Unit II

Enterprise Risk Management

Topic: Internal Loss Financing

These are reference notes only, should not be construed as complete text for the above topic.
Students are expected to do further research and extrapolate the points. They need to
identify/create suitable examples for the points and get them verified.

Reasons for Internal Loss Financing

In theory, we expect very large corporations to be risk neutral and to manage their risks accordingly. Ideally
they should not purchase insurance as the premium paid towards it is loaded with insurers expenses,
profits, taxes etc. Theoretically speaking, losses of any nature are actually indistinguishable from any other
cost of doing business and hence should be offset from the firms cash flows / profits. But there are
practical benefits why corporations should elect formal loss financing arrangements. Following are the
reasons:1. Stronger Control of Risk management Program: Adequate insurance sometimes give rise to moral and
morale hazards within the firm (egs. False claims, procedural negligence, etc). Internal loss financing
should reduce motivation for moral/morale hazard as the corporation not the insurer captures the
benefits of its loss mitigation efforts. A formal internal financing program can facilitate the
implementation of effective internal risk control activities by offering financial incentives to subsidiaries,
departments, divisions and/or employees for favourable loss records and attention to loss mitigation.
Internal risk management program allows some other benefits to the firm especially when it wants to
finance the residual risk above its retention level to an insurance company:Bargaining tool: Increased negotiating strengths with the insurers thereby gaining cost and
coverage benefits and obtain higher limits for excess insurance.
Broader and more uniform coverage: Internal loss financing programs permit the firm to cover a
wider range of exposures customized to specific and dynamic needs of the firm. This removes
the chances of disputes relating to coverage scope, policy wordings, claim amount and
resultant disputes and lawsuits between the firm (insured) and the insurer.
Coverage availability and affordability: Various economic, market and political factors
sometimes cause insurance coverages to be unavailable or unaffordable. Problems of Moral
Hazard, severe competitive pricing in insurance market, catastrophic risk beyond the
underwriting capabilities of insurance market, or the insured failing to meet the underwriting
standards of the insurer can render the insurance unaffordable. Coverages become
unaffordable when the insurers cannot reign in the rising claims, or when an insurer faces
substantial rise in renewal premium after experiencing a huge loss. Formal internal financing
can be an alternative to insurance for entities subject to these conditions.
2. Lowers Firms Cost of Risk: Cost of risk is the sum of a firms risk financing costs, risk control expenses,
retained losses, and related administrative expenses. Internal loss financing program helps in lowering
such cost of risk specifically in the following manner:
Lower administrative expenses: reduce or eliminate costs associated with insurance such as
agency commissions, premium taxes (service tax), insurers profit etc.
Avoid subsidizing others: The class rating approach in insurance allows premium rate to be
based on the average loss of the risk class, thereby charging same rate to all the insured in that
class irrespective whether they are low-risk or high risk. This makes low risk insured to provide
premium subsidy which is enjoyed by the high risk insured.
Provide access to reinsurance: Corporations with captive insurance can gain direct access to
reinsurance market and benefit from lower rates of reinsurance.
Gain tax advantages: A prudent corporation will recognize and take tax advantages as they are
offered. In India, companies can claim expenses incurred on internal loss financing
arrangements against the profit if the authorities allow.

3. Better Cash Flow Control: Formal internal loss financing programs can offer any payment plan
beneficial to the firm alongwith loss payment flexibility that can help reduce its cash flow volatility thus
enhancing firm value. But, the firm should not lose sight of possibility of an unexpected large retained
loss occurring at an inopportune time thus causing a cash flow strain for the firm.
4. Capture Investment Income: Insurers must hold reserves in cash or in marketable securities in order to
remain solvent and attain partial protection against substantial investment loss. These reserves created
by premiums collected from the insured, backed by assets, generate investment income accruing to the
insurer. Captives and funded self insurance programs can earn similar investment income to the firm
itself.
5. Avoid Inefficiencies with the Traditional Insurance: Apart from the inefficiencies like high administrative
costs and subsidization across insureds, the insurance companies are susceptible to inefficiencies like
inability to deliver on its promises for various reasons, for example insolvency.

Self Insurance
Many corporations rely on self insurance. A firm might establish an individual self-insurance plan a special
retention plan solely for the firm or participate in a group self-insurance plan a special retention plan
where two or more entities often in the same industry, and/or within the same geographical area, pool their
capital to cover a common loss exposure (eg. Workmens compensation).
The self-insured firm borrows several key techniques used by insurers. It analyzes the characteristics of
any risks that it might retain, including estimations of expected losses based on past experience as well as
the industry experience. However, self-insurance is not a solution to every risk. All businesses and
individuals should retain exposures that exhibit both low frequency and severity. Exposures reasonably
expected to high frequency and low severity also are prime candidates for self insurance. A firm may use
the industry loss experience as a reference for its estimation of future losses.
But a self insured firm still faces the problem of possible correlation among the loss exposures. This
possibility exists because all exposures belong to the firm only. An extreme loss not necessarily a
catastrophic loss can threaten the soundness of the self insurance program. Self-insured firms limit such
exposures by setting an appropriate upper limit for that portion of exposures financed internally then
purchasing excess insurance from the commercial insurance market.
Any loss estimation result should be statistically significant before it can be applied to a practical situation.
Loss estimation analyses, therefore, becomes a prerequisite for self-insurance. But the firms considering
self-insurance face a challenge whether they have sufficiently large number heterogeneous exposure units.
Loss estimation results will be more near accurate where Law of Large numbers is applicable.
Setting Self Insurance Reserves
Maintaining financial solvency is as critical to self-insured organization as to an insurance company.
Financial solvency requires a self-insured firm not only to set aside a sufficient amount of capital at the
beginning of the program to cover future losses but also to make periodic adjustments of reserves as loss
experience develops.
A risk manager relies on the data provided from the previous years loss experiences to conduct an
estimation analysis. This analysis is aimed to provide an estimate of the adequacy of reserves as on today.
Hence it becomes necessary to adjust past losses to reflect changes that have taken place from then until
today. These changes fall into three categories, adjusting past data to the present:Loss Development factors: adjust the values recorded for losses in past years to reflect the
facts that (a) estimates for incurred but not fully settled losses will be incorrect to some degree
and (b) some losses might have been incurred during past years but not yet reported.
Exposure factors: adjust the losses that have already been adjusted for development to reflect
any changes in the exposure base; e.g. an increase in the number of exposure units.
Trending factors: adjust the losses that have already been adjusted for both development
exposure changes to reflect economic, legel, demographic and other relevant environmental
factors theat affect past losses; e.g., a change in liability laws.
Uses of Self Insurance

Self-insurance cost effective alternative to commercial insurance. Self-insuring a risk, however, may
increase the risk of insolvency for a firm as it is solely responsible for all the losses it has retained. Since
very little, or no risk pooling occurs with self insurance, the probability of insolvency can be higher that of
the insurer. Therefore, governments, globally, tend to discourage if not prohibit self-insurance.
Self-insurance is probably a better choice for liability than for property risk loss exposures. The reasons
being; first, the long-tail nature of liability claim offers self-insured entities more time to accumulate funds
and generate investment income. Secondly, as liability claims tend to be more volatile than property claims,
commercial insurers often add a risk surcharge to base premiums. Self insured entities also can reduce the
total cost of risk by actively implementing loss mitigation programs along with their self-insurance programs.

Captive Insurance
Corporations not in insurance business may finance their loss exposures through captive insurance
companies, the oldest and most common form of Alternative Risk Transfer (ART) techniques. Captive
insurance involves transfer of risk to an affiliated insurance company. Most captives are small and
managed by firms specializing in captive management. Despite their simple structure, captives, can offer
several significant benefits.
[Background and History of captive Insurance to be researched by students]
Uses of Self Insurance
A captive insurance is a closely held corporation whose insurance business is supplied primarily by its
owner(s) and in which the owners are the principal beneficiaries. Captives differ from other insurers in
atleast two aspects.
Ownership and management control: a captive is owned by a corporation not in the insurance business.
The owner has direct influence over its captive operations not in the insurance business. The owner has
direct influence over its captive operations including underwriting, claims management and investment
decisions. This active participation of the insured-owner differentiates captives from public mutual
insurance companies, owners of which have little or no role in the management.

Scope of operation. The business of a captive is confined primarily or exclusively to the risks of its
owners. In fact, the majority of captives underwrite only the exposures of their owner-insureds. This
limited scope of operation differentiates captives from traditional stock insurance companies that
underwrite risks for the general public and whose writings of its parent firm business, if any is incidental.

Captives are not uniform. Some are owned by a single firm and others by a group of firms. Some operate in
the domiciliary countries of their owners, and others offshore. Some captives insure their owner(s) directly,
while others accept risks through fronting insurers. Some businesses operate their own captives, while
others use captives owned by other firms or participate other arrangements. Following are some such
classifications.
Single parent and group captives
Captives may be classified broadly into single parent and group captives. A single-parent captive is an
insurance company owned by one entity. For example a corporation may create its own subsidiary captive,
becoming the principle insured of the captive and also to meet the insurance needs of its other subsidiaries.
Some decentralized corporations operate single-parent captives as mutuals (captive open to underwrite
risks other than its principle), more for the benefit of the insured operating units than for the ultimate owner.
Single parent captives account for more than 70% of the captives internationally.
A group or association captive is an insurance company owned by and providing coverage for two or
more unrelated entities. Organizations using these captives typically exhibit following traits:-

Entities sharing common needs. The captive owners typically share a common risk financing
need and are in the same industry or sector. (Government Sector)

Capital constraint. Two or more firms with capital constraint can pool their financial and
personnel resources to create and operate a group captive.

Business volume constraint. Two or more firms often not having sufficiently large loss exposures
often consider a group captive, through which they can finance their risks together.

Rent-a-captives and protected cell companies.

Establishing and operating a captive insurance firm can be costly, thus leaving this risk financing technique
typically unavailable to medium and small sized firms. Sometimes, even large firms are reluctant to make
capital commitment to create their own captives. Such firms can use rent-a-captive solution. A rent-aCaptive is a captive owned and operated by an unrelated firm with which an entity places its insurance. In
effect, in a rent-a-captive, an insured leases the capital of an existing captive so that the firm can fund some
of its risks more efficiently.
A typical rent-a-captive arrangement requires the insured firm not only to be responsible for the
underwriting results of its own risks but also participate in the ultimate operating results (e.g. investment
performance) of the sponsoring captive and of the other renters of the captive. As a result, the insured firm
places high collateralization and usage costs in addition to counterparty risk. However, rent-a-captives
generally remain short-term solutions.
Protected Cell Companies (PCCs) also known as sponsored captives, are captive insurance operations
established within an existing captive owned and operated by an unrelated firm. The set-up procedure is
similar to that of a single parent captive except for regulatory approval. The sponsoring captive is subject to
regulatory compliance of all if its operations including sponsored PCCs.
The operations of PCCs are shielded from the other operations of the sponsoring captive. This can be a
significant benefit when compared to use of rent-a-captive, operations of which are separate from the
sponsoring firm only at the underwriting level. Risk financing through a PCC is permitted in selected captive
domiciles.