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Topic 6 Risk Financing

1.0 Introduction
- Measures to provide funds to pay for losses
- Applicable to pure / hazard risks only
- Organization can finance their losses using internal
or external sources
- Financing loss internally : risk retention
- External financing of : involves risk transfer via
insurance & non- insurance contracts
- Topic 6 : risk retention & risk transfer (insurance)
- Advance risk retention schemes : Alternative Risk
Transfer schemes (ART) : Topic 7

Risk Financing Techniques Continuum


l_______l_______l_______l_____l______l_____l_______l_____l
unfunded self
funded RR
insuRR
rance

retro alter
captive com.
plan risk
insu- insutransfer rance rance
(ART)

Cont. Cat.
debts bonds

l------- RR ----------------l---------RR & RT----------------l-----RT-----l-------RT---------l


Hybrid
insurance capital market
ART products
Note
RR : Risk Retention technique
RT : Risk Transfer technique
ART : Alternative Risk Transfer schemes

1.1 Risk Financing by Insurance (Risk Transfer)


- Principal source of external loss financing in most
risk financing program
- Important in managing high severity loss exposures
with low probability ( infrequent but large losses)
which are beyond the risk bearing capacity of
organization ( critical risks) . e.g. product liability
claims, fire risks.
- Claim payments received from insurers to finance
the negative financial impact of loss

1.1.1

Insurance : Risk Transfer and Loss Pooling


Mechanism

Key characteristics of insurance :


- Transfer of risk of financial loss from the individual
to a group
- Sharing of losses pooled (risk pooling) under
insurance contract by group of insureds on some
equitable basis.

Definition of Insurance (1)


- Emphasise on risk transfer element
Insurance is a contract between the individual and
the insurer whereby the individual pays a premium
(small certain cost )and transfers a large uncertain
financial loss (the contingency insured against) to the
insurer
Premium ( small & certain loss)
Insured

----------------------------------------->

Insurer

<----------------------------------------Claims ( large and uncertain)

Definition of Insurance (2)


- Emphasise on the sharing of loss by a group of
insureds ( Pooling of risks) through insurance
arrangement
Insurance is an agreement whereby a group of
individuals facing similar risks can share the
fortuitous losses of the unlucky few by the
transferring such risks to the insurer who agrees to
compensate the losses.
(law of large number)
Premium
Insured ------------------->
<
Claim

Manage
Insurance
Pool (Fund)

<-------------

Insurer

.>
Profit / loss
(insurers risk)

Note : Pure risk of insureds are transferred to insurer


and transformed into a speculator risk ( underwriting
profit/loss) of insurer
Risk Reduction through Pooling
- The pooling of risks in insurance mechanism change
the probability distribution of the accident losses and
reduces risk ( uncertainty / variability of the individual
losses) and losses of the insurance pool become
more predictable by the insurer (base on law of large
numbers)
- Pooling arrangement reduces risk (variability or
standard deviation is reduced) through diversification

-As number of insureds becomes very large (infinity),


the standard deviation of loss of the pool of risks
approaches zero. The loss outcome of the pool of risk
approaches the expected value of loss : the Law of
large number
- The mortality rate under life insurance pool is best
pool of insurable risks that has the characteristic that
meets the requirement of Law of Large number :
large number of homogeneous and independent risks
Summary of effect of pooling of risk
-Insurer can predict within narrow limits the amount of
losses that will occur (risk or variability of losses
reduced) from a large pool of risk

- Accuracy of insurers prediction is based on the law


of large numbers : the larger the pool the less the
deviation (risk)
Dual Application of Law of Large Number in
insurance
1)To estimate the underlying probability accurately,
insurer must have a large sample of experience ( a
large pool of risks).
2) Once the estimate of probability has been made, it
must be applied to a large number of exposure units
( a large pool of risks) to permit the underlying
probability to work itself out.

Example on Insurance Mechanism

1,000 owners of building, each pay a premium of


RM250 per year to an insurer to insure their buildings
against fire. The value of each building is RM100,000.
The probability of fire destroying the building in a year
is 0.002 (past experience). Assume, the loss is total
destruction of house .
Each loss = RM100,000

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Scenario 1
Number of buildings destroyed = 0.002 x 1,000 = 2 (as
estimated)
Amount of claim = 2 x 100,000 = RM200,000
Amount of premium collected = 250 x 1,000 = 250,000
Surplus = 50,000 ( for profit and expenses)

Scenario 2
Number of building destroyed = 3 (deviation)
Amount of claim = 3 x 100,000 = RM300,000
Amount of premium collected = 250 x 1,000 = 250,000
Deficit = 50,000 ( Loss)
(Number of loss deviates from that estimated by law
of large number : risk face by insurer)

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1.1.2

Insurability of Risks

- Are all risks insurable ? NO !


Elements Of Insurable Risk
Four prerequisites (ideal elements) of risks required
for the successful operation of insurance mechanism
1) Large numbers of homogeneous exposure units
- For law of large numbers to operates :
reasonable accurate prediction of losses
- Large number insureds pay for a few losses that
occur
2) Definite and measurable loss
-Time of occurrence of loss must be capable be
determined and loss subject to financial measurement

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3) Loss must be fortuitous


- loss must be accidental; result of a chance event /
contingency; loss should be beyond the control of
insured

4) Loss must not be catastrophic


- A loss event should not produce losses to a large
percentage of exposure units at the same time
( earthquake, war)
- Link with requirement for independent exposure
units

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Two Optional Requirements


1) Randomness of risks in insurance pool
- NO adverse selection against insurer
- No intentional selection against the insurer ( higher
proportion of poor risk joining the pool) affecting the
natural distribution of the risk in the pool ( a large
percentage of good risks with a low percentage of
poor risks)
- Affect application of law of large numbers
- May produce large deviation form expected loss
estimated
2) Economic feasibility
- Cost of insurance must not be too high or the
premium is not affordable and equitable to the
insureds

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Comment on the insurability of the following risk


- War,
- Earthquake,
- Flood,
- loss due to default of debtors : trade debtors; credit
card-holders and loan debtors (CDS)
- Loss due to wear and tear,
- Depreciation in value of property,
- Trading loss of a business,
- Loss in share investment
- Financial loss due to cancellation of Olympic game
- Financial loss arising from severe injury to
Ronaldos (footballer) legs

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1.1.3 Insurance Pricing


1) Introduction
- Insurance rates ( price of insurance per unit
protection) are a function of costs.
- Insurance costs are not known when the product is
sold. Why?? (expected future loss of the insurance
pool is not known but estimated on past experience
and only is known at expiry of contract or many years
after that)
- Insurance prices are based on predictions
- Insurance premium must be sufficient to meet :
i) expected claim costs
ii) administrative & marketing costs
iii) expected profit to compensate for the cost of
insurers capital (investment return to its shareholder)
iv) reserve for deviation / fluctuation in actual claim
costs

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- More specifically, the premium should contain the


following components
i) expected claim costs
ii) administrative and marketing loading
iii) profit loading
2) Computation of Premium Rate
- Gross rate is the premium payable per unit
protection purchased by the insured
- Gross rate consists of two components : pure
premium and loading factor
Gross rate =

Pure Premium + Loading Factor

- Pure Premium : component of gross rate used to pay


expected losses

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- Loading Factor : component of premium used to pay


insurers expenses of operation ( commission,
management expenses) & profit
3) Importance of insurance pricing in risk
Management
Gross rate =

Pure Premium + Loading Factor


(expected loss)

- Premium is always higher than the expected loss


sustained by the organization in the long - run
- Insurance is always more costly than cost of losses
actually occurred (expected loss) in risk retention risk
scheme.
- Risk retention is more cost efficient than insurance
and organization should retains all their risk
exposures? Answer is NO !!

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Explanation
- Expected loss is the long- run average loss sustain
by the organization over a long period.
- However, at any one time, organization may suffer a
loss equal to the maximum possible loss ( MPL) even
though the probability of such loss is low.
- If the magnitude of MPL is beyond the financial
capacity of the organization, it may become bankrupt :
- Dont risk more than you can afford.
- Organization may not survive to realize the expected
loss.

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Example :
Building

Value = RM5,000,000

Probability of destruction by fire is 0.001


Expected loss = 0.001 x 5,000,000 = RM5,000 per year
However, owner may suffer a loss RM5,000,000 at any
one time even though it is very unlikely

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Note
- However, in practice, cost of risk retention is more
than cost of the expected loss of the organization.
- It should include the opportunity cost of holding
large liquid asset to fund the future potential large
loss mentioned in (1) above : RM5,000,000.
- In fact, with opportunity cost considered, cost of
risk retention may exceed the insurance premium,
resulting in risk retention appears to be unattractive
financially.
- Details of the comparison between insurance (risk
transfer) and risk retention will be analyzed in more
detail in next section.

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1.1.4 Types of Insurance Rates


1) Class rates
2) Schedule rating
3) Experience rating
4)Retrospective rating
Forward pricing/rating
backward pricing
(1,2,3)
retrospecting rating
l______________________________________l
Period of insurance

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1) Class Rate
- Computing a rate of insurance that applies to all
applicants for a give type of insurance possessing a
given set of characteristics.
- Class-rating system permits insurer to apply a single
rate to a large number of insured.
- In establishing the classes : consider a large pool /
class (include large number of exposures that will
increase the credibility of predictions) and class must
be sufficiently narrow to permit homogeneity.
- e.g. motor insurance; personal accident insurance &
liability insurance & MHI
Note : Rates fixed at inception of insurance contract :
acceptance of risk / formation of contract (forward
pricing)

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2) Schedule Rating*
- Base / class rate determined from experience of a
large pool of average risks
-Scheduled rates determine by applying a schedule of
charges and credits to some base rate or class rate by
debiting and crediting the base rate in connection to
favorable or unfavorable features of the risk .
e.g. fire protection and neighborhood influence the
base rate of fire insurance
Note : Rates fixed at inception of insurance contract :
acceptance of risk / formation of contract (forward
pricing)

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3)

Experience Rating

-Final premium rate based on insureds own past loss


experience (indicated by loss ratio)
- Experience rating is superimposed on a class-rating
system and adjust upward or downward depending
on the insureds experience after the expiry of
insurance
- Frequently used in workers compensation, general
liability and group life and health insurance.
- Experience rating normally used when an insured
generates a premium large enough to be considered
statistically credible.
*(Forward pricing with adjustment at expiry of
insurance)

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Experience-rating formula
- The adjustment factor is determined on the
difference of the actual loss ratio to that of expected
loss ratio adjusted by a credibility factor
Adjustment factor = Actual LR - Expected LR x Credibility factor = - 20%
Actual LR

The experienced rate is obtained by discounting the


class rate by 20%
Class rate = 0.655%
Adjustment factor = -20%
Experienced rate
= 0.655% (1-20%) = 0.655% x 80% = 0.524%
Note : Rates fixed at inception of insurance contract :
acceptance of risk / formation of contract (forward

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4) Retrospective Rating*
- Pricing fixed at expiry of the insurance contract
based on actual loss experiences of insureds
- It is a self-rated program base on the actual loss
experience of the insured during the period of
insurance (NO reference to any class rate or base
rate)
- Where the actual losses during the policy period
determine the final premium for the coverage, subject
to maximum and minimum premium.
The formula for computation of rate includes:
-A fixed charge (expenses) for insurance element in
the plan
- The actual losses incurred
- A charge for loss adjustment
- A loading for premium tax.
- A deposit premium is charged at the inception of the
policy and adjusted after the policy period has
expired, to reflect the actual losses incurred.

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2.0

Risk Retention

2.1 Introduction
- Financing for loss using internal financial resources
- Risk retention is used :
a) severity of loss is low ( high frequency , low
severity or low frequency low severity)

b) losses which can be predicted with relatively


accurately and the losses are treated as another
expense of business ( e.g. shop-lifting or pilferage
loss of stock)

c) insurance on certain risks not available ( product


recall and R&D risk)

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- General advantages of risk retention

i) exercise greater overall loss control than insurer


ii) encourage better loss control in through allocation
of losses to operating units
iii) greater flexibility in cash flow management

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2.2

Classification of Risk Retention (RR)


Techniques

1) Unintentional and Intentional risk retention

a) Unintentional Retention :
- Unaware of loss exposure & no external financing
aaranged : surprise loss! : Highly undesirable
( failure of risk identification process!)
- Effective risk management seeks to avoid such
surprises!
b) Planned/ intentional Retention
- Aware of loss exposures and takes affirmative steps
to plan for its internal financing

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2) Funded and Unfunded Retention


a) Funded Retention
- Identifies / earmark assets : holds assets liquid or
semi-liquid form ready to pay for possible losses
retained
-Segregated assets ( liquid reserve) depend on firms
cash flow & size of losses
b) Unfunded Retention
- No special arrangement to finance losses & use
operating cash flow to paid for losses arising
( Uncertainty of availability of cash)

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2.3

Cost of Risk Retention ( Funded Risk


Retention Plan)

Cost of risk retention


= cost of financing loss + cost of financing risk
1) Cost of financing loss
- Loss refer to expected loss experienced
Expected loss
- Long run average loss occurred in a given year
- Obtained from past loss experience or estimated
from insurance premium ( expected loss = loss ratio x
premium)
Cost of financing loss = Cost of expected loss

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2) Cost of Financing Risk


- Risk : potential deviation of actual loss from the
expected loss in a given year
- Cost of financing risks : cost of providing fund to
pay for large losses that are above the expected loss
predicted ( the fund may not be used at all if large loss
does not occur)
Example
Company X
Building value = RM1,000,000
Expected loss = RM20,000
Possible maximum loss =RM1,000,000
Potential deviation from the expected loss in a year if
maximum loss occurs
= RM1,000,000 20,000 = RM980.000
Risk = RM980,000

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If company X decides to retain the risk


- Provide fund to pay for expected loss (RM20,000)
- Set aside liquid asset/ fund /reserve available to pay
for the risk of large loss, i.e the potential deviation if
the maximum loss occurs (RM980,000)
-Cost of financing risk = cost of setting aside reserve
to be ready to pay for the deviation of loss
( RM980,000) which may or may not occur

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- Cost of financing risk is not RM 980,000. It is the


difference between the return company X can get if
the reserve is invested in the companys business at
the companys rate of return (15%) and the return
when the reserve is actually invested in the liquid
asset ( bank deposit @ 6%).
Cost of financing risk = (R1 R2) x Reserve
R1 : companys rate of return
R2 :rate of return from bank deposit (interest rate)
3) Cost of Retention
= Cost of financing loss + Cost of financing risk
= Cost of expected loss + (R1 R2) x Reserve

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Example (1)
Company X
Building value = RM1,000,000
Expected loss = RM20,000
Maximum loss =RM1,000,000
Risk = RM980,000
Investment return of company = 15%
Bank interest = 6%
Calculate
a) the cost of financing loss
b) the cost of financing risk
c) the cost of retention

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Answer
a) Cost of financing loss = expected loss = RM20,000
b) Cost of financing risk
Reserve = 1,000,000 20,000 = 980,000
Cost of financing risk = (R1 R2) x Reserve
= (15% - 6%) x 980,000
= RM88,200
c)Cost of retention
= Cost of financing loss + Cost of financing risk
= 20,000 + 882,00 = 108,200

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Example (2)
If the building in example ((1) above is insured for
RM1,000,000 and the insurance premium is RM30,000
per year. and is entitled for tax deduction @ 26%.
Recommend to the company the most cost effective
method of handling the risk assuming cost of
retention is also subject to tax deduction
Answer
Net premium = 30,000 26%(30,000) = RM22,200
Net cost of insurance = RM22,200
Net cost of retention
= 108,200 (100% - 26%) =RM84,396
Recommendation : To Insure the risk as it is cheaper
Note : In many countries, cost of retention is not
allowed as expenses and not subject ot tax deduction

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Question
Company Y
Building value = RM2,500,000
Expected loss = RM130,000
Maximum loss =RM2,500,000
Investment return of company = 15%
Bank interest = 6%
Insurance premium = RM200,000
Calculate
A )the cost of financing loss
b) the cost of financing risk
c) the cost of retention
d) the net cost of retention if corporation tax = 26%
e) the net cost of insurance and recommend the best
technique to handle this risk.

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Answer
a) Cost of financing loss = expected loss = RM130,000
b) Cost of financing risk
Reserve = 2,500,000 130,000 = 2,370,000
Cost of financing risk = (R1 R2) x Reserve
= (15% - 6%) x 2,370,000 = 213,300
c) Cost of retention
= Cost of financing loss + Cost of financing risk
= 130,000 + 213,300 = 343,300
d) Net cost of retention
= 343,300 (100% - 26%)= RM 267,774
e) Net cost of insurance
= 200,000 (100% 26%) = RM156,000
Cost of insurance less than cost of retention
Recommendation : To Insure the risk as it is more
cost effective

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2.4

Comparison on Cost of Retention and Cost of


Insurance (Risk Transfer)

Cost of retention
= Cost of expected loss + (R1 R2) x Reserve-------(1)
Cost of insurance
= premium = expected loss + Loading ------------(2)
Rule : Choose the most cost effective options

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2.5 Determining Retention Level


-

Risk retention scheme

a) Full risk retention (low severity & high frequency)


b) Partial risk retention (high severity & low
frequency) ; combination of insurance with partial
risk retention (large deductible)
-

Need to determine level of retention

1) Arbitrary guide / Rule of thumb


- Retention levels based on potential premium savings
for a deductible of a given size against the risk
retained
- Oversimplified : unnecessary costs &
inconsistencies in retention program.

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2) Integrated financial analysis on expected loss and


the loss retention capacity
a) Determine the normal (expected) loss from past
loss experience or may be imputed from the insurance
premium ( loss ratio x premium) and likely potential
deviation

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b) Determine the loss retention capacity


- Retention level depend on resources available to
pay retained losses in excess of the normal loss (that
is, the ability to pay unexpected losses).
- Retention level fixed with respect to following
financial strength indicators:
i) Working Capital (liquid assets)
- working capital = current asset - current liabilities
- Best measure of ability to pay loss and considered
as maximum level of risk retention
- Range : 10% - 25% ( high range when current assets
are more liquid)

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ii) Total Asset


- Indicate corporations borrowing power and overall
financial strength
- Range : 1% to 5%
- Setback : asset may be illiquid and a poor standard
for setting retention level

iii) Retained earnings / net profit


- base on retained earnings over an extended period
( 5 years or more)
- 1% - 3% average pretax earnings ( 5 years)

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iv) Earnings per share


- 10% of earning per share
v) Cash flow
- a range of 5 to 10 percent of the preceding years
non-dedicated cash flow to provide fund for potential
loss

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2.5.1 Setting Retention Level an Art, Not Science


- No hard and fast rule that permits easy computation
of a risk retention level.
- Two additional alternative Indicators may provide
useful suggestions on the retention level based on
Credit Capacity
1) What is the level of uninsured loss that would be
beyond the credit capacity of the firm and would
result in bankruptcy? ( L 1)
2) What is the level of uninsured loss that the firm
could bear without being forced to borrow? (L2)

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Comment
- L1 provides the absolute maximum retention limit for
any exposure.
- Any risks that could result in loss in excess of this
limit must be transferred through commercial
insurance

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2.6

Self Insurance

-Self-insurance : a definitional impossibility : however,


widespread acceptance in risk management practice
- A funded risk retention program in which
organization uses several key insurance techniques to
price risks retained and provision of funds
Example : actuarial technique to estimate expected
loss , loss reserve based on loss experience and
amount of annual contributions to fund the losses :
- Company acts as an insurer for its own risks,
however the premium is retained by the organization
to pay its own losses as they arise in future
- Distinguishing funded retention programs that
utilize insurance techniques from those that do not

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Advantages of self insurance


1) Reduction in Costs
- insurance premium includes a surcharge to cover
the cost of operating the insurance company and its
distribution system & premium taxes
Potential savings :
- premium tax and the allowance for profit and
contingency reserve.
- eliminate acquisition expense.
- insurer overhead and loss adjustment expenses-represent an additional potential for saving.

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Commercial Insurance Expense Ratio (% of gross


rate)
Acquisition expenses

13.7%

State premium tax

3.6%

General administrative expense

7.5%

Loss adjustment fees

8.6%

Profit and contingencies expenses

2.5%
35.9%

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2) Stronger control of risk management program


- Benefits of efficient risk management is captured by
the firm and not insurer in case of purchase of
commercial insurance : stronger incentive /
motivation to undertake effective risk control
measures
3) Better cash flow control
- commercial insurance : annual premium payable in
advance : inflexible
- Self insurance : flexible premium payment plan
beneficial to firm : better control on cash flow
4) Capture investment income from loss reserve
- Investment income from Reserve for IBNR ( Incurred
But Not Reported) retain by the firm, especially
important for liability risks where large reserves are

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Disadvantages of Self Insurance


1) Exposure to Catastrophe Loss
- Major disadvantage : may leave organization
exposed to catastrophic loss ; bankruptcy
-May be eliminated if purchases reinsurance for
potentially catastrophic losses
2) Variation in Losses
- A greater variation of costs from year to year.
- May lose tax deduction for losses that occur in years
when there are no profits from which to deduct
losses.

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2.6.1

The Future of Self Insurance

Table 1 : Distribution of Risk financing Premium


Internationally (2001)
Direct Risk
financing
premium
US$ billion

Largest 2,500 corporations


Premium

370

49

13%

insurance

38

31

80

Self
Insurance

49

22

45

Total

457

102

22

Traditional
insurance

US$

percentage of Total

Captive

Source : Swiss RE (2003)

Comment
- Many large corporations internationally rely on self
insurance especially In North America.(20%)

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2.7

Combination Insurance and Risk Retention

-Trend towards self insurance scheme : detrimental to


insurance business : loss of revenue
-Insurers developed combination programs to
compete with self-insurance programs
(If you cant beat them, join them; e.g. low- cost
carriers)
- One of these programs is retrospectively rated
insurance plan : A combination of insurance and risk
retention

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2.7.1

Retrospectively Rated Insurance Policy

- A self-rated insurance plan under which the actual


losses experienced during the policy period determine
the final premiu, subject to a maximum and a
minimum premium
- A special insurance contract in which the premium
payable is determined on the actual loss experience at
the end of period of insurance
- a cost plus arrangement final premium is claims
costs plus administration expenses

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Operation aspect
- A deposit premium paid at beginning of insurance
period and final premium calculated based on loss
experience at end of the period (retrospective
premium, RP)
-Subject to a minimum and a maximum premium
condition
- If RP is less than the minimum premium, the
minimum premium is payable.
-However, if RP is higher than the maximum premium,
the maximum premium becomes payable

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Calculation of premium for Retrospective Rating Plan


Meanings of terms
1) Standard premium
- Premium payable under a normal policy (base on
class rate)
- Used to calculate administrative charges (basic
premium) of a retrospective rate plan
-Administrative charges is known as basic premium
2) Retrospective premium (RP)
- The actual premium payable under a retrospective
rate plan at the end of the period.
RP
= (Basic Premium + Converted Losses) x Tax

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Basic premium
= administrative cost of plan
= basic premium factor x Standard Premium
Converted Losses
= ( Losses incurred ) x Loss Conversion Factor
- Loss conversion Factor : incorporate claim
administration charges to losses ( a factor of 1.12)
- Tax Multiplier : factor incorporating surcharge for
premium tax (a factor of 1.07)

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Application of maximum and minimum premium of a


retrospective rated plan
Max premium = RM300,000
Minimum premium = 650,000
Losses
Incurred

RP

Actual premium
Payable

40,000

125,511300,000 (min)

200,000

317,255

317,255 (actual)

480,000

652,807

650,000 (max)

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Rating
Factor
Standard Premium
Basic premium factor

Dollar
Amount
500,000

0.145

Basic Premium

72,500

Loss conversion factor

1.120

Tax multiplier

1.07

Minimum premium

.60

300,000

Maximum premium

1.30

650,000

Note : max. & Min premium is based on the standard


premium

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Retrospective Plan Illustrated


(a)

(b)

(c)

(d)

(e)

(f)

If Losses Converted Basic Columns With Tax


Are
Losses Premium (b) + (c ) Multiplier

Final
Premium

$0
40,000
200,000
240,000
280,000
305,240
320,000
440,000
480,000

$300,000 Minimum
300,000
Minimum
317,255
365,191
413,127
443,375
461,063
604,871
650,000
Maximum

$0
44,800
224,000
268,800
313,600
341,869
358,400
492,800
537,600

$72,500
72,500
72,500
72,500
72,500
72,500
72,500
72,500
72,500

$72,500
117,300
296,500
341,300
386,100
414,369
430,900
565,300
610,100

$77,575
125,511
317,255
365,191
413,127
443,375
461,063
604,871
652,807

RP = (Basic Premium + Converted Losses) x Tax Multiplier


Example
Loss = 40,000
RP = { (40,000) x 1.12) + (500,000 x 0.145) }x 1.07
RP = { 44,800 + 72,500) x 1.07 = (117,300 x 1.07) = RM125,511

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Comments
1) For losses less than 470,000, The RP plan is a self
insurance plan : the insured paid its own claims
plus the expenses.
2) For losses exceeding RM 470,000, where the
premium paid is less than RP calculated, there is
an element of insurance as the premium paid is
less than the calculated RP

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Lesson Exercise
Case 1
Given : the formula for computation of RP as :
RP = (Basic Premium + Converted Losses) x Tax
Multiplier
Standard Premium
Basic premium factor
Loss conversion factor
Tax multiplier
Minimum premium
Maximum premium

= 500,000
=0.145
= 1.120
= 1.07
= 300,000
= 650,000

Calculate the retrospective premium for the following


loss experiences and the actual premium payable for
the retrospective plan
a) Losses = 30,000
b) Losses = 280,000
c) Losses = 620,000

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Case 1 : Answers
a) Losses = RM30,000
RP = { (30,000) x 1.12) + (500,000 x 0.145) }x 1.07
= (33,600 + 72,500) x 1.07
=RM113,527
Minimum premium = RM300,000
Actual premium payable = RM300,000

65

b) Losses = RM280,000
RP = { (280,000) x 1.12) + (500,000 x 0.145) }x 1.07
= (313,600 + 72,500) x 1.07
= RM413,127
Minimum premium = RM300,000
Actual Premium payable = RM413,127

66

c) Losses = RM 620,000
RP = { (620,000) x 1.12) + (500,000 x 0.145) }x 1.07
= (694,400 + 72,500) x 1.07
= RM820,583
Maximum premium = RM650,000
Actual premium payable = RM650,000

67

Risk Financing Techniques Continuum


l_______l_______l_______l_____l______l_____l_______l_____l
unfunded self
funded RR
insuRR
rance
*

retro alter
captive com.
plan risk
insu- insutransfer rance rance
(ART)
*

Cont. Cat.
debts bonds

l------- RR ----------------l---------RR & RT----------------l-----RT-----l-------RT---------l


Hybrid
insurance capital market
ART products
Note
RR : Risk Retention technique
RT : Risk Transfer technique
ART : Alternative Risk Transfer schemes

68