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Risk Financing Guidelines: Part II - Risk Financing Methods

9/9/2021

4 Comments

 
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​This is the second article, in a three-article series, that discusses the risk financing guidelines set forth in the Standards Australia/Standard New Zealand Committee OB-007, Risk Management Handbook (“Standards Handbook”). This second article focuses on the various risk financing methods set forth in the Standards Handbook. 

Insurance
This is the second article, in a three-article series, that discusses the risk financing guidelines set forth in the Standards Australia/Standard New Zealand Committee OB-007, Risk Management Handbook (“Standards Handbook”).  This second article focuses on the various risk financing methods set forth in the Standards Handbook.   

Risk Financing Methods

The Standards Handbook identifies several risk financing methods organizations can utilize.  Those risk financing methods include: (1) insurance; (2) self-insurance; (3) mutual insurance; (4) finite risk contracts; and (5) capital markets.  Below is a discussion of each.
 
Insurance
 Most organizations recognize insurance as a risk financing method to manage risks.  There are several principles and concepts of insurance that must be kept in mind.  
First, an insurance policy is a contract.  The insurance policy defines what is and is not covered.  The legal meaning of the wording in the insurance policy depends on statutes and case law that may vary from state to state.
Second, the value of insurance as a risk financing tool depends on the insurance company’s willingness and ability to pay. Insurance companies should undertake careful assessments of each risk to be insured, spread their portfolio of risks, establish reserves in a sufficiently liquid form, purchase reinsurance to cover large or infrequent claims, use multiple insurers to cover a risk (proportional or layered insurance), and set a fair premium.

There are some downsides to insurance:

  • Not all types of losses are insurable
  • Some insurance companies may demand additional requirements from the organization as a condition of issuing coverage
  • Policy language may not provide the coverage that the organization needs – particularly after a claim arises and is presented to the insurance company for payment
  • The financial stability of the insurance company may not be adequate

Self-Insurance

Self-insurance is when an organization recognizes that some or all risks cannot be financed 100% with an insurance policy.  With self-insurance, the organization takes on the funding of risks from its own resources.  Such self-insurance may be in the form of a deductible, or a self-insured retention. Typically, the higher the deductible or self-insured retention, the lower the insurance premium.  It is important that organizations think carefully about becoming self-insured and factoring in the potential that self-funded losses may cause problems in the organization’s financial performance. 

Mutual Insurance

Mutual insurance is when a risk is shared by the members or policyholders of an organization formed for that purpose.  Mutual insurance companies are registered as such and operate similarly to non-mutual insurance companies.  With mutual insurance companies, members (policyholders) pool their premiums into a pool for the payment of claims and expenses.  If there is a shortfall of funds to pay a claim, a “call” on members can be made to collect additional funds. P&I Clubs are an example of mutual insurance.
There are different types of mutual insurance.  
One type of mutual insurance is a risk pool.  A risk pool is formed when a group of individuals (i.e., a professional group of doctors) contribute to a collective fund to provide risk financing for a common source of risk.  Unlike mutual insurance companies, a risk pool only insures a specific source of risk that effects that particular group.
Another type of mutual insurance is a risk purchasing group.  Risk purchasing groups are able to present to the insurance market a collective loss experience and standardized risk controls to obtain more favorable terms than could be obtained individually. 
Captive insurance is a type of mutual insurance.  Some captive insurance companies are set up to insure the organization’s own risk but can also bet set up to accept risks from other organizations.  Captives allow an organization to exercise greater control over their insurance arrangements.

Finite Risk Contracts

Finite risk contracts are usually multi-year insurance policies (contracts) which take into account the time value of money by spreading risk over time.  With a finite risk contract, the insured organization makes payments into an “experience fund” for a finite number of years to build a fund that is large enough to cover a particular risk financing project.  A claim against the fund can be made at any time during the finite period if it meets the criteria set by the organization to trigger the coverage.  Any shortfall between what is in the experience fund at the time of the claim and what is owed for the claim is paid by the insurance company.

Capital Markets

Capital markets are where organizations raise long term funds and carry out other financial transactions.  They include markets for equity, debt, derivatives and commodities.   They may be formally established markets such as securities exchanges or involve over-the-counter agreements between market professionals.  Contingent funding products from capital markets include borrowing and equity raising, insurance futures, catastrophe bonds, weather hedges, and securitization.

Conclusion

Organizations can apply a mix of the above risk financing methods.  There should be good coordination between the methods selected so that there is symmetry within the organization. Making sure that there is good coordination is something that the Chief Risk Officer and the Chief Financial Officer should monitor and review as a part of the overall risk management process. 
The third and final article of the series will discuss effective risk financing programs and the practical guidance of such programs as set forth in the Standards Handbook.  Stay tuned.

4 Comments
soti peter
11/20/2022 02:03:59 pm

Its good

Reply
Alemayehu
5/18/2023 01:09:53 pm

Good

Reply
Life Cover NZ link
6/6/2023 07:38:49 am

I appreciate this comprehensive discussion on risk financing methods. Insurance is widely recognized, but the downsides mentioned remind us to carefully assess policy language and the financial stability of insurers. Self-insurance can be cost-effective, but organizations must weigh the potential impact on their financial performance. Mutual insurance, especially risk pools and risk purchasing groups, provides alternative options. The inclusion of finite risk contracts and capital markets highlights the diverse range of choices available.

Reply
Anderson link
9/5/2024 07:36:53 am

Great readd thank you

Reply



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    Authors

    Lori Siwik and Mark Siwik are the founders of SandRun Risk.  They apply the principles of vertical leadership and lean six sigma to the discipline of risk management.  From time to time they share their blog with guest authors who write about important risk management principles.

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