Contents

The cost of risk financing

Traditional financing methods
Selection of deductibles
Non-traditional financing methods (ART)
Finite risk insurance
Retrospective plan
Captive Insurer
Learning Objective
At the end of this chapter, student should be able to:
calculate the costs of risk financing
distinguish between traditional and nontraditional
financing methods
Identify the different types of deductible and the
implications of the selection
Differentiate between stop loss provision and aggregate
deductible
Apply deductible selection models
Describe examples of specific types of ART products

Cost of risk financing
Risk retention
Expected loss
Opportunity cost on loss reserve

Risk transfer (to insurance co)
Expected loss = loss premium
Premium loadings
Management expences
Advantages of Risk Retention
Business can maintain use of funds until a real loss
occurred.
Business can avoid swings in insurance prices. Not
affected by underwriting cycle (that would lead to the
higher insurance premium)
Save on premium loadings
Can avoid high cost on premium loadings

Traditional Method of Risk
Financing
Common character
Premium is fixed
Premium is not sensitive to losses
Significant amount of risk transferred to insurer
Traditional Method of Risk
Financing
Deductible / Self- Insured Retention: Certain amount
of loss will be retained by policy holder
To eliminate small claim
To reduce premium
To reduce moral/morale hazards
1. Per occurrence deductible: Certain amount be
retained by policy holder on each claim.
2. Aggregate deductible: Policyholder retain losses
in accumulation until the specific amount.
3. Stop-loss provision: Combination of (1) and (2)

Traditional Method of Risk
Financing
Policy limit: maximum amount payable by insurer.
1. Per occurrence limit: maximum amount of claim
payable on each loss that is covered.
RM3m coverage per occurrence above RM1m of per
occurrence SIR.
2. Annual aggregate limit: maximum amount of
claim payment in accumulation in which insurer
is liable during the policy period.
RM3m of annual aggregate limit above RM1m of per
occurrence SIR

Traditional Method of Risk
Financing
In annual aggregate limit policy, insurance policy will
be terminated when the full amount of sum insured
has been paid within the policy period.
Policyholder has to bear own loss unless they have
purchased another insurance policy

Traditional Method of Risk
Financing
Types of excess insurance policy:
Primary policy
provide coverage immediately above SIR
Layering policy
provide coverage above primary policy
Umbrella policy
provide coverage above primary policy and layering
policy
Normally covering liability policy


Non-traditional Risk Financing
(Alternative Risk Transfer)
Common characteristics:
Transferring extremely high risk to insurer
Policy covering more than 1 year (Ex: Contractor All
Risks)
Policy provides multiple sources of risk.
Un-common risk
3 ART methods:
1. Loss sensitive contract (Risk: insurer < policy holder)
Experience-rated policy : premium for coming
policy year is based on the pass loss experience of
individual policyholder.
Retrospective-rated policy : ultimate (retro)
premium is charged at the end of policy period.
if actual loss less than expected loss, the retro premium is
less than upfront premium. Policyholder entitled for
refund.
3 ART methods:
2. Finite risk contract
Multiple-year loss sensitive contract
Policyholder need to pay premium for n years to the
insurer.
Insurer will charge a fee
The premium fund is invested and accumulated interest.
On any claim, the fund is used to pay the claim. If insufficient
amount, insurer will pay upfront. The following year
premium will repay insurer.
At the end of n-year, if there is surplus, it will be refunded
to policyholder. If deficit , policyholder need to pay certain
portion in equal instalments over few years.
3 ART methods:
3. Captive Insurer
Insurance company as subsidiary of parent
company.
Pure captive insurer Vs Group captive insurer
Onshore captive insurer Vs Offshore captive
insurer