Introduction As instructed by DEF plc’s Board, theobjective of their risk management initiative is to reduce the annual insurancecost over the course of three years. Before setting this objective, it is assumedthat the company completed the first two key steps of the risk managementprocess. First, the identificationof 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 andthe 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 isrequired to deal with the related financial impact (Ashby, 2017). Following theguideline of the initiative, the subsequent proposals will analyse and evaluatesome risk financing and risk transfer approaches and recommend a combinationthat is suitable for the company. For interpretation purposes, please refer tothe following definitions: – Risk Management, according to the International RiskManagement Institute (2017) “is the practice ofidentifying and analysing loss exposures and taking steps to minimize thefinancial impact of the risks they impose”. Furthermore, in an insurancecontext, it entails the process of anticipating and dealing with risk anduncertainty in a formal way (Ashby, 2017). – Attritional Losses, is a term used to label a non-catastropheloss event (Association of Lloyd’s Members, 2017).
In other words, areexpected losses associated with ordinary operations, naturally of low severityand high frequency. Because of their size, they are usually retained by theinsurer and not passed on to the reinsurer (Munich Re, 2010). – Risk financing and risk transfer, are risk control tools used byorganisations.
Although, they are two different strategies, commonly they donot exist in isolation and are both part of the organisation’s broader riskmanagement activities (Ashby, 2017). Proposals Risk financing approach: Focuses on ensuring that funds will be available to dealwith the financial consequences of a risk event. 1. Using cash-flows to finance expectedlosses (pre-loss unfunded risk financing)Unfunded mechanisms appear as the defaultoption for risk financing.
When nothing is planned to face the potentialaftermath of losses, then, the regular cash-flows of the company are theobvious route to obtain the necessary funds. However, in cases where the probabilityand/or impact of the expected losses is quite small, a company can deliberatelychoose to take this path. In lines of business where substantial historic datais available and conditions are constant year on year, a company can predict a fairlyaccurate expected yearly loss amount and accordingly price and budget those attritional losses. Based on theabove, DEF plc could rely on the claims history and recorded informationavailable from both, the motor industry and their own experience. Once thisanalysis is completed, the company should increase the income side of theannual accounts to accommodate those expected losses, considering them as partof the regular operation costs and avoiding additional expenses such ascontingent capital or credits. 1.1.
Advantages Withthis alternative, the organisation will bypass extra expenses, such asinsurance 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 totalfunds disbursed being very close to the actual amount of the losses incurred. Furthermore, thefunds will be used only if needed and when needed, avoiding the “waste” ofmoney in case of a neat loss record. Therisk perception and appetite of the organisation’s stakeholders will determinethe importance of saving up-front or in the future. Provided that theorganisation 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. DisadvantagesOne ofthe main inconveniences of unfunded risk financing, is the fact that thecompany has limited resources to face losses. When these become greater thanthe income, then, the organisation might find itself insolvent or even bankrupt (Ashby, 2017). Insolvency islikely to lead the organisation to extra financial costs and charges, inaddition to potential rating downgrades and regulatory penalties. Even thoughbankruptcy is a way of stopping the aforementioned insolvency extra costs, itusually results in a significant reduction of the company’s value or disposalmuch below book value. Furthermore,an organisation relying uniquely in cash-flows to finance losses, will beaffected by the fluctuation of its income and expenditure. Even if they manageto avoid insolvency, an inaccurate estimate or budgeting of expected losseswill reduce the surplus income, having an immediate effect on the efficientfunctionality and future of the organisation.
Anotherdownside of unfunded risk financing, is the possible adverse reaction of thestakeholders after a loss event. Despite avoiding insolvency, bankruptcy ormajor disturbances to the cash-flows, the organisation’s risky approach andappetite might encourage stakeholders to “charge” more for their engagement oreven terminate their relationship entirely (Ashby, 2017). 2. Allocating pre-tax reserves (pre-lossfunded risk financing)Funded mechanisms are used, by organisationswho decide to retain the financial impact of loss events, to accumulate orfacilitate access to cash. Allocating reserves is one of the moststraightforward funded financing technics. Where the company retains a share ofthe profits generated in “good” years as cash reserves to be used in fundingfuture losses (Ashby, 2017).Thecash can be accumulated for a particular risk event or merely as a contingentfund against unexpected losses.
It is fundamental for the reserves to be keptsecurely and as liquid as possible, allowing the organisation an expeditedisposal of the funds. While holding cash in a bank account grantsinstant access to the funds, the little interest gained and erosion of thevalue over time, might outweigh the benefit of this instant access. On thecontrary, investing in low-risk instruments will aid theorganisation to offset the effects of inflation and even in some cases obtainsome profits. Based on theabove, DEF plc could generate an accounting provision to allocate the reservesmore efficiently.
By recording them as a cost item in the profit and lossstatement, they will avoid reductions in the form of corporation taxes.However, it is important to consider the jurisdiction, as for instance in theUK, general provisions are not always tax-exempt. When invested adequately,these reserves, might even generate a slight gain for the organisation. 2.1 AdvantagesSimilarto unfunded risk solutions, when allocating reserves, funds are instantlyavailable for disbursement and usable for almost every purpose.
Furthermore,the reserves serve as a primary source of funding in case of a loss, leavingthe 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 extraincome for the organisation. Theassurance that funds to face the financial consequences of future losses, areallocated beforehand, will increase the stakeholder’s confidence in thecompany. Exhibiting greater preparedness against attritional losses, willcertainly be rewarded by stakeholders in various ways, from creditors offeringlower interest charges, to attraction of better talent or even an increase inthe market value of the organisation (Ashby, 2017). 2.2 DisadvantagesWhen anorganisation decides to retain the risk, it should consider the costs relatedto the losses that will have to be covered.
Expenses such as claims handlingand adjusting, experts’ fees or legal costs might outweigh the benefits ofholding reserves. Thereis no certainty on the occurrence or severity of loss events. Therefore, evenwhen the loss analysis, pricing and budgeting are carried out properly, it isalways 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, ifthe reserve is larger than required, then, the long-term opportunity costsassociated to the funds will increase, leaving aside more profitable venturessuch as research and innovation or development and growth. Risk transfer approach: Involves ceding the risk to a third party. This cessionmight occur in two ways: transferring only the financial impacts ortransferring the financial and non-financial impacts of the risk event (Ashby, 2017). 3. Insurance (pre-loss)Insurance is the most common risk transfermechanism, offering protection against the adverse effects of various risks.Under a contractual agreement, the insured cedes whole or part of the risk, tothe insurance company, in exchange of a premium. Then, the insurance company isbound to pay the losses upon occurrence of circumstances specified beforehandin the contract. Frequently, insurance is considered more as arisk-sharing mechanism, with the insured retaining part of the risk.
Thisretention can take different forms, such as deductibles and coinsurance orsimply as a contractually agreed percentage of the risk. The fact that theinsured is willing to share part of the financial effects of a loss, will havea 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 expertisein risk evaluation, assessment and mitigation can be of assistance to thepolicyholder when developing its risk management strategy.
Transferring to theinsurer activities like loss adjusting or legal services, can also be costeffective for the insured. Motor has become one of the most prolificlines in the insurance industry. With more than 20 million households acquiringmotor policies in the UK every year (Association of British Insurers, 2017), it offers differentoptions depending on the customer’s needs. The main types of motor insuranceare: a) Third party liability (legally required inthe UK).b) Third party, fire and theft.c) Fully Comprehensive Cover. Certainly, the wider the coverage purchasedthe higher the rate charged. Though, there are different payment schemes inwhich the company can rely and avoid large upfront disbursements or even receivebonuses in case the claims are minimal.
Based on theabove, DEF plc is obliged to purchase an insurance policy. However, it is up tothem to decide the level of cover required, aside from the mandatory thirdparty. Since part of their business is the operation of a motor fleet, inaddition to determining the level of cover, they should also considerpurchasing insurance for “business use” (Association of British Insurers, 2018).
3.1 AdvantagesThis alternative, is a source of funds thatentails lower cost of capital than most risk financing mechanisms. Purchasinginsurance, from trustworthy or highly rated insurance companies, will give theorganisation confidence that claims will be paid, consequently, allowing themto reduce the reserves and decrease the opportunity costs incurred by fundsallocated as reserves. Similar to funded tools, insurance will serveas a safeguard to the company’s cash-flows against the financial impact ofpossible losses.
It will also assist in turning the volatility of risk intocertainty, hence, driving the organisation to an efficient operation andlessening the exposure to insolvency and bankruptcy. Besides, insurance willmake the organisation more attractive to risk-averse shareholders. Another benefit is that insurance isconsidered a tax-deductible expense, granting the organisation a “discount” onthe premium costs (Ashby, 2017).Opposite to uninsured losses, which are deductible post-loss, the premium canbe deducted upon disbursement disregarding the occurrence of losses. 3.2 DisadvantagesInsurance can be expensive, especially forsmall companies highly exposed or within industries where the claims record isrelatively high. Plus, where no losses occur, then, the premium paid can beobserved as a “waste” of funds.
Even when motor claims have a 98.4%acceptance rate (Association of British Insurers, 2017) in the UK, thepossibility of insurers disputing claims is always latent. Furthermore, thereare cases where the claims handling takes such a long time, that the insuredhas to use its own funds to finance the loss from the date of occurrence untilthe claim is finally settled. Insurance has a limited scope when it comesto covering the outcome of risk events. While financial effects are veryimportant, there are some other non-monetary or intangible consequences thatshould also be considered. For instance, damaging the reputation of a company,could cause catastrophic drops in the market value, which will end up beingmore expensive than the tangible cost of the loss. 4. ServiceContracts (pre-loss)Service contracts are an alternate solutionto more conventional risk transfer tools, where a third-party provides acertain service to the organisation.
Besides, these contracts may also coverthe non-financial impact of risk events. There are several types of contracts,depending on the scope and duration, they can be simple service contracts likeelectricity or long-term outsourcing agreements for certain segments of thecompany’s operation. Outsourcing is usually used by large corporationsin an attempt to reduce the staff, bureaucracy or operation costs. On the otherhand, small and medium organisations can use service contracts to facilitatetheir expansion or productivity specially when highly trained staff is priceyor hard to find. It is important that the contracts clearly determine thelimit of the supplier’s liability to avoid possible future disputes.
Based on theabove, DEF plc could outsource training and education on safer driving for theoperators, in order to reduce collision rates. Hiring a specialised third partyto provide these services will allow the organisation to develop an on-roadsafety culture which will in turn reduce the ultimate attritional claims cost (Margerison, 2013). 4.1 AdvantagesOutsourcingallows custom-made risk transfer.
Similar to insurance contracts, theorganisation is able to pass-on the desired risks only. Sincemost specialised service providers intend to offer competitive prices tooutweigh costs of in-house functions, they use economies of scale to grantbetter prices than those ones resulting from the organisation’s in-housefunctions. This “premium free” risk transfer can result in savings or expensereductions, facilitating cost-effective growth and productivity (Dan Burge, 2012). As long as the quality control ismaintained, this risk transfer solution offers outstanding return oninvestment. Additionally, transferring riskthrough service contracts, will result in fewer losses affecting the companydirectly. Once the risk is transferred to the supplier, then the aftermath ofthe risk event is also transmitted. 4.
2DisadvantagesOutsourcingcertain activities will undoubtedly create new risks, which in the end canovershadow the benefits obtained through risk transfer. Bylosing control of the way in which the service is provided, the organisation issubject to new threats. Service providers might not comply with the expectedquality standards or have inappropriate risk management strategies, exposingthemselves to insolvency or bankruptcy (Ashby, 2017). Whenengaging in a service contract, the organisation should always considerpossible interferences in the provider’s continuity. Service providers failuremay be fatal for companies excessively relying on a crucial outsourced supply (Dan Burge, 2012). In addition, thecosts of replacing the supplier with a new solution might result in extraexpenses for the organisation. Ultimately, failures in the outsourcedservice may cause enormous reputational damage to the organisation.
RecommendationAfteroutlining and evaluating four different alternatives, one can become aware thatthere is no optimal combination of risk financing and risk transfer. With allthese strategies having benefits and disadvantages, no reliable method can determineif an alternative is better than other. It strongly depends on theorganisation’s risk management team to define the most suitable combinationconsidering the company’s risk appetite, approach and strategy. Thereare four key elements that should be considered when deciding the bestcombination for the organisation: a) AvailabilityNot allrisk financing and transfer alternatives are always accessible fororganisations. 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 ascash flows, might appear to be the easiest to obtain since they depend entirelyon the company.
Conversely, to achieve risk transfer, the organisation requiresa third party or supplier. For theoperation of a motor fleet, insurance is not only available but mandatory. Withmany providers in the market, it is up to DEF plc to decide the scope and priceof the policy. Likewise, service contracts for safe-driving training are prettymuch accessible with a wide range of offers. b) CostIf allother things were to remain constant, then, the organisation would probably choosethe lower-cost alternative. However, DEF plc shall consider not only the priceof the solution but also the opportunity cost incurred, when selecting suchalternative. Financingsolutions might appear to be the cheapest, with cash-flows and reserves being”free” of extra charges.
But then again, the lack of preparedness againstunexpected losses aside with the forfeited earnings of investing those fundselsewhere, might result in a significant opportunity cost. On the other hand, risk transfer has a minor opportunitycost, lessened by actions like the release of reserves and investment of thosefunds in more profitable ventures. Still, premiums or service fees need to bepaid regardless of the occurrence of losses. The additional services offered byinsurance companies and included in the premiums, can compensate the disbursementof funds and appear as particularly cost-effective solutions for organisations