RISK FINANCING

RISK FINANCING IS THE DETERMINATION OF HOW AN ORGANIZATION WILL PAY FOR LOSS EVENTS IN
THE MOST EFFECTIVE AND LEAST COSTLY WAY POSSIBLE. RISK FINANCING INVOLVES THE
IDENTIFICATION OF RISKS, DETERMINING HOW TO FINANCE THE RISK, AND MONITORING THE
EFFECTIVENESS OF THE FINANCING TECHNIQUE THAT IS CHOSEN.
OBJECTIVES

• Define risk financing

• Describe each of the risk financing techniques
• Differentiate between first party and third party insurance.
• Explain the difference between claims-made and occurrence insurance.
• Discuss the cost of risk.
• Compare a soft market and a hard market.
BASICS OF RISK FINANCING

• Encompasses all ways of generating funds to pay for

losses that risk control techniques do not entirely prevent.
• Designed to obtain funds, at the least possible cost, to
restore losses that strike the organization and assure
post-loss financial resource availability
SIGNIFICANCE OF THE DISTINCTION BETWEEN
RISK CONTROL AND RISK FINANCING

• An organization should apply at least one risk control and at

least one risk financing technique to each of its significant loss
exposures unless exposure avoidance is a practical and safe
alternative.
• One risk control technique often may be substituted for another;
one risk financing technique often may be substituted for
another.
RISK FINANCING TECHNIQUES

•Risk Retention
•Risk Transfer
RISK FINANCING TECHNIQUES

• Risk Retention
-Current expensing of losses
-Unfunded loss reserve
-Funded loss reserve
-Borrowed funds
-Self-insurance
-Self-insurance trust
-Affiliated, captive insurer
 RISK FINANCING TECHNIQUES

Risk Retention
-Current expensing of a loss
• Charging off losses as current expenses without a fund or reserve; paying for
losses out of available cash as they occur.
• Acceptable for losses that are small in nature and infrequent in occurrence
• Example: deductible for automobile or property loss
 RISK FINANCING TECHNIQUES

Risk Retention
• Unfunded loss reserve
• An accounting entry that shows a potential liability, segregates a portion of
surplus equal to booked value of retained losses
• Examples
• Uncollectible accounts
• Loss of revenue for lost items (dentures, eye glasses, hearing aides, etc.)
RISK FINANCING TECHNIQUES

• Risk Retention
• Current expensing of a loss
• Charging off losses as current expenses without a fund or reserve; paying for
losses out of available cash as they occur.
• Acceptable for losses that are small in nature and infrequent in occurrence
• Example: deductible for automobile or property loss
RISK FINANCING TECHNIQUES

Risk Retention (cont.)

• - Borrowed funds
• An organization borrows to pay losses
• Results in a reduction in its line of credit or ability to borrow for other purposes
• Represents a depletion of its own resources to pay its losses and, in time, uses
its own earnings to repay the loan
RISK FINANCING TECHNIQUES

Risk Retention (cont.)

• - Self-insurance trust
• A funding vehicle that is a bank account administered by an
independent third party (trustee).
• The funds are designated for the sole and restricted purpose of
paying losses.
Risk Transfer
• Definition: transmit an organization's risks to an outside party.
• Funding the payment of losses from outside the organization after a specified loss.
• Contract or provision of a contract.
• Commitment to pay.
• Organization can transfer the financial burden of losses but not necessarily the ultimate
legal responsibility for losses.
Risk Transfer
• Noninsurance
• Insurance
• Risk retention groups
Noninsurance
A contract under which one party, the transferee/indemnitor,
agrees to pay money for specified types of losses for which,
in the absence of the contract, the financial burden would
fall on the transferor.
Insurance
Insurance is a system by which a risk is transferred to an
insurance company, which reimburses the insured for
covered losses and provides for sharing costs of losses
among all insureds.
•Insurance policy is a legal contract
Standard elements
•Declarations page
•Insuring agreement
•Conditions
•Exclusions
•Direct insurance is a contractual arrangement involving,
the purchase of insurance by an "insured" from an
"insurer"
•Primary insurance is the first layer of coverage, the
layer that is prone to loss
•Excess insurance sits over specific primary insurance
to afford additional limits of liability
REINSURANCE

•Reinsurance is a contractual arrangement involving the purchase

of insurance by an "insurer" from "another insurer"
•Risk sharing reduces ultimate loss exposure to a more
comfortable level
•Stabilizing effect - smoothes the ups and downs of fluctuating loss
experience
•Increases capacity
•Catastrophic protection - protects against the adverse effects
oflarge losses from natural forces or man-made disasters
 TERM’S AND CONDITIONS OF LIMIT OF
LIABILITY

•Policy limit - represents the maximum amount the insurer will

pay for losses
•Per occurrence - applies to a specific loss
•Aggregate - applies to all losses within a policy term
•Defense costs can be included within the policy limit or outside
RISK FINANCING TECHNIQUES