Risk managers create value through a host of prevention, reduction, enablement and enhancement projects. Yet despite their best efforts, undesired losses and inadequate return on investments do occur. Even when the desired speculative outcomes result, the projects must be funded. So financing these outcomes is a realistic component of a comprehensive risk management portfolio containing both risk control and risk financing components.
One of the most common risk financing techniques is retention, or the self-funding of losses. Risk retention is the preferred risk financing method when the loss values are relatively low. An important advantage of using retention is that it encourages the organization to adopt loss prevention projects, thus reducing the total cost of risk. There are five common categories of retention:
Current expensing. This is appropriate when the probability of loss and the expected loss value is relatively low. Relatively small speculative project costs are also expensed on the current income statement. That is, these small costs are not material to the organization's liquidity. Many firms have a special fund set aside to pay these little investments or claims (current expense funds). The expense of these losses is taken as a tax-deductible expense on the income statement.
Borrowing. When slightly larger projects or losses (but still with low probabilities) occur, the preferred risk financing method is borrowing. There are typically two methods to obtain cash to pay for these losses. First, for a nominal fee, the firm can obtain a letter of credit from a bank or other financial institution that promises to provide cash if certain contingencies occur. Second, the firm can issue bonds to obtain cash to rebuild a building or finance other assets. In either case, the firm should proactively set up this risk financing plan before any losses occur. This helps to obtain the lowest possible interest rate on the borrowed money. Note, however, that this financing method ties up a firm's ability to borrow should other speculative projects arise.
Reserving. The reserve is a claim on assets for future expected losses or project costs. Reserves are appropriate when the loss values are low but the likelihood of loss is medium. This method informs users of the financial statements that these losses are expected. To set up a reserve, the firm places an appropriate amount (usually the expected value of loss plus a certain multiple of the standard deviation) on the right-hand side of the managerial balance sheet. With an unfunded reserve the claim can be paid for by liquidating any of the firm's assets. This permits the firm to use the assets for projects, but it usually also means an asset must be liquidated at sub-optimal value. With a funded reserve, the claim is paid for with an ear-marked asset. The challenge with these funds is that they must remain liquid and out of the reach of other executives who may have other plans for the resource.
State qualified self-insurance plan (SIP). Some states permit firms to set up this special form of a funded reserve. The regulations for these schemes are different in every state. A risk manager should consult with an expert if interested in this idea. Sometimes used for financing a firm's workers compensation statutory obligations, state qualified SIPs require the firm to file an application, provide evidence of adequate financial resources and comply with various reporting rules.
Captives. There are two basic types of captives: single parent and group. A "single parent captive" is a subsidiary owned entirely by the parent. A single parent that only provides risk financing for the parent is called a "pure captive." These may be used to provide a front to the reinsurance market, as a means to front through an admitted insurer, or various other reasons. The contribution to a pure captive is not a tax deductible expense. A "broad captive" is owned by a single parent but also sells indemnity contracts to participating firms. In contrast, a "group captive" is owned by multiple firms and therefore usually meets the IRS rules for accounting for the contributions as tax deductions. Some other captive forms are owned or administered by agents or brokers. Some firms participate in captives because they believe their underwriting experience is superior to the market. Consequently they believe the captive will be a profit center. As long as the captive manager is diligent and efficient (and not to mention lucky) in underwriting, adjusting, investing and all the other usual functions of insurance, then profits are possible. But a significant disadvantage of captive financing is that, unlike a Lloyd's association, the participating names do not have unlimited personal liability so the captive could go bankrupt.
James Kallman, Ph.D., ARM, is the owner of Kallman Consulting Services. He writes materials for and teaches RIMS Fellow in Risk Management courses and is a professor of risk management at the International School of Management and at Kaplan University.
