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