Risk financing is the economic process associated with the transfer of risk, either
internally or externally.
The types of risk financing:
Retained cost is the economic cost of transferring risk to an
enterprise’s shareholder or shareholders. The root cost — that is, the sum
of all direct and indirect costs — of the transferred risk is the cost of any
losses plus loss adjustment expenses. Unless the enterprise is extremely large or is
subject to frequent similar losses, the statistical sample of losses based on its
operations alone is not large enough to allow for meaningful loss projections.
Traditional insurance is the financing of a risk associated with the transfer
of that risk to a third party, who combines the transferred risk of many parties to
pay for losses of a small portion of the insured population. The root cost of the
transferred risk can be determined actuarially by using generally accepted
statistical testing methods.
Multi-peril/multi-line/multi-year risk financing is the combination of more
than one traditional insurance placement under a single insurance contract. The root
cost is the statistical sum of the individual exposures determined by traditional
methods.
Alternate risk transfer (ART) is the financing of risk by any method other
than transfer to a traditional insurer in a traditional manner, as discussed above.
ART includes transfer to an enterprise subsidiary, as well as transfer to a
traditional insurer on a non-actuarial basis. The root cost of the transferred risk
is equal to estimated losses less interest income over an agreed period.
Blended risk transfer combines traditional insurance with non-traditional
risk transfer plus the transfer of certain enterprise financial exposures (such as
commodity, foreign exchange, or interest-rate hedging) under a single contract
without common pricing. The root cost of the transfer is the sum of the individually
priced parts.
Integrated risk transfer combines traditional insurance with non-traditional
risk transfer plus the transfer of certain enterprise financial exposures (as noted
in blended risk transfer, above) under a single contract, subject to common pricing.
For coverage to be triggered under this contract, a loss-causing incident composed
of at least two events — one of which must be a traditional insurable peril
— must occur. An example of a contract-triggering incident is a single
occurrence consisting of a fire and an adverse change in commodity prices. The root
cost of the transfer is the sum of the individually priced parts.
Enterprise risk financing is the transfer of the entire enterprise risk
portfolio under a single contract. The root cost of the transfer is the actual cost
of losses plus the financial charge for the protection. Thus, this method provides
the broadest enterprise protection at the most favorable cost to the enterprise.
