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Risk Financing

Risk Financing

Definition

Risk Financing — achievement of the least-cost coverage of an organization's loss exposures, while ensuring post-loss financial resource availability. The risk financing process consists of five steps: identifying and analyzing exposures, analyzing alternative risk financing techniques, selecting the best risk financing technique(s), implementing the selected technique(s), and monitoring the selected technique(s). Risk financing programs can involve insurance rating plans, such as retrospective rating, self-insurance programs, or captive insurers.
Links for IRMI Online Subscribers Only: RF, Five Key Steps to the Risk Financing Process

Related Terms

Captive

An insurance company that has as its primary purpose the financing of the risks of its owners or participants. Typically licensed under special purpose insurer laws and operated under a different regulatory system than commercial insurers. The intention of such special purpose licensing laws and regulations is that the captive provides insurance to sophisticated insureds that require less policyholder protection than the general public.

Deductible

An amount the insurer will deduct from the loss before paying up to its policy limits. Most property insurance policies contain a per-occurrence deductible provision that stipulates that the deductible amount specified in the policy declarations will be subtracted from each covered loss in determining the amount of the insured's loss recovery. Usually, the amount of the deductible is not subtracted from policy limits.

Risk Management

The practice of identifying and analyzing loss exposures and taking steps to minimize the financial impact of the risks they impose. Traditional risk management, sometimes called "insurance risk management," has focused on "pure risks" (i.e., possible loss by fortuitous or accidental means) but not business risks (i.e., those that may present the possibility of loss or gain). Financial institutions also employ a different type of risk management, which focuses on the effects of financial risks on the organization. For example, interest rate risk is a bank's most important financial risk, and various hedging tools and techniques such as derivatives are used to manage banks' exposure to interest rate volatility.

Risk Management Techniques

Methods for treating risks. Traditional risk management techniques for handling event risks include risk retention, contractual or noninsurance risk transfer, risk control, risk avoidance, and insurance transfer. Other techniques used for other types of risk (e.g., credit, operational, interest rate risks) include financial tools such as hedges, swaps, and derivatives.

Self-Insurance

A system whereby a firm sets aside an amount of its monies to provide for any losses that occur—losses that could ordinarily be covered under an insurance program. The monies that would normally be used for premium payments are added to this special fund for payment of losses incurred. Self-insurance is a means of capturing the cash flow benefits of unpaid loss reserves and offers the possibility of reducing expenses typically incorporated within a traditional insurance program. It involves a formal decision to retain risk rather than insure it and is distinguished from noninsurance or retention of risks through deductibles by a formalized plan or system to pay losses as they occur.

Self-Insurance Pool

A legal entity regulated by the states that allows unrelated insureds to retain their own risks and collectively purchase claims administration services and excess insurance to meet statutory coverage requirements.

Self-Insured Retention (SIR)

A dollar amount specified in a liability insurance policy that must be paid by the insured before the insurance policy will respond to a loss. Thus, under a policy written with a SIR provision, the insured (rather than the insurer) would pay defense and/or indemnity costs associated with a claim until the SIR limit was reached. After that point, the insurer would mame any additional payments for defense and indemnity that were covered by the policy.

In contrast, under a policy written with a deductible provision, the insurer would pay the defense and indemnity costs associated with a claim on the insured's behalf and then seek reimbursement of the deductible payment from the insured. For example, assume that two policies are identical, except for the fact that Policy A is written with a $25,000 deductible, while Policy B contains a $25,000 SIR. Also assume that defense and indemnity payments for a given claim total $100,000. In the event of a claim under Policy A, the insurer would pay the $100,000 in defense and indemnity costs that were incurred. After the claim is concluded, the insurer will bill the insured for the $25,000 in payments made on the insured's behalf. In the event of a claim under Policy B, the insured will pay the first $25,000 of defense/indemnity costs, after which, the insurer will make the additional $75,000 in defense and indemnity payments on the insured's behalf.

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