Introduction (Ashby, 2017). Proposals Risk financing approach: Focuses

Introduction

 

As instructed by DEF plc’s Board, the
objective of their risk management initiative is to reduce the annual insurance
cost over the course of three years.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!


order now

 

Before setting this objective, it is assumed
that the company completed the first two key steps of the risk management
process. First, the identification
of the relevant risks to which they are exposed. Then, the assessment of two types of losses: attritional and non-attritional.
Considering that their business is based on the operation of a motor fleet and
the fact that in motor insurance losses tend to be more frequent than severe,
DEF plc’s priority is the reduction of the annual cost of attritional losses.

 

Moving forward to the risk control strategy,
wherever there is risk, some form of risk financing or risk transfer is
required to deal with the related financial impact (Ashby, 2017). Following the
guideline of the initiative, the subsequent proposals will analyse and evaluate
some risk financing and risk transfer approaches and recommend a combination
that is suitable for the company.

 

For interpretation purposes, please refer to
the following definitions:

 

–  Risk Management, according to the International Risk
Management Institute (2017) “is the practice of
identifying and analysing loss exposures and taking steps to minimize the
financial impact of the risks they impose”. Furthermore, in an insurance
context, it entails the process of anticipating and dealing with risk and
uncertainty in a formal way (Ashby, 2017).

 

–  Attritional Losses, is a term used to label a non-catastrophe
loss event (Association of Lloyd’s Members, 2017). In other words, are
expected losses associated with ordinary operations, naturally of low severity
and high frequency. Because of their size, they are usually retained by the
insurer and not passed on to the reinsurer (Munich Re, 2010).

 

–  Risk financing and risk transfer, are risk control tools used by
organisations. Although, they are two different strategies, commonly they do
not exist in isolation and are both part of the organisation’s broader risk
management activities (Ashby, 2017).

 

Proposals

 

Risk financing approach: Focuses on ensuring that funds will be available to deal
with the financial consequences of a risk event.

 

1. Using cash-flows to finance expected
losses (pre-loss unfunded risk financing)

Unfunded mechanisms appear as the default
option for risk financing. When nothing is planned to face the potential
aftermath of losses, then, the regular cash-flows of the company are the
obvious route to obtain the necessary funds.

 

However, in cases where the probability
and/or impact of the expected losses is quite small, a company can deliberately
choose to take this path. In lines of business where substantial historic data
is available and conditions are constant year on year, a company can predict a fairly
accurate expected yearly loss amount and accordingly price and budget those attritional losses.

 

Based on the
above, DEF plc could rely on the claims history and recorded information
available from both, the motor industry and their own experience. Once this
analysis is completed, the company should increase the income side of the
annual accounts to accommodate those expected losses, considering them as part
of the regular operation costs and avoiding additional expenses such as
contingent capital or credits.

 

1.1.  Advantages

With
this alternative, the organisation will bypass extra expenses, such as
insurance premiums or funding costs, which usually have to be paid up-front.
Financing the loses with the company’s own cash-flows will result in total
funds disbursed being very close to the actual amount of the losses incurred. Furthermore, the
funds will be used only if needed and when needed, avoiding the “waste” of
money in case of a neat loss record.

 

The
risk perception and appetite of the organisation’s stakeholders will determine
the importance of saving up-front or in the future. Provided that the
organisation complies with the corresponding governance and regulatory codes,
they have entire liberty to use the funds at hand in their best interest (Ashby, 2017).

 

1.2.  Disadvantages

One of
the main inconveniences of unfunded risk financing, is the fact that the
company has limited resources to face losses. When these become greater than
the income, then, the organisation might find itself insolvent or even bankrupt (Ashby, 2017). Insolvency is
likely to lead the organisation to extra financial costs and charges, in
addition to potential rating downgrades and regulatory penalties. Even though
bankruptcy is a way of stopping the aforementioned insolvency extra costs, it
usually results in a significant reduction of the company’s value or disposal
much below book value.

 

Furthermore,
an organisation relying uniquely in cash-flows to finance losses, will be
affected by the fluctuation of its income and expenditure. Even if they manage
to avoid insolvency, an inaccurate estimate or budgeting of expected losses
will reduce the surplus income, having an immediate effect on the efficient
functionality and future of the organisation.

 

Another
downside of unfunded risk financing, is the possible adverse reaction of the
stakeholders after a loss event. Despite avoiding insolvency, bankruptcy or
major disturbances to the cash-flows, the organisation’s risky approach and
appetite might encourage stakeholders to “charge” more for their engagement or
even terminate their relationship entirely (Ashby, 2017). 

 

2. Allocating pre-tax reserves (pre-loss
funded risk financing)

Funded mechanisms are used, by organisations
who decide to retain the financial impact of loss events, to accumulate or
facilitate access to cash. Allocating reserves is one of the most
straightforward funded financing technics. Where the company retains a share of
the profits generated in “good” years as cash reserves to be used in funding
future losses (Ashby, 2017).The
cash can be accumulated for a particular risk event or merely as a contingent
fund against unexpected losses.

 

It is fundamental for the reserves to be kept
securely and as liquid as possible, allowing the organisation an expedite
disposal of the funds. While holding cash in a bank account grants
instant access to the funds, the little interest gained and erosion of the
value over time, might outweigh the benefit of this instant access. On the
contrary, investing in low-risk instruments will aid the
organisation to offset the effects of inflation and even in some cases obtain
some profits.

 

Based on the
above, DEF plc could generate an accounting provision to allocate the reserves
more efficiently. By recording them as a cost item in the profit and loss
statement, they will avoid reductions in the form of corporation taxes.
However, it is important to consider the jurisdiction, as for instance in the
UK, general provisions are not always tax-exempt. When invested adequately,
these reserves, might even generate a slight gain for the organisation.

 

2.1   Advantages

Similar
to unfunded risk solutions, when allocating reserves, funds are instantly
available for disbursement and usable for almost every purpose. Furthermore,
the reserves serve as a primary source of funding in case of a loss, leaving
the cash-flows as the last resource and reducing the probability of insolvency,
bankruptcy or disruption to the efficient operation of the organisation.

 

Also,
these reserves can be invested in several financial tools delivering an extra
income for the organisation.

 

The
assurance that funds to face the financial consequences of future losses, are
allocated beforehand, will increase the stakeholder’s confidence in the
company. Exhibiting greater preparedness against attritional losses, will
certainly be rewarded by stakeholders in various ways, from creditors offering
lower interest charges, to attraction of better talent or even an increase in
the market value of the organisation (Ashby,
2017). 

 

2.2   Disadvantages

When an
organisation decides to retain the risk, it should consider the costs related
to the losses that will have to be covered. Expenses such as claims handling
and adjusting, experts’ fees or legal costs might outweigh the benefits of
holding reserves.

 

There
is no certainty on the occurrence or severity of loss events. Therefore, even
when the loss analysis, pricing and budgeting are carried out properly, it is
always complex to build up the appropriate level of reserves (OECD, 2015). If the funds are insufficient,
then the company is exposed to insolvency or bankruptcy. On the contrary, if
the reserve is larger than required, then, the long-term opportunity costs
associated to the funds will increase, leaving aside more profitable ventures
such as research and innovation or development and growth. 

 

Risk transfer approach: Involves ceding the risk to a third party. This cession
might occur in two ways: transferring only the financial impacts or
transferring the financial and non-financial impacts of the risk event (Ashby, 2017).

 

3. Insurance (pre-loss)

Insurance is the most common risk transfer
mechanism, offering protection against the adverse effects of various risks.
Under a contractual agreement, the insured cedes whole or part of the risk, to
the insurance company, in exchange of a premium. Then, the insurance company is
bound to pay the losses upon occurrence of circumstances specified beforehand
in the contract.

 

Frequently, insurance is considered more as a
risk-sharing mechanism, with the insured retaining part of the risk. This
retention can take different forms, such as deductibles and coinsurance or
simply as a contractually agreed percentage of the risk. The fact that the
insured is willing to share part of the financial effects of a loss, will have
a positive impact in the pricing of the policy.

 

Insurance companies usually offer a range of
“additional” services whose costs are already included in the premium. Their expertise
in risk evaluation, assessment and mitigation can be of assistance to the
policyholder when developing its risk management strategy. Transferring to the
insurer activities like loss adjusting or legal services, can also be cost
effective for the insured. 

 

Motor has become one of the most prolific
lines in the insurance industry. With more than 20 million households acquiring
motor policies in the UK every year (Association of British Insurers, 2017), it offers different
options depending on the customer’s needs. The main types of motor insurance
are:

a)  Third party liability (legally required in
the UK).

b)  Third party, fire and theft.

c)  
Fully Comprehensive Cover.

 

Certainly, the wider the coverage purchased
the higher the rate charged. Though, there are different payment schemes in
which the company can rely and avoid large upfront disbursements or even receive
bonuses in case the claims are minimal.  

 

Based on the
above, DEF plc is obliged to purchase an insurance policy. However, it is up to
them to decide the level of cover required, aside from the mandatory third
party. Since part of their business is the operation of a motor fleet, in
addition to determining the level of cover, they should also consider
purchasing insurance for “business use” (Association of
British Insurers, 2018).

 

3.1 Advantages

This alternative, is a source of funds that
entails lower cost of capital than most risk financing mechanisms. Purchasing
insurance, from trustworthy or highly rated insurance companies, will give the
organisation confidence that claims will be paid, consequently, allowing them
to reduce the reserves and decrease the opportunity costs incurred by funds
allocated as reserves.

 

Similar to funded tools, insurance will serve
as a safeguard to the company’s cash-flows against the financial impact of
possible losses. It will also assist in turning the volatility of risk into
certainty, hence, driving the organisation to an efficient operation and
lessening the exposure to insolvency and bankruptcy. Besides, insurance will
make the organisation more attractive to risk-averse shareholders. 

 

Another benefit is that insurance is
considered a tax-deductible expense, granting the organisation a “discount” on
the premium costs (Ashby, 2017).
Opposite to uninsured losses, which are deductible post-loss, the premium can
be deducted upon disbursement disregarding the occurrence of losses.

 

3.2 Disadvantages

Insurance can be expensive, especially for
small companies highly exposed or within industries where the claims record is
relatively high. Plus, where no losses occur, then, the premium paid can be
observed as a “waste” of funds.

 

Even when motor claims have a 98.4%
acceptance rate (Association of British Insurers, 2017) in the UK, the
possibility of insurers disputing claims is always latent. Furthermore, there
are cases where the claims handling takes such a long time, that the insured
has to use its own funds to finance the loss from the date of occurrence until
the claim is finally settled.

 

Insurance has a limited scope when it comes
to covering the outcome of risk events. While financial effects are very
important, there are some other non-monetary or intangible consequences that
should also be considered. For instance, damaging the reputation of a company,
could cause catastrophic drops in the market value, which will end up being
more expensive than the tangible cost of the loss.

 

4.  Service
Contracts (pre-loss)

Service contracts are an alternate solution
to more conventional risk transfer tools, where a third-party provides a
certain service to the organisation. Besides, these contracts may also cover
the non-financial impact of risk events.

 

There are several types of contracts,
depending on the scope and duration, they can be simple service contracts like
electricity or long-term outsourcing agreements for certain segments of the
company’s operation.

 

Outsourcing is usually used by large corporations
in an attempt to reduce the staff, bureaucracy or operation costs. On the other
hand, small and medium organisations can use service contracts to facilitate
their expansion or productivity specially when highly trained staff is pricey
or hard to find. It is important that the contracts clearly determine the
limit of the supplier’s liability to avoid possible future disputes.

 

Based on the
above, DEF plc could outsource training and education on safer driving for the
operators, in order to reduce collision rates. Hiring a specialised third party
to provide these services will allow the organisation to develop an on-road
safety culture which will in turn reduce the ultimate attritional claims cost (Margerison, 2013).

 

4.1 Advantages

Outsourcing
allows custom-made risk transfer. Similar to insurance contracts, the
organisation is able to pass-on the desired risks only.

 

Since
most specialised service providers intend to offer competitive prices to
outweigh costs of in-house functions, they use economies of scale to grant
better prices than those ones resulting from the organisation’s in-house
functions. This “premium free” risk transfer can result in savings or expense
reductions, facilitating cost-effective growth and productivity (Dan Burge,
2012). As long as the quality control is
maintained, this risk transfer solution offers outstanding return on
investment.

 

Additionally, transferring risk
through service contracts, will result in fewer losses affecting the company
directly. Once the risk is transferred to the supplier, then the aftermath of
the risk event is also transmitted.

 

4.2
Disadvantages

Outsourcing
certain activities will undoubtedly create new risks, which in the end can
overshadow the benefits obtained through risk transfer.

 

By
losing control of the way in which the service is provided, the organisation is
subject to new threats. Service providers might not comply with the expected
quality standards or have inappropriate risk management strategies, exposing
themselves to insolvency or bankruptcy (Ashby, 2017).

 

When
engaging in a service contract, the organisation should always consider
possible interferences in the provider’s continuity. Service providers failure
may be fatal for companies excessively relying on a crucial outsourced supply (Dan Burge, 2012). In addition, the
costs of replacing the supplier with a new solution might result in extra
expenses for the organisation.

 

Ultimately, failures in the outsourced
service may cause enormous reputational damage to the organisation.

 

Recommendation

After
outlining and evaluating four different alternatives, one can become aware that
there is no optimal combination of risk financing and risk transfer. With all
these strategies having benefits and disadvantages, no reliable method can determine
if an alternative is better than other. It strongly depends on the
organisation’s risk management team to define the most suitable combination
considering the company’s risk appetite, approach and strategy.

 

There
are four key elements that should be considered when deciding the best
combination for the organisation:

a)    Availability

Not all
risk financing and transfer alternatives are always accessible for
organisations. Depending on their size and the risks to which they are exposed,
an organisation can have some limitations when searching for options.

 

Currently,
the four alternatives are available for DEF plc. Unfunded solutions, such as
cash flows, might appear to be the easiest to obtain since they depend entirely
on the company. Conversely, to achieve risk transfer, the organisation requires
a third party or supplier.

 

For the
operation of a motor fleet, insurance is not only available but mandatory. With
many providers in the market, it is up to DEF plc to decide the scope and price
of the policy. Likewise, service contracts for safe-driving training are pretty
much accessible with a wide range of offers.

 

b)    Cost

If all
other things were to remain constant, then, the organisation would probably choose
the lower-cost alternative. However, DEF plc shall consider not only the price
of the solution but also the opportunity cost incurred, when selecting such
alternative.

 

Financing
solutions might appear to be the cheapest, with cash-flows and reserves being
“free” of extra charges. But then again, the lack of preparedness against
unexpected losses aside with the forfeited earnings of investing those funds
elsewhere, might result in a significant opportunity cost.

 

On the other hand, risk transfer has a minor opportunity
cost, lessened by actions like the release of reserves and investment of those
funds in more profitable ventures. Still, premiums or service fees need to be
paid regardless of the occurrence of losses. The additional services offered by
insurance companies and included in the premiums, can compensate the disbursement
of funds and appear as particularly cost-effective solutions for organisations