Fall 2008 Version Professor Dan C. Jones FINA 4355 Handout.
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Transcript of Fall 2008 Version Professor Dan C. Jones FINA 4355 Handout.
Fall 2008 VersionFall 2008 Version
Professor Dan C. Jones
FINA 4355
Handout
Risk Management and Insurance: Perspectives in a Global EconomyRisk Management and Insurance: Perspectives in a Global Economy
13. Internal Loss Financing 13. Internal Loss Financing ArrangementsArrangements
Professor Dan C. Jones
FINA 4355
Handout
3
Note to the ProfessorNote to the Professor
There are two sections which add discussions (or figures) to the book.
One is about rent-a-captive and protected cell company.
The other is about contingent capital as an ART technique.
4
Study PointsStudy Points
Motivations for internal loss financing
Self-insurance
Captive insurance companies
Other ART techniques
5
Internal Loss Financing ArrangementsInternal Loss Financing Arrangements
UnplannedThe firm is unaware of the loss exposure.
PlannedInformal
The firm makes no special arrangements to finance losses (internally)
Formal
Self-insurance
Captive insurance We cover mainly self-insurance and captive
insurance in this chapter.
Motivations for Internal Loss Financing
7
MotivationsMotivations
Stronger control of risk management programEven when transferring residual risks to an insurance company, the firm may benefit from:
Greater bargaining
Broader and more uniform coverage
Less problems of coverage availability/affordability
Lower firm’s cost of riskLower administrative expenses
Avoid subsidizing others
Provide access to reinsurance
Grain tax advantages
8
MotivationsMotivations
Better cash flow control
Capture investment incomeWhen facing long-term loss exposures
When using a captive
Avoid inefficiencies with traditional insuranceCounterparty risk
Subsidizing poor risks
Information asymmetry
Self-insurance
10
Self-insuranceSelf-insurance
Individual self-insurance
Group self-insurance
11
Risk AnalysisRisk Analysis
The self-insured borrows several key techniques used by insurers.
But, self-insurance is not a solution to every risk. Candidate risks may include:
Exposures exhibiting both low frequency and severity
Exposures reasonably expected to exhibit high frequency and low severity
A large number of exposure units is desirableA self-insured firm still faces the problem of possible correlation among loss exposures.
12
Risk Analysis – Reliability AnalysisRisk Analysis – Reliability Analysis
CaseA manufacturer examines its exposure to workplace injuries.
The number of injuries has been 10 percent of the number of employee years.
Willing to self-insure these injuries, if a minimum of 95% of the injuries does not exceed 125% of the expected value.
Workplace injuries commonly follow a pattern typified by a Poisson distribution
Using the central limit theorem, we approximate the Poisson distribution via a normal distribution. Hence, using a 95% confidence interval, we get 433 as the number of full-time employees during a year – the number the firm needs for self-insurance.
Pages 324-325
13
Risk Analysis – Setting ReservesRisk Analysis – Setting Reserves
Maintaining financial solvency is critical even in self-insurance
Factors to be examinesLoss development factor
Exposure factor
Trending factor
Table 13.1You may not agree with
these factor classifications.
14
Estimation of Loss Reserves Estimation of Loss Reserves (Table 13.1)(Table 13.1)
15
Use of Self-insurance – the U.S.Use of Self-insurance – the U.S.
Commercial liability risks
Group health plans
Workers’ compensation benefits
16
Third Party Administrator Third Party Administrator (Figure 13.1)(Figure 13.1)
17
The Future of Self-insurance The Future of Self-insurance (Table 13.2)(Table 13.2)
Captive Insurance
19
BackgroundBackground
Captives are not new to risk management and insurance professionals.
However, not until the 1960s did several pioneers flight the resistance of established commercial insurers and persuade many U.S. corporations to create their own insurers.
Captive insurance has become a significant market force internationally
More than 90 percent of the top 500 U.S. firms own a captive.
The share of the global captive insurance market by 2,500 world’s largest firms was 80% in 2001
20
BackgroundBackground
Captive insurance use is not limited to the private sector.
Captives exert a disproportionate influence on the commercial insurance market.
Captives also are a result of the growing instability and unpredictability of modern economic activities.
21
Definition and ClassificationDefinition and Classification
DefinitionA closely held corporation whose insurance business is supplied primarily by its owner(s) and in which the owners are the principal beneficiaries.
Differences from traditional insurerOwnership and management controlScope of operation
ClassificationSingle-parent captiveGroup (association) captiveRent-a-captiveProtected cell companies (sponsored captives)
22
Single-parent Captive Single-parent Captive (Figure 13.2)(Figure 13.2)
23
Group CaptiveGroup Captive
Organizations using it typically exhibit the following traits:
Entities sharing common needs
Capital constraints
Business volume constraints
24
Group Captive Group Captive (Figure 13.3)(Figure 13.3)
25
Rent-a-CaptiveRent-a-Captive
Fronting Insurer
Client Firm B
Client Firm A
Client Firm C
RAC
Client Account A
Client Account B
Client Account CPremium/Insurance
Premium/Reinsurance
Segregated by contract and shareholders agreements
Not in the book!An illustration involving a fronting company (see
also Figure 13.5)
26
Protected Cell Company ArrangementProtected Cell Company Arrangement
Fronting Insurer
Client Firm B
Client Firm A
Client Firm C
PCC
Cell A
Cell B
Cell CPremium/Insurance
Premium/Reinsurance
Segregated by statutes
Not in the book!An illustration involving a fronting company (see
also Figure 13.5)
27
Risk Retention Group (RRG)Risk Retention Group (RRG)
A type of U.S. group captive created underThe Product Liability Risk Retention Act of 1981
The Liability Risk Retention Act of 1986
Unlike typical insurers, they need to be licensed in a single state only – by default, their domiciliary state – but can operate in all U.S. states.
Declining RRG marketsThe restriction of business to liability lines and the unavailability of state insurance guarantee benefits to their insureds.
A lack of uniform accounting standards, non-uniformity in RRG management standards
28
Use of Captive as a Risk Financing TechniqueUse of Captive as a Risk Financing Technique
Capital commitment and expensesSee Figure 13.4
See also Table 13.4
Risk of adverse results
Captive as a distraction
29
Captive Feasibility Study Captive Feasibility Study (Figure 13.4)(Figure 13.4)
There are two typos in the figure (first printing of the book).
The third box on the left has “exiting,” which should be “existing.”
The fourth box on the left states “Is involving financial officer possible?” The correct one should
be “Is involving a financial officer possible?”
The corrected figure is made availablein the next page.
30
Captive Feasibility Study Captive Feasibility Study (Figure 13.4)(Figure 13.4)
Turnover greater than £50 million?Yes
Does the premium spending exceed £1 million for property, £500,000 for general liability, £1 million for motor liability, or £1 million for other liability?
Does existing or planned risk retention exceed £1 million for property, £500,000 for general liability, or £1 million for motor liability?
Yes
Is involving a financial officer possible?Yes
Single-parent Captive
Can you accept the following indicative costs of £20,000 for feasibility study, £25,000 of annual operating cost, plus a minimum capitalization of £500,000?
Yes
No Conventional Insurance Market
or
If premium or retention amount exceeds £250,000 in any line, will you consider a cell captive in a protected cell company?
Yes
No
Is involving financial officer possible?Yes
Cell Captive
Can you accept the following indicative costs of £20,000 for feasibility study, £25,000 of annual operating cost, but without capitalization commitment?
Yes
Continue Feasibility Study
No
No
No
31
Captive Operational IssuesCaptive Operational Issues
Underwriting
Direct insurance and reinsurance
Captive reinsurance and fronting arrangements
Captive management
Selection of captive domicile
Tax situation
Corporate governance
32
Captive in a Fronting Arrangement Captive in a Fronting Arrangement (Figure 13.5)(Figure 13.5)
33
Number of Captives by Domicile Number of Captives by Domicile (Table 13.3) (Updated)(Table 13.3) (Updated)
34
10 Largest Captive Management Firms 10 Largest Captive Management Firms (Table 13.5 ) (updated)(Table 13.5 ) (updated)
Business Insurance (March 3, 2008)
35
Considerations in Selecting a Domicile Considerations in Selecting a Domicile (Insight 13.1)(Insight 13.1)
Quality of regulation and supervisionInvestment restrictionsMinimum capitalization requirementsPremium and other taxes and expensesUnderwriting restrictions and reserve requirementsReinsurance restrictionsReporting requirementsTax relationship of domicile with home country of the ownerCurrency stability and convertibilityQuality of local infrastructurePolitical and economic stabilityQuality and ease of transportation and communications
36
The Tax SituationThe Tax Situation
Conditions for tax deductibility of premiumsThe captive assumes underwriting risk.
Risk distribution is present.
The captive operates according to accepted industry practices.
37
Captive Corporate GovernanceCaptive Corporate Governance
The Sarbanes-Oxley Act
The captive must be managed based on a well-established code of ethics. The code governs the scope of responsibilities and authority of the board and its members.
The board of the captive bears the responsibility for overseeing sound captive operations.
The board bears the responsibility for financial reporting according to the laws governing the captive. The responsibility includes appointment of an auditor or an auditing committee as well as oversight of the auditing process.
Other ART Techniques: Contingent Capital
Not in the book!
39
FundamentalsFundamentals
Contingent capitalSimply, an option to issue a corporate security
Contingent capital facilityRight to issue new debt, equity or structured security
During a specified period
At a predefined issue price
On the occurrence of a triggering event
Unexpected & substantial loss by the right holder
High correlation between the loss exposure and the price of the security
40
Contingent Capital - ElementsContingent Capital - Elements
UnderlyingDebt, equity or hybrid security defined at the beginning of the option period; that is, before the security is issued
Tends to be deeply subordinated debt or preferred stock
TenorLimited duration; for example, right to issue five-year, fixed rate subordinate debt at any time during the next three months
41
Contingent Capital - ElementsContingent Capital - Elements
Intrinsic value (strike price)Usually at-the-money at inception; that is,
Price set prior to loss realization
Value tied to the price of the underlying on the date of contingent capital negotiation
Cost-of-capital difference between
[1] One under the arrangement and
[2] The other in the open market at the time of exercise
No option exercise if [1] > [2]
42
Contingent Capital - ElementsContingent Capital - Elements
Exercisability – dual triggers
The underlying with a greater-than-market value and an objectively defined loss event
First trigger usually American, thus giving the right holder to issue the securities at any time during the tenor period
Instead of loss, the second occasionally tied to a variable beyond the firm’s influence, thus minimizing problems of moral hazard
Linking the firm’s negative earnings shock to the average industry earnings, for example
43
Contingent Capital - ElementsContingent Capital - Elements
PlacementCommonly a private placement with a (lead) option writer
Until exercise, the writer collects a periodic commitment (premium) until the facility is exercised
On exercise and in case of a put option, the writer gets a security in return for the (cash) payment to the owner of the facility
Compare it with an insurance contract!
44
Committed Capital Facility ExampleCommitted Capital Facility Example
Insurer
Purchase the option, pay the premium until exercise
SPVPrior to exercise, holds capital,
say, commercial papers
On exercise by the insurer, liquidate its own securities to
purchase, say, preferred stock issued by the insurer
Investors
Put Option CommitmentFee/Premium
CashIssue
Securitiesw/
Collateral
Investment
Coupon + Premium
Trust
Discussion Questions
46
Discussion Question 1Discussion Question 1
Other than the involvement of a third party, can we argue that self-insurance and traditional insurance are virtually identical? What bases of arguments for or against this statement can you provide?
47
Discussion Question 2Discussion Question 2
Do you believe it is necessary for very large, well diversified MNCs to purchase excess insurance over their self-insurance limits?
48
Discussion Question 3Discussion Question 3
Why might a widely held corporation utilize a captive even though it would not purchase commercial insurance if it had no captive?
49
Discussion Question 4Discussion Question 4
What types of exposures might a firm specifically want to avoid writing in its captive and why?
50
Discussion Question 5Discussion Question 5
Do tax laws in your country discriminate for or against captives or are they neutral toward them vis-à-vis commercial insurers? Vis-à-vis non-captive self-retention?