Risk financing helps organizations achieve the strategic balance of risk management—aligning the willingness and ability to take risk with business goals. Generally, the objective of financing risk is to ensure liabilities are either paid or cost-effectively financed while maintaining an adequate level of internal liquidity. Sometimes, this strategy includes planning to meet legal or regulatory requirements.
Risk financing is a plan for covering liabilities—such as loss events and legal or regulatory requirements—while maintaining an adequate level of internal cash flow. Organizations use risk financing to effectively balance the willingness and ability to take risks with strategic goals. Historically, two main tactics involved either retaining the risk by allocating funds to meet expected losses (i.e., self-insurance) or transferring the risk to an insurance company by purchasing a policy.
However, during the liability crisis of the 1980s, when many businesses had trouble obtaining some types of commercial insurance coverage, new mechanisms for financing and transferring risk emerged:
Today, the alternative risk transfer (ART) market features a host of innovative products that enable organizations to transfer risk without involving a conventional insurance policy including:
Risk financing that involves risk retention can offer some flexibility and cost control. These options can include self-insurance, which requires setting aside the money or pooling resources with other organizations (usually those commonalities such as geographic locations or industries) to address potential losses Instead of engaging an insurance carrier. Or, in workers compensation, for example, many companies choose to retain a larger portion of their risk exposure through policies with large deductible amounts of $100,000 or higher, typically to lower or stabilize cash outlay for insurance premiums. This risk retention strategy of using higher deductibles is increasing in most lines of insurance.
In addition to protection from rising premiums, organizations can develop long-term risk management strategies because policy renewal is not a concern. Risk retention can work well when losses are reliably predictable and occur in financially manageable amounts for the organization. However, retaining risks without a comprehensive understanding of potential exposures can lead to being unprepared to meet liabilities.
Risk retention groups (RRGs) were introduced under federal laws passed by Congress in the 1980s to help businesses, professionals and municipalities obtain liability insurance, which had become either unaffordable or unavailable.
Under the Liability Risk Retention Act (LRRA), RRGs must be domiciled in a particular state. Once licensed by its state of domicile, an RRG can insure members in any state. It need not obtain a license in a state other than the one where it was chartered.
Risk purchasing groups (RPGs) are comprised of insurance buyers who band together to purchase their liability insurance coverage from an insurance company. This contrasts with RRGs, which act as insurance companies, issuing their own policies and bearing risk. Another key difference between the two entities is that RRGs typically require members to capitalize the company, whereas PGs require no capital.
Catastrophe bonds – also known as insurance-linked securities (ILS) – developed in the wake of hurricanes Andrew and Iniki in 1992, and the Northridge earthquake in 1994. These mega catastrophes resulted in a global shortage of reinsurance for such disasters.
Tapping into the capital markets allowed insurers to diversify their risk and expand the amount of insurance available in catastrophe-prone areas. Insurers and reinsurers typically issue cat bonds through a special purpose vehicle, a company set up specifically for this purpose.
Catastrophe bonds pay high interest rates and diversify an investor's portfolio because natural disasters occur randomly and are not associated with economic factors. Depending on how the cat bond is structured, if losses reach the threshold specified in the bond offering, the investor may lose all or part of the principal or interest.
Developed by an energy company in the late 1990s and now being offered by insurers, reinsurers and hedge funds, weather derivatives are typically indexes derived from average temperatures, snowfall, or rainfall. Contracts can be tailored to meet specific needs and may take the form of an option or swap.
A weather option is a trade that pays an agreed upon amount at a specific time, based on the occurrence of certain weather conditions, such as summer temperatures more than five degrees below average. A weather swap is an exchange of funds between two entities likely to experience different conditions. Money changes hands for every point above or below a certain threshold.
A sidecar is a financial structure that allows sophisticated investors to take on the risk and return of a book of insurance business. A typical sidecar exists for a finite period to reinsure a specific book of property catastrophe business.
Usually, the reinsurance company creates the sidecar by creating a separate subsidiary known as a special purpose vehicle. The sidecar is funded by investors who want to reinsure a specific set of reinsurance contracts. The reinsurer cedes part of the contracts to the sidecar, meaning the sidecar receives premium and pays claims commensurate with the terms of the contract.
The reinsurer handles the sidecar’s administrative needs. Generally, the sidecar is fully collateralized, meaning it has sufficient assets to pay the maximum amount of claims it could sustain in a worst-case scenario.
Collateralized reinsurance refers to a treaty in which a nontraditional reinsurer places in escrow the entire amount of the coverage it is offering. If a treaty offers $30 million in protection, for example, the reinsurer escrows $30 million for the life of the contract. Provided the escrowed funds are invested safely, as in a Treasury note, there is little doubt the reinsurer will have funds to pay any claim.
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