Professional Documents
Culture Documents
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
retro alter
captive com.
plan risk
insu- insutransfer rance rance
(ART)
Cont. Cat.
debts bonds
1.1.1
----------------------------------------->
Insurer
Manage
Insurance
Pool (Fund)
<-------------
Insurer
.>
Profit / loss
(insurers risk)
10
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
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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
20
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) 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
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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
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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)
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2.2
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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2.3
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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
36
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
37
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
38
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.
39
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
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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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
49
50
13.7%
3.6%
7.5%
8.6%
2.5%
35.9%
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2.6.1
370
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13%
insurance
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31
80
Self
Insurance
49
22
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Total
457
102
22
Traditional
insurance
US$
percentage of Total
Captive
Comment
- Many large corporations internationally rely on self
insurance especially In North America.(20%)
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2.7
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2.7.1
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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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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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RP
Actual premium
Payable
40,000
125,511300,000 (min)
200,000
317,255
317,255 (actual)
480,000
652,807
650,000 (max)
60
Rating
Factor
Standard Premium
Basic premium factor
Dollar
Amount
500,000
0.145
Basic Premium
72,500
1.120
Tax multiplier
1.07
Minimum premium
.60
300,000
Maximum premium
1.30
650,000
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(b)
(c)
(d)
(e)
(f)
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
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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
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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
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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
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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
retro alter
captive com.
plan risk
insu- insutransfer rance rance
(ART)
*
Cont. Cat.
debts bonds
68