According to Kaye (2001), there is a template which can be put in place by an organization to enable it finance a loss, taking into consideration the maximum possible loss.
The possible template for financing plan on financing could be as the figure below.
Figure 13.1: Template for Financing Plan on Risk Exposure
RISK EXPOSURE MAX FUNDING
POSSIBLE LOSS
1 Killer Risk Destruction Investment in
Brand value Risks controls
Customer Risk management
Confidence Impact reduction
Employer skill base Contingency planning
Optional failure
Business and financial controls
2 Liabilities: Retained <N10m
Public Captive 50m N10-
Employee
Product <N500m
Insurance of N50m- Professional
captive Director and officers
500m
Claims Handling outsourced
3 Assets (any one risk) N100m Retained <N10m Captive 50m N10- Insurance of N50m- captive
500m capital market 1000m
Source: Kaye, D. (2004). Risk Management. London: Chartered Insurance Institute, p. 18.
4.0 CONCLUSION
You have observed from the discussion in this study unit that there are many costs and losses inherent in occurrence of risks in operations of any organization. There are some mechanisms that are available for risk financing, such as self-funding, internal fund, captive insurer, risk sharing, risk transfer, transfer to counter party and transfer to insurance company. There are some other methods available for financing risk exposures, which are embedded in alternative risk transfer. These methods include are derivatives, put options, loans, catastrophe bond, and catastrophe risk exchange.
5.0 SUMMARY
In this study unit, topics covered include the following:
Cost Inherent in Incidents of Risk
Determinants of Risk Financing
Corporate Risk Financing
Alternative Risk Transfer
Risk Financing Plan
In the next study unit, you will be taken through the discussion on risk and quality control.
6.0 TUTOR-MARKED ASSIGNMENT
What are the determinants of risk financing? Mention and explain the methods of risk financing.
Solution to Self Assessment Exercise SAE 1.
The various costs inherent in incidents of risk include:
cost of capital;
salaries of administrative staff;
insurance charges;
Rental payments for premises;
Wear and tear of assets;
Severance payments for employees; and
Redundancy payments.
SAE 2.
The determinants of risk financing are as follows:
vii) Evaluate the potential cost that the organization could have in a given period.
viii) Note the maximum probable losses as well as its maximum possible loss.
ix) Measure the total loss alongside tile maximum single possible loss.
x) Identify the cost that could need to be funded.
xi) Quantify the level of cost that can be absorbed without a significant impact on the organization itself.
xii) Identify potential sources of funding to meet larger losses
vii) Consider how such funds can be available at the time they are needed viii) The risk manager can choose from any of the available options.
SAE 3.
i. Self - Funding
This involves setting aside some funds through which organizations indemnify themselves in the event of a loss. In most cases, the corporate entities set aside funds to finance small losses while they transfer bigger losses to other organizations.
ii. Internal Fund
In this mechanism, the organization sets aside fund to enable it to finance losses internally.
iii. Captive Insurer
The organization may decide to establish its insurance company to underwrite its risk in place of the internal fund method. This is regarded as captive arrangement.
iv. Risk Sharing
The mechanism evolves when members of some profession decide to come together so as to share any loss any member of such group might have suffered. Such professionals could be lawyers, accountants or medical doctors.
v. Risk Transfer
This mechanism involves transferring risks to another company that specializes in the management of risks such as insurance companies.
vi. Transfer to Counter Party
This involves the process of negotiations between the parties of which the associated risks to the contract are identified and transferred to one of the parties.
vii. Transfer to Insurance Company
This is a common practice whereby an organization decides to transfer its risks to insurance company so as to concentrate on its areas of operation. It is normally regarded as a viable risk funding mechanism.
SAE 4.
i. Derivatives
For the purpose of risk, an organization sells its risks at a specified amount over a period of time for compensation at a specified amount in the future if the risk takes with a specified period of time.
ii. Catastrophe Bond
This is a type of bond that pays some return to an investor on the basis of insurance event rather than financial event. Therefore, the instrument helps organizations to transfer their risks beyond the insurance market to the capital market.
iii. Catastrophe Risk Exchange
This mechanism is an electronic system which trades in insurance risk whereby licensed risk bearers exchange their catastrophe exposures.
iv. Loans
The access to loan funds can afford an organization the opportunity to finance its loss after a catastrophe. This is in view of the fact that a company can borrow funds to take care of the financing its loss.
v. Put Options
The mechanism makes it possible for the organization to exercise its right to act to be after a catastrophe loss. It is then that the damaged organization could use the contracted right to sell a pre-agreed level and type of quality to the financial organization that provides the option.
7.0 REFERENCES/FURTHER READINGS
Crockford, Neil (1986). An Introduction to Risk Management (2 ed.). Cambridge, UK:
Woodhead-Faulkner.
Dorfman, Mark S. (2007). Introduction to Risk Management and Insurance (9 ed.).
Englewood Cliffs, N.J: Prentice Hall.
Hubbard, D. (2009). The Failure of Risk Management: Why It's Broken and How to Fix It, New Jersey: John Wiley & Sons.
Malonis, Jane A. (Ed) (2000). Encyclopedia of Business, 2nd Edition. Detroit: Gale Group.
Pritchet, S.T. et al (1996). Risk Management and Insurance, 7th Ed., New York: West Publishing Company.
Trieschmann, J.S., Gustavson, S.G. and Hoyt, R.E (2001). Risk Management and Insurance, 11th Ed, Illinois: Spout – Western College Publishing.
Wilcox J.F. (1996). “Risk Management in the Oil Industry”, Journal Of The chartered Insurance Institute of Nigeria, Vol. 2, No. 2, June.
Williams, C.A., Smith, M.L. and Young, P.C. (1995). Risk Management and Insurance, 7th Ed, New York: McGraw-Hill, Inc.
Further Reading
Kaye, D. (2004). Risk Management, London: Chartered Insurance Institute.