Alternative Risk Financing
Name given to the set of methods by which an organization may retain its risk.
It is a self-insurance agreement that finances the risk by means other than a transfer to a traditional insurer.
Common Alertvnative Risk Methods in Canada
- Captive Insurance Companies
- Self insured retention (SIR)
- Reciprocals
Growth of Alternative Markets
- Began with the liability crisis in the 1980s.
- Continued event roughs oft market for insurance that followed the crisis.
- Premiums have grown faster than risk.
- Taking control of its own risk means cost is based on the company’s own experience.
- Allows company to be less dependent on commercial insurance market and the availability of coverages and limits from insurers.
Decline of First Dollar Coverage
- Has become a luxury of the past.
- Doesn’t make sense if high frequency of smaller claims.
- Subjective due to the fact companies self insure even when they buy insurance (deductibles or SIR’s).
First Dollar Coverage
Represented coverage that the insured company enjoys in at least the lowest of the several potential layers into which a risk might be divided.
Trading Dollars
A company with a high frequency of smaller claims may find that it is in effect merely trading floors with the insurer while also paying part of the insurer’s expenses.
Fundamental Characteristics of Insurance
- Insurance is a mechanism for transferring risk
- Premium an insurer charges must cover not only the pure premium needed to pay losses, but the insurer’s additional costs (acquisition, administrative and allowance for profit)
The Retention Alternative
- Trading dollars makes insurance inefficient.
- Retaining risks may eliminate costs.
- Allows control over claims.
- Propert IT programs can alert risk managers to problems in their company.
- Pitfalls: inadequate risk management, insufficient funding of losses, lack of understanding company’s exposures.
Captives
- Sparked by lack of insurance availability and capacity in the regular insurance market.
- Started in the 1980s
Captive Insurance Company
Is an insurer owned and controlled by its insured or insureds.
Usually a special purpose subsidiary created to insured the risks of its parent organization(s).
Types of Captives
- Single Owner
- Group
- Association
- Agency
- Rent-a-captives
Single Owner Captive
AKA Single Partent Captive, Pure Captive
Insures only the risks of the owner or the owner’s subsidiary operations.
Group Captive
AKA Multi Parent Captives
Insure the risks of the multiple non related organizations that own them.
Association Captive
Insure the risks of companies in the same or similar industries or organizations in the same area or areas of endeavour.
Agency Captive
Owned by insurance companies and formed to insure the risks of the clients of insurance agencies.
Rent-a-captive
Established by organizations unrelated to the companies that use the captives.
Make captives available for a fee.
Captive Domiciles
Captives can only be established in a jurisdiction that has passed legislation allowing the jurisdiction to be a domicile - a permanent legal resident - for captives.
Offshore Captives
A captive in a country other than the country in which the organization itself has been incorporated or established.
Captive Front
Typically offshore can only engage in reinsurance transactions.
May have to approach a local insurer to act as a front for the captive. Acts as the insurer on record.
The Case for Captives
- Broader protection for parent.
- Fills coverage gaps.
- Commitment to loss control.
- Expenditures can be limited to needed services
Frictional Costs
The implicit and explicit costs associated with market transactions.
Frictional costs are generally those costs incurred in addition to the pure cost of financing the risk.
Financial Benefits
- Benefits accrue to owners.
- Premiums and reserves are tax deductible.
- Direct access to reinsurance market.
- Cede commission from reinsurers.
Other Advantages and Disadvantages
- Commitment of owners is essential.
- Predictable, non catastrophic exposure
- Insurance can obscure true cost of risk
- Captive rates may better reflect cost of risk
- Captives for family businesses
- Significant capital required
- Depends on effectiveness and commitment of insured
Underwriting the Captive
Fronting:
- Advantage: Can accept a fronting free
- Disadvantage: Loss of control over claims
