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RSK4803 Topic 4 Learning Unit 17 summary notes
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- University Of South Africa (Unisa)
RSK4803 Topic 4 LU 17 summary notes
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By: mosimadiks • 4 year ago
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Topic 4Learning unit 16
Explain the concept of finite risk insurance
Finite risk insurance is a method of funding liabilities typically of a long term nature, for which
a corporation is either unable or unwilling to purchase traditional guaranteed cost insurance.
The underlying principle behind finite risk insurance is to allow for the matching of current
and potential liabilities against assets over an appropriate length of time. While this is also
the objective of traditional insurance, finite risk insurance can improve your accessibility to
the time value of money, is flexible and can be structured to meet a corporations unique
cash flow, exposure, tax and reporting requirements.
The premise of finite risk insurance is a formal recognition that the corporation will pay the
majority of its losses over time, but in the event of a favourable loss experience, it will share
not only in the underwriting profit, but also in a portion of the investment income that accrues
on its premiums.
Finite risk insurance is not as cost effective as unfunded self-insurance if there are no losses
but provides other advantages like greater budgeting stability, and depending on the
program structure, potential for tax deductibility of premiums. Finite Risk Insurance can
provide significant cost savings for more comprehensive coverage. Due to the corporation
paying for a big amount of its own losses and can receive a return of a portion of the
premiums paid result of the favourable loss experience, finite risk programs often have
complex tax and accounting issues that need to be addressed.
Describe the characteristics of a candidate for finance risk insurance
Moderate-high severity/low frequency loss profile
Unique/difficult risk to insure
High tolerance for risk retention/profit sharing
Strong financial statements
Sophisticated risk management systems
Give examples where finite risk insurance can be of use to an enterprise
Fund or insure an otherwise uninsurable exposure
Reduce balance sheet liabilities
Manage cash flows
Accelerate tax deductions or obtain tax deductions, for payments that might not
otherwise be deductible
Budget with greater accuracy and less volatility
Shelter money in a tax-advantaged environment
Reduce dependence on the commercial insurance market
Protect against adverse loss development
Move money out of a country or between operating companies
Use as basis for funding multiple risks
Purchase insurance at a lower cost
Benefits of finite risk insurance:
Allows you to use risk financing to attract or retain customers
, Protects earnings from unexpected losses
Allows for profit sharing if loss experience is favorable
Provides protection against catastrophic loss
Insulates against cyclical insurance market fluctuation
Stabilizes expenses over a period of time
Funds losses with pre-tax dollars
Transfer the timing risk to an insurance company
Gives incentive for the promotion of good risk management practices
• Explain the key features of and objectives of finite risk insurance
The key features of finite risk insurance are as follows
(1) The transfer of risk from the enterprise to the insurer is limited to a finite (overall
aggregate limit) amount.
(2) The coverage usually comprises of underwriting risks, as well as timing, credit, interest
rate or exchange rate risks, also non-insurable risk or hard-to-place risk can covered by finite
risk insurance. Coverage of these kinds of risks is important for a holistic approach to risk
management. The coverage is usually provided in a broad sense, without a long list of
exclusions, but less risk is generally transferred than with traditional insurance products.
(3) The policy term is usually longer than one year as multi-year periods are used to obtain
diversification benefits, as well as insurance market equilibrium by focusing on demand for
and supply of coverage.
(4) As a finite risk insurance arrangement is a unique customised solution for a particular
enterprise, the effective costs depend on the claim experience of the enterprise. The claim
experience can partially determine the policy terms and conditions, for example the extent of
the premium, the excess payable in the event of a claim and the limits of coverage.
(5) A portion of the premiums that is not utilised to settle claims is usually paid back to the
insured when the contract terminates. A profit-sharing relationship therefore exists between
the enterprise and the insurer.
(6) Potential investment income earned on the premiums by the insurer during the insurance
period is taken into account when premiums are calculated. The time value of money
therefore plays an important role. One of the fundamental objectives in using finite risk
insurance is for enterprises to achieve their planned financial results over more than one
year.
For example, an enterprise wants to smooth its loss experience over a multi-year period, in
such a way that the amount of capital needed to adequately cover these risks can be
reduced .The volatility of earnings can accordingly be reduced and the financial results of an
enterprise become more predictable. Smoothing earnings over time may, however, conceal
the true financial position of an enterprise which is in financial trouble. An enterprise may
also utilise finite risk insurance solutions to stabilise and improve its liquidity by transferring
future liabilities to an insurer insurance consequently is very popular when enterprises
experience dramatic changes due to inadequacies in the insurance and capital markets.
Enterprises are able to pursue more effective employment of their capital base by utilising
finite risk insurance rather than maintaining equity to cover risks. The possibility exists that,
under particular circumstances, an enterprise can transfer a loss reserve from its balance
sheet to an insurer. In this way the equity of a firm is increased approximately by the
difference between the loss reserve (which represents a liability) and the premium paid
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