred, then what are sources of funds to pay for the loss? Internal funds  Retention, Self-insurance External funds  Insurance, Line of credit, Issuance of debts

12. 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 Self- Insurance Retention

13. Risk Financing Options - Retention  Assumption of a financial responsibility for losses Retain the loss exposure units Not buying insurance (auto physical damage insurance) Less than full insurance  low coverage limit  deductible  What determines the retention decision? Costs, self-confidence, failure to identify, etc

14. Risk Financing Options - Retention  Active vs passive retention Active: aware of this decision. Passive: decision without awareness.  Usually result from failure to identify the loss exposures  Funded vs Unfunded retention Funded: a firm sets aside funds to pay for losses as they occur  Better for losses that are less predictable Unfunded: if a loss occurs, it is paid for out of current operating revenue  For more predicable and lower severity losses

15. Risk Financing Options - Self-insurance  Planned, funded retention Retention program for firms with many exposure units and potentially large overall losses Formal program 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

16. Risk Financing Options - Self-insurance  Advantages Use of funds set aside to pay for future losses Potentially less expensive Can 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 once a firm has left Deniable claims may not be denied since it is managed by employer

17. Risk Financing Options - Captive  Definition of captive A form of self-insurance Wholly owned subsidiaries created to provide insurance to the parent companies (from AICPA Audit and Accounting Guide) Pure captive, Group captive, Risk Retention Group  Coverage General liabilities, product liabilities, and W/C are the most common types Automobile and auto physical damages

18. Self-Insurance versus Captive  Self-insurance Premium payments are not tax deductible No other income No tax deduction for loss reserves Claims are tax deductible when paid  Captive insurance Premium payments are tax deductible Other incomes Captive Has deduction for loss reserves on discounted Basis

19. 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

20. 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

21. 1986 Liability Risk Retention Act  1981 Product Liability Risk Retention Act.  Outcry from businesses and municipalities across the U. S. who were unable to obtain or afford liability insurance during the mid 1980's  Amendments to the 1981 Product Liability Risk Retention Act - Liability Risk Retention Act of 1986 (or The Federal Liability Risk Retention Act of 1986)  Under the 1986 Act, two new vehicles by which insurance buyers could more readily avail themselves of liability insurance. risk retention groups (RRGs) purchasing groups (PGs)

22. RRG versus PG  Risk Retention Group A liability insurance company. The owners of the RRG must be its insureds. Membership in the RRG is limited to persons engaged in similar businesses or activities with respect to the liability to which they are exposed. A RRG must file annual financial statement  Purchasing Group Not an insurance company. Could be a member of a RRG. Any group of persons with similar or related liability risks who form an organization to purchase liability insurance on a group basis. No specific requirements regarding the legal structure of the PG.

23. RRG vs. PG