Insurance as Risk Financing Strategy - Literature review Example

Insurance as Risk Financing Strategy Student’s Name Course Tutor’s Name Date: Introduction Broadly, international organisations have two choices in risk financing: they can retain risk or transfer risk. In the former, an individual organisation would have to shoulder the financial responsibility for the entire or part of losses it incurs. Self-insurance is an example of the risk-retention strategies that an organisation could choose to use. Risk transfer on the other hand, eliminates the responsibility of financial loss from the organisation, and transfers the same to an insurer through an insurance contract. The organisation thus undertakes to pay premiums to an insuring organisation, which in turn agrees to take up the financial responsibility of paying specific types of potential losses that the other organisation may have in future. By their description, international business organisations are those commercial or industrial enterprises and the people who constitute them, which operate in more than one global market (Answers Corporation 2012, n.pag.). While the multiple global locations present diverse business opportunities to organisations, they also come with their fair share of diverse financial risks. It is such risks that most organisations choose to finance through insurance. Due to the regional and cultural diversity of different business environments however, it is also evident that the financial risks are diverse and oftentimes calls for different strategies of managing the same. One of the major reasons why international organisations choose to finance risk through insurance is that insurers in international locations are in most cases better equipped with services and competencies needed to manage disruptions in facilities and supply chains, and political risks (Kleindorfer 2009, p. 4). The aforementioned is especially important because new market entrants in most cases lack the knowledge or the capacity to handle risks in the new business environment. Such lack of knowledge thus means that in most cases international organisations seek the services of insurers who can manage country-specific risk. According to the American Institute for Chartered Property Casualty Underwriters (AICPCU) (2010, p. 1), the insurance cover most preferred by international organisations is best described as ‘guaranteed cost insurance’. By definition, guaranteed cost insurance refers to ‘insurance policies in which the premium and limits are specified in advance’ (Ibid.). Additionally, the premiums in the guaranteed cost insurance policies are guaranteed and therefore do not depend on losses incurred during coverage. Such type of insurance is designed to finance risks related to personnel, liability, property and net losses that may be incurred on incomes (ibid.). In such cases, the international organisations act as the insurance buyers, and through purchasing insurance service, are able to transfer potential financial losses to the insurer. The international organisations’ preference for insurance as the main way of financing risk often overshadows some other alternatives, which are discussed in the section below Different methods of financing risk 1. Self insurance Self-Insurance is defined as “a form of retention under which an organisation records its losses and maintains a formal system to pay them” (AICPCU 2010, p. 3). According to Investopedia (2012, n.pag.), self-insurance requires an individual or an organisation to set aside money for use when unexpected losses occur. Theoretically, Investopedia (2012, n.pag.) observes that people or organisations can self-insure for different kinds of losses. In reality however, most organisations choose to purchase insurance from external providers especially where the risk of financial or other losses is large and infrequent. The rationale for self-insurance is based on the reasoning that managing some losses internally is more economical than buying insurance cover from third party companies (Hodd et al. 2005, p. 13). The decision on whether or not to self-insure depends on the extent (or magnitude) of the potential loss, and the predictability or lack thereof of a particular risk. In cases where the potential loss is small, and the predictability of the risk bigger, most organisations would choose to self-insure. The self-insurance concept is further founded on the reasoning that insurance companies are profit-making organisations, and as such, they charge premiums in addition to the value of expected losses (Investopedia 2012, n.pag.). This therefore means that a self-insured organisation would be able to save the premiums that would otherwise be used in purchasing the insurance cover, and over time, the organisation would have sufficient financing to cover potential losses in future should losses occur. The organisation then draws the exact amount needed to cover the same, and retain the surplus amount for use in future loss coverage (Nawaz & Stein 1998, p. 70; Punter 2000; Punter 2003). . In addition to creating a fund where they can draw funds when losses occur, international organisations with a self-insurance strategy can: I) treat losses as expenses; II) obtain funding from financial institutions; and III) purchase insurance with a partial self-insured retention which would require the organisation to fund a predetermined level of the losses as and when the occurs (Risk Identification 2001, p. B-2). An organisation that chooses to treat losses as expenses draws funds to finance the losses from the regular operating budget. Alternatively, the organisation can choose to sell some of its assets to get the funds needed to pay for the incurred losses. Obtaining credit from a financial institution is also a viable option, although that attracts short-term to long-term financial implications on the organisation, since it has to service the loan on a pre-agreed interest rate level. The major shortcoming with self-insurance, especially for international companies, is that it becomes a hard (almost impossible) task to gauge the predictability and the potential losses that the general environment posses. For example, gauging the probability of political, government policy, social, macroeconomic, and natural uncertainties in an international location may be too overwhelming for an organisation. Additionally, and even if it were possible to measure the risks associated with the aforementioned uncertainties, self-insuring against the same would require huge amounts of money, which most organisations may not be willing to set aside for liquidity reasons. As such, it becomes easier for such organisations to purchase third-party insurance and rest in the knowledge that they have been cushioned from unexpected losses in identified areas. 2. Risk financing pools Also known as “mutuals”, the risk financing pools are owned by members who come together to share the losses caused by specific risks (Hood & Young 2005, p. 569). According to Standards Australia (2010, p. 24), members form mutuals either because the cost and terms of obtaining third party insurance is unreasonable to them, or because they have difficulties finding an insurer who can insure them adequately. Notably, the pools do not share the risks; rather, it is the financial burden occasioned by risks that members of the financing pools seek to share (Guard Risk 2012, n.pag.). An example of the common risk pools is the Guaranteed Indemnity Mutual (GIM). According to Hood and Young (2005, p. 569), GIMs “are, in effect, insurance companies and would be subject to substantial capitalisation requirements before they could transact business”. A different category of risk pools offers services for a narrow category of risk, often inspired by the needs of an affinity group. While mutual insurance or risk pools are common in some countries, they rarely offer adequate risk financing for international organisations. In the case of narrow-purpose risk pools, their limited risk financing may not cover the needs of international organisations. Similarly, mutual insurance companies may not have adequate risk financing mechanisms for the international organisations. As such, most such firms have little options other than to use insurance in financing their risks. 3. Deductibles A deductible is “an agreed amount of any otherwise insured loss that will be borne by the insured rather than the insurer” (Standards Australia 2010, p. 23). Through deductibles, the insurer does not fund the numerous losses in pre-identified and agreed upon areas, and this enables the premiums to be priced at a low and attractive price. The insured parties, cognisant of the deductible are also able to exercise more caution thus reducing the probability of over-exposure to risk since the organisation would have to bear part of the cost of financing losses, thus reducing the associated moral-hazard (Dembe & Boden 2000, p. 257). Since they cannot be used alone to finance risk, deductibles need to be paired with insurance. The amount of deductibles that an organisation takes however depends on its financial might, and the deductibles limits set by the insurer (Standards Australia 2010, p. 23). 4. Net effect considerations Net effect considerations are used by producers or manufacturers of scarce commodities such as oil, petrochemicals and gas (Standards Australia 2010, p. 23). In this type of risk financing, the producing or manufacturing organisation does not insure the business from risks related to interruptions that may limit the optimal production of products therein. Instead, they rely on the demand-supply market mechanisms, which respond by increasing prices whenever inadequate production of a scarce commodity is the case to cushion themselves from losses. In some cases, Standards Australia (2010, p. 23) observes that producing or manufacturing organisations seek low premiums for interruptions in their business based on the knowledge that the loss to their respective businesses would be calculated based on the net effect. Usually, the net effect is low, because as explained above, a shortfall in production creates a shortfall in supply, which triggers a price increase in the market. Although preferable as a risk financing strategies, most organisations do not have the luxury of engaging in the same owing to the fact that the products or services they offer cannot be categorised as scarce. In light of competitors, it would thus be argued that a shortfall in the production of products or services by one international organisation would create opportunities for its competitors to supply the same products, a scenario that would lead to a diminished market share for the affected organisation. It thus becomes crucial for organisations to insure their production facilities in order to reduce the negative effects that would be incurred in case of losses. 5. Risk Purchasing Groups (RPGs) Risk Purchasing Groups (RPGs) are made up of members who are attracted to the collective approach of managing and financing risk (Standards Australia 2010, p. 26). Such an approach gives members a standard manner of controlling risks and financing the same. According to Standards Australia (2010, p. 26), RPGs are ideal for small and medium-scale enterprises, hence suggesting that international organisations would not consider them as a suitable risk financing option. However, even where international organisations would consider using them, it is likely that their availability and willingness to take an organisation that has different perspectives on risk financing would pose a major challenge (Mwihaki 2009, p. 4). This then means that insurance would still be considered as a better alternative when compared to RPGs by the international organisations. 6. Captives Captive insurers are set up by organisations as a way of insuring against own organisational risks. In some cases however, the captives accept risks from other organisations, a situation defined as rent-a-captive (Standards Australia 2010, p. 26). Through captives, organisations are able to have greater control over their own insurance arrangement, and can even access pooled insurers. Additionally, and as observed by Standards Australia (2010, p. 26), captives can act ‘as a vehicle for structuring more exotic forms of risk financing’. Although the use of captive is extensive in today’s business environments, Standards Australia (2010, p. 26) observes that they are mostly ‘recognised as just another risk financing tool for an organisation to have in its risk management armoury’. In other words, not many (if any) international organisations consider the use of captives as a comprehensive risk financing tool. 7. Finite Risk Plans Finite risk plans are multi-year contracts that in most cases cover risks that are not insured by conventional insurance companies or those that are too expensive to cover using conventional insurance (Standards Australia 2010, p. 29). They involve an aggregate limit of liability, and usually involve the insurer and the insured aligning their interests (usually for purposes of sharing profits attained from the premiums paid by the insured party). Although they are preferable risk financing options for organisations dealing in goods or services that would otherwise encounter challenges obtaining cover in the conventional insurance industry, they are ideal as a substitute of insurance only in some cases, probably the reason why their use is not widespread. 8. Capital market risk financing solutions Capital markets provide contingent funding to finance losses from different products which include: insurance futures; borrowing and equity financing; catastrophe bonds; securitisation; and weather hedges (Standards Australia 2010, p. 32). In each of the identified capital market solutions, the beneficiary organisation ought to meet the criteria or standards set by the providers of the risk financing services. 9. Takaful Takaful is an Islamic form of risk financing where people or organisations cooperate mutually for purposes of protecting, assisting and assuring each other against loss (Standards Australia 2010, p. 32). Takaful runs for a financial year, during which losses are ‘divided and spread’ among members (Ibid.). Any cash surplus is then distributed to policy holders at the end of each financial year. The use of Takaful is however limited to Muslims and the corporations they own, hence making it difficult for international organisations with non-Islam orientation to subscribe to the concept. Regulatory reasons In some international locations, specific types of risks attract compulsory insurance. In other words, an international company operating in the affected international locations would have to finance specific risks through purchasing an insurance cover because it is mandatory to do so. For example, some international locations’ labour laws make it mandatory for employers to insure their workers for work-related risks. In such a scenario, whether an organisation would prefer self-insurance would be inconsequential because it would have to act in accordance with the labour laws. Notably however, some countries (and states) allows exceptions in cases where the organisation proves that it can provide qualified self-insured plans, which would have to meet specific country or state-mandated requirements (Risk Identification 2001, p. B-2). Another mandatory form of insurance in most international locations involves motor insurance. However, and as observed by Financing Risk (n.d., p.3), even motor insurance is not without players who have chosen to self-insure. Such include the car manufacturer BMW. Purchasing and managing an insurance portfolio From the section above, it is clear why most international organisations prefer insurance as the method of financing risk. For such organisations, the common method of purchasing insurance includes identifying an insurance company that would give them the ideal cover and entering into an insurance contract with them (CravensWarren 2012, n.pag; Trieschmann 2006, p. B3). As indicated by the Baron Insurance Group (2012, n.pag.), an insurance contract includes the premium that the insured party will be paying, and other terms of contracts which include the amounts of deductibles (if any), the risks covered, and the criteria of claiming damages. However, international organisations that have numerous insurance covers need to be prudent in managing their insurance portfolios. As the Zurich American Insurance Company (2011, p. 2) observes for example, ‘companies with foreign subsidiaries... need to be certain that their insurance programmes are appropriate to exposures and in compliance with local regulations’. Failure to ascertain the nature of insurance cover that an organisation has in different international locations may lead to less-than-optimal (at least in a desired sense), but this may only become apparent after losses have been incurred (Zurich Financial Services 2009, p. 11). Managing an insurance portfolio therefore needs the international organisation to consider the different social cultural and regulatory factors necessary for insurance in an overseas location. As suggested by the Zurich American Insurance Company (2011, p. 2), it would be easier for international companies to contract brokerage companies which have experience in handling international insurance programmes to provide a ‘one-stop service’. Alternatively, international organisations can purchase a controlled master programme from a multinational insurance provider thus eliminating the need to purchase coverage in every country location. In addition to local policies, the organisation can also consider the ‘difference in conditions’ [DIC/’difference in limits [DIL] policy’ (Zurich American Insurance Company (2011, p. 2). The DIC/DIL is an insurance management approach that provides additional liability coverage above the sufficient local policies and also fills gaps in areas where local policies do not fully cover exposure. The premiums and losses are paid in the specific country where an organisation operates. Conclusion As indicated in the introductory part of this paper, one of the major reasons why international organisations choose to finance risk through insurance is that insurers in international locations are in most cases better equipped with services and competencies needed to manage disruptions in facilities and supply chains as well as political risks. Most of the above defined risk financing alternatives are either not comprehensive enough for international organisations, or do not attract the attention of brokerage companies that are entrusted with managing the international insurance services to organisations. 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