Risk Financing

Topics: Risk management, Insurance, Risk Pages: 9 (3009 words) Published: April 1, 2011
Risk Financing
Risk imposes costs in two broad forms – loss costs and the costs of uncertainty. Risk financing attempts to mitigate the impact of these costs by structuring the availability of funds to pay claims, aid recovery and enable the organization to maintain financial stability as it moves forward towards its mission. How risk financing occurs can vary. At one end of the scale, fully self-insured entities retain responsibility and, if risk-related costs arise, the entity directly bears those costs. At the other, fully-insured entities transfer the direct responsibility for bearing risk to an insurance company, trading regular losses (the premiums paid) to avoid the potential of large and irregular losses (claims payments). CIS’ pooling programs occupy a middle ground. They enable entities to retain losses up to some pre-determined level; then to share the cost of losses within a mid-layer, and then to transfer risk above the pooled layer by securing reinsurance up to available limits. In reality, most local governments finance the cost of risk through a combination of retention, sharing and transfer. By design or default, a local government entity’s risk-financing portfolio will almost always contain a self-financed component. Losses within stated sub-limits or above the overall limits of coverage are retained by the entity. They may also choose to retain lower levels of risk. For example, members in current CIS pools reduce their contribution levels by using various deductible levels, from $1,000 to $125,000, to pay the first part of some or all losses. In reality, what is being shared or transferred is the timing risk associated with a loss. Most conventional risk transfer (insurance) or risk sharing (pooling) programs provide a smoothing effect that protects an entity from the risk of not having sufficient funds on hand at the time a loss occurs. When risk financing occurs – before, during or after resources are needed - is another variable. Guaranteed cost insurance is an example of a prospectively funded risk transfer device. Average expected losses for a group are the basis for premium or contribution calculations. Cost will not change regardless of actual loss experience during the coverage period. Some self-insured entities fund on a pay-as-you-go basis without any pre-funding. On the other hand, entities with credible loss data may be retrospectively rated, i.e. their actual loss experience plays a large role in determining their ultimate price for the coverage period. Others have initiated lines of credit that allow them to draw on funds after an incident if existing reserves are inadequate to finance losses. CIS pooling programs have a retrospective feature in that contributions and other revenue in excess of losses and operating costs remain in the pool to be used in ways that benefit the contributing members.


Risk Retention, Risk Sharing, Risk Transfer The degree to which risk retention is attractive to a public entity is related to the control that the government can exert over the risk; the level of predictability associated with that risk; and the entity’s financial capacity to both bear the risk and to withstand variations from the expected. As an entity reviews whether to retain or pool risk, the following considerations are relevant: The cost of financing options Your pool contribution is based on estimates of average expected losses to be paid out, the cost of adjusting and settling claims that give rise to those losses, and other operating expenses. Pool members protect one another by smoothing the impact of large losses on individual members. Since an individual entity’s contribution will reflect its share of the entire group’s loss experience, the contribution may, or may not, track closely with its own loss expectations. A judgement has to be made about the value of this protection and the likelihood that the entity may incur large losses. The quality and value of services offered...
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