This post discusses alternative risk financing and non-traditional financing options.

RISK FINANCING AND RISK FINANCING TECHNIQUES

Risk financing entails efforts and plans of an organisation to pay for loss or finance its risk exposure if it crystallised. Risk financing focuses on funding and monitoring an organisation’s risk exposures. Hence, it is suitable for organisations to have a good risk finance technique to fund organisational loss before its occurrence. There are two categories of risk financing techniques: risk retention and risk transfer.

RISK-RETENTION

Risk retention (also known as retained risk) refers to accepted or retained risks, consciously or unconsciously, by an organisation. Risk retention is a financing technique to generate funds within or outside a firm to pay for or finance losses the organisation retains. There are two types of risk retention: 

1. Active or planned retention, and 

2. Passive or unplanned retention.

FUNDING OF RETAINED RISKS

Funding of losses arising from retained risks (i.e., risk retention). There are three methods through which organisations could fund or pay for losses that arise from retained risks: 

1. Pre-loss funding: This is a way of funding retained risks where a fund is budgeted aside to take care of retained risks before a loss or loss occurs.

2. Current loss funding: Current loss funding refers to situations where no fund is budgeted to take care of retained risks, but a fund is generated after a loss to finance the loss or make good the loss.   

3. Post-loss funding: This is a way of funding retained risks where a loss is paid after a loss using borrowed funds or some other method of raising funds to finance retained risks when they crystalise.

This implies that retained risks can be financed internally and externally within and outside a firm. There are two ways of funding retained risks: 

1. Funded retentions; and 

2. Unfunded retentions.

Funded Retentions

Funded retentions are retained risks, and active retentions are budgeted for in the company’s budget. Funded retentions are active retentions. Funds are budgeted to finance funded retention, and an arrangement is made before the loss to fund retained losses. Consequently, there is a pre-made arrangement for the financing of funded retentions.

Unfunded Retentions

Unfunded retentions are passive and unintentional retentions without pre-arranged funding. Unfunded retentions are retained risks that are passive and unintentional retention budgeted for by individuals, households and organisations. With unfunded retentions, the fund is not set aside or pre-arranged to fund or finance retained losses. The fund is set aside to pay unfunded retentions before the loss.

RISK TRANSFER

Risk transfer entails transferring risk or shifting the financial consequences of a loss to another party through insurance and non-insurance techniques. Let us discuss the transfer of business risks through insurance and non-insurance techniques.

INSURANCE

Insurance is a funded risk transfer mechanism that facilitates the transfer of financial consequences of specified loss exposures from one party (known as the insurer) to another party (known as the insurer) in exchange for a premium payment. See the post on insurance.

NON-INSURANCE RISK TRANSFER

Non-insurance risk transfer is a risk financing technique that facilitates the transfers of all or part of the financial consequences of losses to another party other than an insurer. There are two primary forms of non-insurance risk transfer which are:

1. Hold harmless (indemnity) agreements, and 

2. Hedging.

HOLD-HARMLESS AGREEMENTS

A hold-harmless agreement, also known as an indemnity or no-fault agreement, is a contract whereby a party (known as the Indemnitor) agrees to undertake the liability of another party (known as the Indemnitee) due to the occurrence of specified events. Hold-harmless agreements are suitable for more than one party working together on a project or providing services to another party.

HEDGING

Hedging is a financial instrument through which one asset is held to offset the risk associated with another asset. Hedging is a financial instrument that is aimed at reducing the expected loss. By hedging a risk, an individual and organisation minimise risk and losses in times of uncertainty. Hedging can be applied to any business transaction or undertaking to reduce risk and ensure financial security. Hedging works based on assuming the worst-case scenario for a set time to reduce the possible loss.

A derivative is an effective form of hedging, and the main types of derivatives include:

1. Forwards, 

2. Futures, 

3. Options, and 

4. Swaps.

ALTERNATIVE RISK FINANCING AND NON-TRADITIONAL OPTIONS

Business organisations can use several alternative risk financing techniques and products to mitigate and transfer risk beyond the traditional insurance risk transfer technique. 

There are two broad categories of alternative risk financing products: 

1. Alternatives to insurance companies, and 

2. Alternatives to insurance products.

ALTERNATIVES TO INSURANCE COMPANIES

Alternatives to insurance companies is an alternative risk financing techniques provided by organisations and institutions other than insurance companies. These are alternative risk financing, other than insurance policies. There are different types of alternative risk financing for insurance companies. Examples of alternative risk financing for insurance companies include 

1. Self-insurance, 

2. Insurance pools, 

3. Captive insurers, and 

4. Risk retention groups.

SELF-INSURANCE

Self-insurance is an effective alternative to insurance companies in managing risk. Self-insurance is a strategy for saving cash flow and creating an insurance plan against future losses. Self-insurance entails setting aside funds to finance a risk or pay for a possible loss rather than insuring the risk with an insurance company. Self-insurance works the same way as insurance. 

However, self-insurance allows individuals, households, and organisations to control their risk management by managing and financing their risk exposures. Self-insurance is an alternative to purchasing an insurance policy by individuals and organisations. Self-insurance enables a firm to retain an eligible risk while designating money to compensate for potential losses. Self-insurance does not mean an organisation has not or will not take up or purchase an insurance contract from insurers.

INSURANCE POOLS

Insurance pools are an extension of self-insurance. A group of insurers and reinsurers creates insurance pools to combine resources to underwrite one or more specialised risks. An insurance pool consists of insurance companies (with similar risk profiles within a sector and geographical location) who have agreed to share the profits and losses of the pool based on joint liability arrangements. 

Insurance pools benefit the insurance industry by enabling insurers to mobilise their expertise and capabilities to undertake significant risks beyond individual insurer capacity. For example, insurance companies may form an insurance pool to provide flood or earthquake insurance coverage in flood and earthquake-prone areas. 

The insurance pool’s specialisation might be on a class of business (e.g., automobile, marine, aviation and liability pools) and an event (e.g., flood and natural catastrophic risk pools). Members of the pool will contribute premiums to a fund and administer the pool. Surplus funds may be reinvested into the pool or shared among member companies at the members’ discretion.

CAPTIVE INSURER

A captive insurer is an insurance company owned and controlled by an organisation or group of companies. A captive insurer is an insurance company established by a non-insurance parent company to insure risks of the parent and sister companies. This is the basic form of a captive, but a captive can also insure firms’ risks outside its group of companies. A captive insurer protects its owner, who enjoys paying lower premiums and benefits from the underwriting profits. See the post on captive insurance.

RISK RETENTION GROUPS

Risk Retention Groups are like multi-owner captive insurance companies or self-insurance groups. Companies with similar risk management objectives form risk retention groups or risk groups. Risk-retention groups are liability insurance companies owned by their insureds (who have engaged in a similar business or been exposed to similar risks). Risk-retention groups are licenced under the Liability Risk Retention Act of 1986, which permits the insurance company to insure members in all states within the United States of America. 

The primary purpose of the risk retention group is to continuously improve risk management among members of companies by understanding their risk exposures, capacities, strengths, and vulnerability. Risk retention groups enjoy several benefits, including members’ ability to control their programmes, coverage at affordable rates, and direct access to reinsurance markets. Risk retention groups cannot underwrite certain risks, including employer’s liability and loss from personal or household responsibilities.

ALTERNATIVES TO INSURANCE PRODUCTS

There are alternatives to insurance products. Many alternative methods to insurance products are products and instruments of the capital markets. Studies have shown that the global capital markets are far beyond the insurance markets. The world’s capital markets are generally diverse enough to handle the risk of natural disasters without drastically increasing prices. There are several alternatives to insurance products. Many alternative methods to insurance products are products and instruments of the capital markets. 

Alternatives to insurance products include:

1. Credit securitisations, 

2. CAT bonds, 

3. Weather derivatives, and 

4. Finite risk products.

CREDIT SECURITISATIONS

Credit securitisation is a process of borrowing money to finance assets. Credit securitisation typically involves lending funds to buy or refinance an existing outstanding loan, typically secured by property or equipment. Financial institutions and other asset-holders use credit securitisation to protect their interests in an asset when purchased or sold. 

The objective is to provide the borrower cash during acquisition and reduce or eliminate outstanding debts with new equity capital. The collateral used for this purpose may include first-lien or business property (sometimes known as commercial real estate). The process of acquiring new credit is often complicated and time-consuming. Hence, credit securitisations can be used to stabilise and expand credit lines.

CATASTROPHE BONDS

Catastrophe bonds are debt instruments insurance and reinsurance companies use to raise funds for and spread risks associated with natural disasters or catastrophic events such as hurricanes, earthquakes, and tornadoes. Catastrophe bonds, also CATS bonds, are risk-linked securities that transfer specified risks from the issuer to the investors. They are usually structured as corporate bonds whose principal repayment is forgiven if certain specified trigger conditions are met. 

Catastrophe bonds are used to fund events with high severity and low frequency. The bond issuer will only receive funding from the bond if a pre-specified natural disaster (e.g., earthquake, flood, and tornado) occurs. Hence, catastrophe bonds are event-linked securities insurance companies use to raise funds after a natural disaster to finance a pre-specified catastrophic event. CAT bonds have a short maturity period of between three to five years. Hedge funds, pension funds, and institutional investors are the primary investors in catastrophe bonds.

WEATHER DERIVATIVES

Weather derivatives are financial instruments companies can use as a risk management strategy to reduce the risk associated with adverse or unexpected weather conditions. Weather derivatives are designed to compensate companies for lost revenues arising from unseasonable temperatures. Weather derivatives are suitable for hedging against the risk of weather-related losses.

A weather derivative contract consists of two parties (seller and buyer) whereby the seller agrees to bear the risk of disasters in exchange for a premium paid by the buyer. If no damage occurs within the contract period, the seller will make a profit. Still, if an unexpected event or adverse weather occurs, the buyer of the weather derivative will claim the agreed amount.

FINITE RISK PRODUCTS

Finite risk products are insurance products with relatively low payout and high expected complexity. Unlike typical insurance contracts with 12 months, finite risk insurance products have a longer-term – say, ten years. A Finite risk product (FRP) is an insurance product in which the risk of loss is limited to a specified amount, with a fixed payout amount when the risk crystallised. 

Finite risk products are a type of risk management strategy in which the rewards are limited and known in advance. The concept of a “finite risk product” is straightforward. It is a product or service with a high likelihood of failure, typically with a low expected value. For example, the most popular financial product is a credit card. A credit card is finite because if a customer does not pay off the balance in full each month, the company will retain the money and possibly force the customer to pay more interest.

See the full video on Alternative Risk Financing & Non-traditional Financing Options: https://youtu.be/yczU7EsshrU