Raising Entrepreneurial Capital

NON-INSURANCE TRANSFER

A technique used by some entities for risk control is to transfer the

property or liability that creates an exposure to another entity. Examples

of this include outsourcing business functions, leasing business property,

disclaimers, and formal legal strategies such as hold-harmless and indemnity

agreements. The success of these strategies is often a matter of a court’s

interpretation rather than the original intent of the user. Therefore, they

should be used carefully and with the advice of counsel.

OVERALL RISK CONTROL

Overall risk control includes all of the following areas where the tech-

niques mentioned previous ly are applied.

. personnel safety

. industrial hygiene

. compliance (e.g., with OSHA)

. security of people, pro perty, and data

. property conservation

. liability prevention and defense (e.g., product quality control)

FUNDAMENTALS OF RISK FINANCING

There are fundamentally four choices for risk financing: non-insurance

transfers, retention, insurance, and financial derivatives. (Some persons view

financial derivatives as a hybrid device involving aspects of both risk control

and risk financ ing.) Beyond some limited use of non-insurance transfers, the

essential choice for virtually every pure risk exposure is whether to retain it

or to insure it. The core notion is that an entity either bears losses through

retention or shares losses through insurance.

In some instances, insurance may be required. Examples include required

insurance on real property covered by a mortgage, required insurance on

personal property financed by a loss payee, and state-mandated workers’

compensation insurance. Theoretically, every exposure that has been identi-

fied will be matched with a risk financing procedure.

RETENTION

Retention involves absorbing losses within the entity’s own financial re-

sources. This is a logical strategy for frequent, predictable losses. Active

Essentials of Risk Management 343

retention occurs when the entity makes a conscious choice after an analysis

of the potential severity of a known exposure. Passive retention occurs when

the entity is not aware of an exposure or when the potential severity has been

underestimated.

Possible funding sources for retention include current expensing of the

losses, a reserve (funded or unfunded), or a line of credit. Borrowing can be

an effective strategy for some kinds of losses. Larger entities with financial

stability may form captive insurance companies or participate in risk reten-

tion groups. These more-sophisticated risk financing strategies are used

when an entity realizes that it controls a critical number of exposure units

to make its losses predictable and further realizes that it is paying its own

losses in its insurance premiums. There is also an assumption that the entity

has a firm commitment to risk co ntrol.

A caution about retention is that it does not make losses go away. There is

sometimes a false belief that retention will allow savings of the entire

insurance premium. The losses will still occur, though, and there will be

costs associated with adjusting those losses. There is a tax shelter on retained

losses because of their deductibility. Most entities will consider formal

retention carefully and will use a service entity both for claim services and

the acquisition of stop-loss reinsurance. The stop-loss reinsurance puts a

limit on the entity’s annual loss payments.

Most entities will make the choice to acquire insurance and will limit their

retention to the deductibles in that insurance. This relates to a preference for

stability and peace of mind. Los ses are random, but insurance premiums are

(relatively) stable. The entrepreneur is a risk taker but recognizes that an

insurance company has a comparative advantage when dealing with pure risk.

INSURANCE

Insurance involves sharing of losses within a group of entities that are

‘‘similarly situated.’’ That means that they represent the same degree of

risk to the insurance company (e.g., they are insuring the same kinds of

property for the same perils or they face the same liability expo sures). The

insurance premium is paid in exchange for the promise of indemnity in case

of loss. Indemnity is the promise to make the insur ed whole in the event of a

covered loss. With insurance the entity pays its fair share of losses, whereas

with retention the entity pays its exact share of losses.

The insurance premium is composed of the loss and loss adjustment costs,

the costs of services and admini stration, distribution costs, and state pre-

mium taxes. Some of the services provided (e.g., underwriting), are critical to

the interests of insured s. If you are aware that you are sharing losses with

others, then you have an interest in having a ‘‘gatekeeper’’ to determine what

344 Essentials of Risk Management