RSK4803 Topic 4

RSK4803 TOPIC 4: RISK FINANCING – RISK RETENTION
RSK4803: RISK FINANCING

TOPIC 4: RISK FINANCING – RISK RETENTION
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TABLE OF CONTENTS
TOPIC 4: RISK FINANCING – RISK RETENTION.................................................................................... 1
STUDY UNIT 11: RISK RETENTION ......................................................................................................... 3
STUDY UNIT 12: CONTINGENT CAPITAL ............................................................................................. 31
STUDY UNIT 13: FINITE INSURANCE ................................................................................................... 34
STUDY UNIT 14: CAPTIVE INSURANCE ............................................................................................... 37
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TOPIC 4: RISK FINANCING – RISK RETENTION

AIM
The aim of this topic is to provide an overview of risk retention strategies as part of risk
financing in the risk management process. Risk retention strategies that will be covered
include contingency capital, finite insurance and captive insurers.
LEARNING OUTCOMES
At the end of this topic, you should be able to:
 explain the measures individuals can use to reduce risk the quantum of a risk or the
probability of it occurring
 evaluate the dynamics between self-insurance and self-protection
 explain the concept of mental accounting
 argue why self-insurance and saving can be regarded as substitutes
 determine when self-funding should be considered by classifying risks into funding
categories based on frequency, severity and predictability
 demonstrate the ability to determine the appropriate level of self- funding by determining
the level of self-funding an enterprise can afford
 argue the advantages and disadvantages of risk retention
 explain the central limit theorem
 explain the law of large numbers
 calculate the probable maximum loss (PML)
 explain the estimated maximum loss (EML)
 calculate the maximum probable yearly aggregate loss (MPY)
 explain the probability of ruin
 explain risk retention strategies
 argue the benefits of debt
 explain the cost of debt
 analyse the business effects of credit downgrades
 explain the concept of contingent capital
 evaluate the key features of contingency capital
 explain the forms of contingency capital
 criticise the strategies the enterprise can deploy to reduce the information cost of capital
 explain the concept of finite risk insurance
 evaluate the key features of and objectives of finite risk insurance
 explain the finite risk insurance structures and solutions
 argue how the financial needs of an enterprise can be met with a finite risk solution
 distinguish between the features of finite risk insurance and traditional insurance
 explain the nature of liabilities that are typically covered by finite risk programmes
 evaluate pre-loss versus post-loss funded finite risk programmes
 argue the sound principles of finite risk insurance
 analyse the purpose of a captive
 evaluate the benefits of forming a captive
 explain the factors that should be considered when evaluating the feasibility study of a
captive
 discuss the types of captives
 explain the captive design life cycle
 evaluate the attributes of a successful captive insurance programme
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TOPIC CONTENT
Study unit 11: Risk retention

Study unit 12: Contingent capital
Study unit 13: Finite insurance
Study unit 14: Captive insurance
OVERVIEW
Topic 1 began with examples of enterprises where things went wrong, and although the
causes for the problems appear to simple and easy to identify when we read the reports on
the collapses, it is unfortunately a lot more complicated for the participants while the situation
unfolds. We also discussed enterprise wide risk management to demonstrate the importance
for top management to understand the “big picture” .to enable them to make the best decision
for the enterprise.
Topic 2 provided some notes on decision making techniques, including the philosophy
underpinning probability theory. We shall apply some statistical techniques during the course.
For that reason, you need to read the section on “Assumed Knowledge” under the study units.
The purpose of Topic 3 was to introduce the fundamentals of risk financing such as the cost
of risk and the alternatives available to the enterprise to finance risk.
Topic 4 covers risk retention and the methods that can be used to optimise risk retention and
risk transfer strategies. We also cover captive insurance and finite insurance. Although one
can make a case that finite insurance, and to some extent captives can form part of alternative
risk transfer (ART), we have included under this topic as there is a part of risk retention in the
structures.
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STUDY UNIT 11: RISK RETENTION
AIM
The aim of this topic is to provide an overview of risk retention strategies as part of risk
financing in the risk management process.
KEY CONCEPTS
Self-funding
Nature of losses
Risk retention ability
Risk aversion
Probable maximum loss (PML)
Estimated maximum loss (EML)
Maximum probable yearly aggregate loss (MPY)
LEARNING OUTCOMES
You must be able to:
 explain the measures individuals can use to reduce risk the quantum of a risk or the
 evaluate the dynamics between self-insurance and self-protection
 explain the concept of mental accounting
 argue why self-insurance and saving can be regarded as substitutes
 determine when self-funding should be considered by classifying risks into funding
categories based on frequency, severity and predictability
 demonstrate the ability to determine the appropriate level of self-funding by determining
the level of self-funding an enterprise can afford
 argue the advantages and disadvantages of risk retention
 explain the central limit theorem
 explain the law of large numbers
 calculate the probable maximum loss (PML)
 explain the estimated maximum loss (EML)
 calculate the maximum probable yearly aggregate loss (MPY)
 explain the probability of ruin
 explain risk retention strategies
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LEARNING MATERIAL
At this stage, we have provided a good background of enterprise risk management and
decision making under uncertainty. We also discussed the cost of risk and the concept of risk
financing. The purpose of this study unit is to delve deeper into the analyses the finance and/or
risk management department should perform to determine whether a risk should be retained
or transferred. It is also important to note that it is not a binary decision. In many cases, it can
be a bit of both as it can be prohibitively expensive to transfer 100% of the risk, but it can be
catastrophic should the enterprise decide to retain the total risk.
Even when the risk is transferred, insurers cap their exposure via limits and set risk mitigation
requirements for certain risks. Insurance policies are further in most instances structured that
claimants must pay the first loss, which implies that a certain component of the risk is retained.
The amount of risk that the enterprise retains, or transfers should be aligned with its risk
appetite and constraints of the enterprise. As can be seen from the discussion, risk financing
is significantly more complicated than purchasing insurance.
As discussed with various insurers and risk managers, enterprises are required to provide
certain data to insurers when proposing or renewing policies. The data collected also assists
with modelling risk as the risk management functions are becoming more sophisticated,
enterprises can more accurately determine the quantum of retention and which risks are to be
transferred.
11.1. Risk retention versus transfer

An enterprise with a low-risk appetite will be inclined to transfer more risk to the insurer, and
the higher its risk tolerance, the more the enterprise would prefer to accept and manage its
own risk. Other factors will also play a role, e.g. its ability (capital, skills, expertise, tax
advantages) to manage complex risk and whether it has insurable or uninsurable risk. Figure
11.1 below depicts the principle and some of the products available on the spectrum.
Maximum risk transfer No/minimum risk transfer
Risk transfer Intermediate Risk retention

retention/transfer
Full insurance Standard insurance Self-insurance

Partial insurance
Loss- sensitive contracts
Finite risk programmes
Captives
Figure 11.1 Alternatives to retain and transfer risks. Van Huyssteen (2014:46)
As risk management developed into a well-researched and widely implemented discipline, the
market began to develop a wider range of risk financing alternatives, as illustrated in
Figure 11.1. The spectrum covers the position where the form retains all or most of the risk to
the other end where the maximum risk is transferred. In the real world, risk financing strategies
are a combination of risk retention and transfer.
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11.2. Risk retention and self-financing

Self-funding is a subset of the funding alternatives available to cater for the financial
consequences of losses. It usually refers to a set of financing alternatives other than
insurance, although some of the alternative risk financing techniques combine self-funding
with insurance as a funding alternative. The nature of losses must be considered to
understand the risk financing strategy of the enterprises to retain and finance certain risks.
Loss experience Scenario analysis
Frequency
Severity
Risk Risk
Risk transfer transfer/Capital
retention
allocation
Figure 11.2 Risk financing alternatives as adapted from Young (2014:143)
Three categories of losses can be identified in any database of historical loss experience and
are defined according to individual effect on the finances of the enterprise.
 There is a range of relatively small losses which have no particularly disturbing effects on
the finances of the enterprise beyond their direct cost.
 The effects of the next range can be established by adding the direct cost of the loss to
the cost of having to borrow the additional funds. The transfer of this cost to an insurer
may be advisable.
 In the third range, the costs of large losses have a more serious effect on the ability of the
enterprise to finance from regular cash flows or contingency capital.
For small losses, the enterprise may consider funding the losses from its operational budget
as insurance may be too expensive for that type of loss. Once a certain threshold is reached,
the enterprise may transfer the risk to an insurer. For larger losses, the enterprise may transfer
a certain component of the risk but may also consider other alternatives in addition to
insurance such as contingent capital, creating capital reserves and establishing credit lines.
Banks and insurance companies must hold regulatory reserves calculated on using
standardised formulae or internal models in terms of the Banks Act or Insurance Act,
respectively.
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Risk financing is evaluated in the context of the objectives of the entity and should therefore
not be isolated from general finance and investment principles. For the purposes of this
module, risk finance is described as:
Risk finance is the process that an enterprise use to ensure that adequate funds
are available to survive a material unexpected loss that arose from a deliberately
retained risk.
Risk finance consists of a pre-loss and a post-loss component. Pre-loss risk finance refers to
funds that were set prior to the loss, and post-loss are funds that are based on pre-loss terms
but are raised after a loss to ensure that the enterprise remains financially sustainable.
Enterprises can use different time horizons to try to determine the probabilities of unexpected
loss events.
11.3. Risk retention strategies

There are a number of risk retention strategies available to the enterprise, which can be
divided into funded and unfunded risk retention.
11.3.1. Unfunded retained risk
A risk is retained and unfunded when no specific provision is made for the financial
consequences of the loss. Not providing funding for risk is the most common risk financing
method, mainly because of the range of risks the enterprise is exposed to. Although this
discussion is mainly focused on the retain or transfer decision, implementing systems,
processes or additional personnel to manage/reduce the risk profile of the enterprise forms
part of the cost of risk as pointed out in the previous topic. Unfunded retained risks can be
divided into two broad categories:
 risks that are insurable but retained

 risks that are uninsurable
Risks that are insurable, but retained, are normally the high frequency, low severity losses, for
example, each and every excess on motor losses. Risk managers may decide not to make
provision for these excesses but rather fund them out of the operational expenses of the
enterprise. Risks that are uninsurable would include speculative risks that are usually purely
financial in nature. Often risks are not funded because funding it through insurance may far
exceed the perceived benefit to the insured, e.g. the risk of an earthquake in certain parts of
South Africa is small and therefore risk managers may decide not to insure the risk or make
provision for it.
11.3.2. Funded retained risk
Where an enterprise is in a position to fairly accurately predict certain losses and estimate
their annual cost, an amount can be paid into a fund and in this way, predicted losses can be
economically retained. The fund represents a form of pre-loss financing into which
contributions are paid and from which withdrawals are made following a loss. This is known
as funded risk retention.
11.3.3. Self-insurance and self-protection
Funded retained risk can take the form of self-protection and self-insurance. Although the
enterprise can fund small losses with high frequencies from its operating capital, large financial
losses should only be retained after proper analysis of the risk and loss history. Self-protection
and self-insurance are both pre-loss measures.
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Definition: Self-protection
Self-protection refers to activities implemented to reduce the probability of a loss.
The risk management process consists of a number of steps to identify and evaluate risks,
determine a risk control strategy to prevent and mitigate risks, determine a risk financing
strategy, risk reporting to management and monitoring the risks on an ongoing basis. Self-
protection is a preventative measure implemented to reduce the probability of the potential
risk to materialise.
An enterprise may identify fire in a warehouse as a risk. Self-protection measures that can be
implemented to reduce the possibility of fire damage may include smoke alarms, sprinkler
systems, removing of used package material and other combustibles from the vicinity of the
warehouse. Insurers may also require enterprises to implement risk prevention and reduction
measures to insure certain risks, or to reduce premiums.
Definition: Self-insurance
Self-insurance refers to reducing the magnitude of a loss.
Management of the enterprise may find that self-insurance may have cash-flow benefits if they
can afford to retain the financial consequences of potential losses by establishing a reserve
fund from which loss can be funded.
Download the following article:
Hofmann, A. & Peter, R. 2016. Self-insurance, self-protection, and saving: On consumption

smoothing and risk management. The Journal of Risk and Insurance. Vol. 83, No. 3, 719-734.
DOI: 10.1111/jori.12060
Study the following sections in the document:
 Introduction
 The models
 The models including endogenous saving
 Conclusion
Self-assessment 11.3
 Explain the measures individuals can use to reduce risk the quantum of risk or the
 Explain the dynamics between self-insurance and self-protection
 Explain the concept of mental accounting
 Explain the argument why self-insurance and saving can be regarded as substitutes
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11.4. The advantages and disadvantages of risk retention and self-funding

Risk retention and self-funding can have significant advantages for the enterprise if
management have a good understanding of the business model of the enterprise, the
necessary skills and data to evaluate the risks and loss history. Risk retention and self-funding
also have disadvantages as discussed below.
11.4.1. The advantages of risk retention and self-funding
The objectives of self-funding are the following to reduce insurance costs, improve cash flow,
provide the opportunity to earn investment income and increase the scope of risks funded.
 To reduce insurance costs
By reducing the risk being insured, i.e. by self-funding the predictable losses, premium
expenditure is reduced. The insured risk can be reduced by excluding the peril from cover in
terms of the insurance policy, that is, fully providing for the loss from own funds or by
participating in the cost of any loss. Such participation can be proportional or non-proportional.
Proportional or co-insurance is where the insured agrees to pay a percentage of each and
every loss and receives a percentage discount on premiums. Non-proportional is where the
insured undertakes to pay an agreed monetary amount or deductible for each and every loss.
If the loss is less than this amount, the insured pays the full amount of the loss. If the loss is
greater than this amount, the insured's share of the loss is limited to the agreed monetary
amount.
 To improve cash flow
Premiums are normally due and payable on the first day that insurance cover begins. This
means that the insured loses the benefit of the cash flow whether a loss is suffered or not. If
the loss or risk is self-insured, loss payments are only made if the loss actually happens and
only when the quantum and liability have been finally agreed.
 To provide the opportunity to earn investment income
If risks are self-insured, losses are paid at some future date. Funds set aside to meet such
liabilities earn investment income. Depending on the timing of loss payments, up to 50% of
loss costs may be earned as investment income on outstanding claims reserves. The longer
the delay in settlement, the greater the investment income will be.
 To increase the scope of risks funded
Self-funding provides the opportunity to finance a wider range of risks. Insurance policies
generally restrict cover to specific insurable and rate-able types of risks.
11.4.2. The disadvantages of risk retention and self-funding
The potential disadvantages of self-funding are:
 Self-funding can leave the enterprise exposed to catastrophic loss. This disadvantage can
be eliminated by purchasing reinsurance just as insurers do.
 There may be a greater variation in losses from year to year, resulting in the loss of the
tax deduction in losses where there are no profits from which to deduct losses.
 Possible adverse employee and public relations may arise out of the adjusting losses.
 Insurer services, such as loss prevention services and claim handling, will be lost. This
can be resolved by purchasing these from insurers (unbundled) and by retaining a third-
party administrator to handle claims.
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11.5. Steps to implement a retention programme

Implementing a risk retention programme can be costly for the enterprise, especially if the risk
retained are underestimated or not clearly understood. The enterprise should follow a
structured process to implement a retention programme. The process can consist of four
steps. The first is to have an in-depth understanding of the loss experience of the enterprise.
The second step is to determine the quantum that the enterprise can afford to retain. The third
step is to consider the risk retention alternatives available, and the last step is to select the
appropriate retention strategy.
Note: This is a long and intensive section and very important in the context of this
module. Refer to the annexures for a detailed discussion of the methods to
calculate the estimated losses. You will be assessed on the information in the
annexures.
This section discusses the four steps to implement a risk retention programme,
which consists of
11.5.1. Analyse the data
11.5.2. Determine the risk retention capacity
11.5.3. Determine the risk retention alternatives
11.5.4. Select the most optimal risk retention strategy
Questions in the assignments and examination may cover the whole section or just a
component. A good guide of what is expected, is the marks allocated for the question e.g.:
if the question requires you to discuss the steps for 20 marks, then you need to discuss
each step, with a summary of what the step entails i.e. 5 marks allocated for each step.
To earn the 20 marks, you need to summarise each step.
The question may also relate to a specific sub-section such as the financial factors that
can be used to determine the ability of the enterprise to retain risk, or the maximum
probable loss. It follows then that only the relevant section is discussed/evaluated in your
answer.
11.5.1. Analyse the data

The evolution of risk management from crude loss control to more sophisticated frameworks,
techniques and practices has enabled enterprises to formulate a more balanced risk financing
strategy. This is made possible as management has more data available to make informed
decisions and can properly evaluate the different alternatives available to finance risk. The
best source of information to understand the frequency and amount of losses that the
enterprise may experience is to analyse the statistical properties of historical losses. The
classification of the losses and the accurate and complete recording of losses are important
to ensure that all the losses are considered and also that the management has a very good
understanding of the type and amount of insurance cover to purchase or to retain risk.
11.5.1. 1. Purpose
Statistical analysis is critical in risk management as the accurate estimation of losses and
probabilities need to be made to inform decisions. The estimates are essential for decision-
making in risk retention and self-funding plans, providing aspects such as estimates of
maximum probable early aggregate loss, and the analysis also enables an enterprise to
identify economies of risk retention. Statistical analysis of the loss data is also useful in
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preparation when applying for insurance cover as better cover and terms can be negotiated.
Risk financing decisions are complicated as management often must decide between the
optimal quantum and a combination of financing from two or more competing sources, e.g.
the use of debt, internal liquid resources and/or insurance. The primary consideration is the
partial use of insurance, i.e. the integration of insurance and retention funding as an optimal
composite financing strategy. The integration of insurance and retention funding requires
statistical analysis to be conducted. These indicators of financial ability to assume loss are
applied under the financial constraints of the enterprise and the general attitude of the
enterprise towards risk as expressed by the risk appetite. It is possible that the analysis of
historical losses and other relevant financial factors may produce different results and if taken
in isolation, may lead to suboptimal risk financing strategies.
11.5.1.2. Sources of data
Before proceeding with the discussion of the estimation techniques, it is appropriate to look at
the source of data available to the risk manager. The most obvious source of data is the past
loss experience of the enterprise (and other enterprises engaged in a similar industry). The
historical data may be presented as frequency distribution, and statistical inference used to
interpret the data.
Unlike an insurance company, which usually has a more comprehensive statistical base, the
enterprise may have limited data, and the historical loss experience may be a limited and
random selection of events that is not representative of all possibilities. The internal data can
be supplemented with relevant external data. The relevance of data depends on the extent to
which the enterprise is representative of the industry. Although statistical testing may assist in
establishing whether samples of loss experience for two enterprises may be drawn from the
same probability distribution, if internal data is limited, whether external data is relevant
becomes a matter of subjective judgement.
Data can also be supplemented with non-statistical sources, which could include technical,
organisational and economic opinions about the probability of events and the financial
consequence given certain plausible scenarios. Statistical and subjective data can be
combined so that statistical inference is biased with subjective opinions and judgement.
11.5.1.3 Probability Distributions
Included in the material under the tab, Assumed Knowledge, is the Rational Decision
Making DSC2602 study guide. This guide covers important topics such as descriptive
statistics, probability concepts, probability distributions and decision analysis. It is important to
understand these concepts in risk management and risk financing.
Normal distribution: https://www.youtube.com/watch?v=IhtmW28slDw
Poisson distribution: https://www.youtube.com/watch?v=BbLfV0wOeyc
Binomial distribution: https://www.youtube.com/watch?v=_FbZI9mtSSM
Probability distributions: https://www.youtube.com/watch?v=b9a27XN_6tg
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Do not limit yourself to these videos as similar videos are available on YouTube and you are
strongly recommended to strengthen your understanding of statistics and probability if
necessary.
11.5.1.4. Decisions under uncertainty
You have downloaded the following article under Topic 2. The difference between risk and
uncertainty is relevant to the section below. Although it makes sense to use historical data to
analyse the loss history and make predictions for possible future losses, there are limitations
to use historical data in isolation as the past is not necessarily an accurate prediction of the
future.
Neth, H., Meder, B., Kothiyal, A. & Gigerenzer, G. 2014. Homo heuristicus in the financial
world: From risk management to managing uncertainty. Journal of Risk Management in
Financial Institutions. Vol. 7, No. 2. 134-144.
Study the following sections of the article:
 Introduction
 Risk vs uncertainty in the financial world
 How people and models manage uncertainty
 Financial regulation with fast and frugal trees
 Means and measures for managing financial uncertainty
 Concluding remarks
Self-assessment 11.5.1.4.
 Explain the difference between situations of risk with situations of uncertainty.

 Why are researchers abandoning the ideal of “Homo oeconomicus”?
 Explain the concept “heuristics”.
 How can bias be reduced when developing models?
 Explain the concept of fast and frugal trees (FFT).
Included in the lectures in Topic 2 is the Rational Decision Making DSC2602

study guide. This guide covers topics such as descriptive statistics, probability
concepts, probability distributions and decision analysis. In addition, it is important to
understand these concepts in risk management and risk financing.
You can refer to the specific chapters in the study guide:

- Chapter 2: Probability concepts
- Chapter 3: Probability distribution
- Chapter 4: Estimation
A number of methods have been developed to determine the potential largest total loss to
which an enterprise may be exposed to enable management to make informed decisions are
discussed in the next section.
11.5.1.5. Methods to determine the potential total losses
Concepts such maximum probable yearly aggregate loss (MPY), maximum foreseeable loss
(MFL), estimated maximum loss (EML) and possible maximum loss (PML) are mentioned
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frequently in the risk management and insurance literature, and it is necessary to clarify the
difference between the different concepts. The terms are sometimes used interchangeably
and for the purpose of this module, we shall use the definitions below.
 Probable Maximum Loss (PML)
The PML is the proportion of the total value of an exposure unit which will be equal or exceed
the actual amount of an individual loss from a specified event or group of events, given a
stated probability.
Definition: Probable Maximum Loss (PML)
The PML for a property is that proportion of the total value of the property which will equal
or exceed, in a stated proportion of all cases, the amount of loss from a specified peril or
group of perils.
The primary use of PML is firstly to quantify the risk as part of underwriting decision by the
insurance company when selecting and pricing risk, and by the insurer to determine the
retention levels for reinsurance purposes. The purpose of setting underwriting retention levels
is to ensure that one or more large individual losses will not adversely affect the annual
underwriting results for the insurer. PML is also used when surveying properties and
performing an engineering analysis for safety and loss prevention of building designs. PML is
an input into the risk decision process and should not be regarded as the only answer, as the
interpretation of other factors may influence the final decision.
The risk manager can follow the following steps to calculate the PML for a property.
- Determine the value of the property

- Proportion of the value
- Identify and evaluate risk factors
- Identify and evaluate risk mitigation factors
- Determine to what extent the mitigation factors reduce the risk factors i.e.
assign/calculate a probability.
- Calculate the PML
Example
The value of a property = R5 000 000
Risk mitigation factors assessed to reduce the expected losses by 20%
PML = R5 0000 000 x (1-.20) = R4 000 000
 Estimate Maximum Loss (EML)
Definition: Estimated Maximum Loss (EML)
The estimated maximum loss is that value that will equal or exceed, in a stated proportion
of all cases, the amount of loss from a specified peril or perils.
EML is the largest loss that can occur under the worst condition that is likely to occur. EML is
a severity concept associated with individual losses, i.e. it does not consider the
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frequency/probability of the individual loss occurring to arrive at an expected loss for the given
level of likelihood. Instead, it represents the maximum severity of an individual loss for the
given level of likelihood. The EML does not apply to a group of exposure units, as it is valid
only for individual exposure units. In contrast, the MPY applies to one exposure unit or a group
of exposure units and is that value that will equal or exceed, in a stated proportion of all cases,
the sum of all losses sustained by the group of exposure units during a one-year period.
Applications of estimated maximum loss (EML)
EML is often used by insurers in deciding whether their capacity permits the acceptance of
particular exposures. Insurers use different techniques to manage their underwriting risk by
setting policy limits for certain exposures, premium loadings, set underwriting requirements
e.g. improved security, and refusing to insure certain risks. Commercial fire insurers set limits,
which indicate the maximum exposure to loss that the insurer will accept on any given
property. Although the enterprise may use the EML to determine and limit the amount of
insurance to purchase, the enterprise may be exposed to catastrophic losses, and a strategy
to structure the policy with an increase in retention via deductibles instead of reduced
insurance cover will be a more prudent strategy.
 Maximum Probable Yearly Aggregate Loss (MPY)
The maximum probable yearly aggregate loss (MPY) is calculated to enable management to
make informed decisions on the amount of self-insurance and the optimal deductible levels.
The results of the MPY should be compared with other financial indicators such as the working
capital and sales that are used to determine the risk retention capacity of the enterprise to
decide on the optimal risk financing strategy. The methods to calculate the MPY is covered in
Annextures A and B.
Definition: Maximum Probable Yearly Aggregate Loss (MPY)
The MPY is the largest total loss amount that an exposure or group of exposure units is
likely to experience during a one-year period.
The MPY applies to a portfolio of risks. Historical loss data is used to calculate the MPY and
although the analysis of historical data can provide a good understanding of current and
previous events, it is not necessarily a good predictor of future events. As management makes
decisions under conditions of uncertainty, we must keep in mind that the MPY is an estimated
value, which means that the MPY can be underestimated or overestimated. Another important
concept to consider when deciding on the amount to retain is the probability of ruin.
Insurance companies calculate the probability of ruin to determine the level from which they
wil be unable to recover. Insurers use different methods to determine the proabability of ruin.
The first method is the method of upper and lower bounds, the second method determines the
possibly complex roots of the equation that defines an adjustment coefficient and lastly,
simulations.
Most enterprises do not employ acturaries and may also due to limited data not be able to
calculate the probability of ruin. Management can however determine the probability based on
experience, expert opinion and the risk appetite of the enterprise. For the purpose of this
module, we can assume that management can determine the proability of ruin. Keep in mind
that the enterprise has limited capital and therefore cannot afford to retain the financial
consequences of large risks which may ruin the enterprise.
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Definition: Probability of ruin
The probability of ruin is where the aggregate losses in a given period exceed the value of
the retention fund in that period.
If the probability is , then (1 - ) represents the probability of ruin (i.e. the probability of
loss) exceeding the MPY.
The MPY is that value that will be equal or succeed with a probability no greater than 
actual aggregated losses during a period of one year.
This statement can be mathematically described as follows:
P(L > MPY) < where
MPY = Maximum Probable Yearly Aggregate Loss
Stated probability (Determined by management in terms of the risk appetite of the

enterprise and expert opinion)
P = Probability
L = total annual losses
Example
XYZ Ltd established a retention fund of R100 million at the beginning of the year. Management
has determined that the maximum amount that they are prepare to lose of the MPY is 90%.
The probability of ruin is then (1 - 0,90), or 10%. A level of 90% of the MPY of R100 million
therefore means that aggregate losses will in 90% of the cases be equal to or less than
R100 million.
Applications and limitations of maximum probable yearly aggregate loss (MPY)
While it is useful for an enterprise to know its EML values, the MPY has greater applicability,
especially when an increase in retention limits is being considered. The possible losses to
individual exposures will influence the aggregate loss distribution, and different deductibles
will lead to different MPY values. The MPY can inform decisions on the trade-off between
higher risk following further retention and the resulting savings in premium.
The MPY can provide additional information about the alternative loss cost distributions, i.e.
information to supplement the usual summary statistic where the enterprise may have the
opportunity to choose between various levels of retention. The choice of MPY loss value and
probabilities is somewhat arbitrary. There is little theoretical guidance to indicate how and what
level should be chosen. Consequently, a careful analysis of the financial position of the
enterprise, coupled with informed judgement, is also necessary before selecting the loss level.
Establishing the probability value can be difficult as management is generally unaccustomed

to thinking in terms of probabilities, especially small probabilities. There is also the related
problem that the MPY represents only one single point on the probability distribution of total
loss costs. In complex situations, the selection of the best alternative necessitates a more
thorough analysis of the loss distribution e.g. management might react very differently to a
0,90 of the MPY of R500 000 and a 0,995 of the MPY of R1.5 million.
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11.5.1.6. Estimation of maximum probable yearly aggregate loss from loss data
A number of different MPY estimation procedures exist. In estimating the MPY, the purpose
is to locate a particular point on the probability distribution of total losses. One way to develop
such information is to observe the total cost of losses over a period and to develop an empirical
distribution from the observed value. The observation can be divided into convenient ranges,
and the relative frequency of losses within each range is divided by the number of
observations, and the cumulative frequency can be calculated. The frequency values may be
used as probability estimates. The MPY would then be elected from this empirical distribution.
An alternative approach is to use the available data to develop two probability distributions,
one relating to the frequency of losses, the other to the severity of losses. The combination,
mathematically, of these distributions, would derive the total loss distribution, a process known
as convolution. The process is somewhat richer than the direct estimation of the distribution
of aggregate loss since the additional information on frequency and severity is used, but the
computation of an MPY estimate is relatively difficult. This approach can be costly and need
sophisticated methods to implement the distributional approach. To reduce cost, more simple
methods can be used to approximate the distribution. Consequently, other procedures have
been developed that estimate the MPY without determining the total loss cost distribution but
rely instead on the certain statistic (sample mean and variance) that can be computed from
the data.
There are two groups of methods to estimate the MPY - one contains the method that requires
the estimation of the form and shape of the underlying loss distribution, while the other
contains the procedures that base the MPY on statistics developed from the loss data. The
methods covered in this module are:
 Normal approximation
The normal approximation is regarded as the simplest method to calculate the MPY. The
method, however, understates the actual losses as the formula, as one of the assumptions
that the mean and standard deviation is known but that both values must be estimated from
sample data. The typical loss distribution is normally skewed to the right, which implies that
the MPY based on the normal approximation will be understated. Enterprises with a more
conservative risk appetite may prefer the MPY to be rather overstated than understated for
decision-making purposes.
 Chebyshev method
The Chebyshev method can be used regardless of the underlying loss distribution, but users
need to keep in mind that the estimates of the MPY will be on the upper bounds of the real
MPY. The Chebyshev method is regarded as very conservative as an overestimation of the
MPY may lead to suboptimal investment decisions. The Chebyshev method may not be the
most appropriate method if a higher level of accuracy is required.
 Normal power method
The normal power method uses the MPY estimates calculated from the normal approximation
and then adjusts the MPY to correct the skewness, as annual loss distributions are normally
skewed. The benefit of the normal power period is that the method is easy to use, and it also
adjusts for skewness and for distributions with small skewness values appears to be accurate.
The caveat is that it is only accurate for values < 2. When skewness is greater than 2, the
normal power method overstates the MPY.
The three methods are explained in the annexures at the end of this study unit. The notes are
prescribed and will be covered in assessments.
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11.5.2. Determine the risk retention capacity
Before a decision is taken to self-fund losses, the risk retention level of the enterprise needs
to be calculated to determine the extent of resources available to pay for assumed losses. It
is also important to bear in mind that the risk appetite, dividend policy and signal capital
strategies of the enterprise will determine the percentage and amounts that the board will
approve for the risk retention and self-funding strategy. When evaluating the risk retention
programme, the risk manager should engage with the insurance broker/insurer to negotiate
different premiums and deductible levels based on the risk profile of the enterprise. This trade-
off should continue if the enterprise receives at least proportional reductions in its premiums.
To complicate matters further, the calculation of the retention levels based on the financial
indicators can differ e.g. the working capital approach can show R1million in loss assumption
ability; total assets R2 million; sales budget R3 million; and earnings per share R500 000.
Management must therefore understand the characteristics and limitations of each financial
indicator to ensure that they make an informed decision.
Financial indicators to determine risk retention capacity
 working capital
 total assets
 earnings
 earnings per share
 sales
11.5.2.1. Working capital
Working capital reflects the liquidity of an enterprise and its ability to meet current obligations
and can also serve as a measure of loss assumption ability. Where an enterprise cannot
liquidate current assets easily, a smaller percentage, e.g. 1% of working capital, could be set
aside to finance losses. Management should also consider the relative liquidity of working
capital fluctuates throughout the year, e.g. if working capital is constrained at the end of the
sales cycle due to a concentration in receivables or at the beginning of the sales cycle caused
by a concentration in inventory. The proportion of working capital allowed for loss assumption
should be adjusted incorporate the liquidity constraints.
Where an enterprise has a very liquid working capital position and the cash or cash
equivalents or accounts receivable turnover on a regular and predictable basis, 10% to 25%
can be used. As a guideline, 1% to 25% of working capital is a measure of loss assumption
ability.
11.5.2.2. Total assets
The ability to absorb losses can also be determined by deciding on the proportion of total
assets available to finance losses. A lower percentage would apply to an enterprise where
assets are already highly leveraged and illiquid. A greater percentage may be applicable
where the enterprise has a high concentration of assets that may be liquid or unencumbered
to provide for unforeseen events. A range between 1% to 5% of total assets is considered
practical.
11.5.2.3. The retained earnings method
The risk manager should consider current earnings to obtain an indication of the ability of the
enterprise to fund losses through earnings. The proposed range of values will depend on the
industry and the enterprise and can be expressed as a percentage of current retained earnings
plus a percentage of the average pre-tax earnings over the past five to ten years. In contrast
to the working capital and total assets approaches, which are measures of the short-term
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ability to raise funds, the earnings method is long-range in nature. It relies on the underlying
earning power as demonstrated by past performance as the ultimate source of funds to
provide for losses. The range between is 1% to 3% of current retained earnings plus 1% to
3% of average pre-tax earnings over the past five years.
11.5.2.4. Earnings per share
The effect of self-insurance losses on the earnings per share of companies is normally the
most tightly constrained measure of loss assumption ability. The earnings per share guideline
is used as a conservative measure to ensure that self-insurance does not overextend the
enterprise to a point where earnings per share or current budget would be impaired by a large
loss in a single financial reporting period. The board should approve a normal level of loss
assumption percentage of earnings per share for a publicly held enterprise and a percentage
of the expected excess of revenues over expenses in a public entity, in line with the approved
risk appetite of the enterprise. The normal level of loss assumption is 10% of earnings per
share for a publicly held company and 10% to15% of the expected excess of revenues over
expenses in a public entity.
11.5.2.5. Sales budget
The sales budget measures the ability of the enterprise to generate sales and revenues and
must be considered with the other indicators to develop a valid measure of loss assumption
ability. A range between 0,5% to 2% of the annual sales budget or revenues are used. The
lower level of 0,5% is used by leveraged enterprises with high sales volumes and the high
level of 2% is more applicable to manufacturing or service enterprises with higher profit
margins.
Application
The decision of how much the enterprise is willing to retain will be influenced by the MPY, the
retention capacity and the risk appetite. The amounts that can theoretically be retained can
differ between the different methods.
X (Pty) Ltd is a retailer and considering the implementation of a self-insurance programme.

The following information is supplied by the auditor of the enterprise to assist you with your
final recommendations:
 Sales budget: R60 000 000

 Net Assets: R50 000 000
 Working capital: R2 500 000
The risk appetite approved by the board for the different financial factors are as follows:
 Working capital: 1% - 25%

 Net current assets: 1% - 5%
 Total earnings: 1% - 3%
 Earnings per share: 10% - 15%
 Sales budget: 0.5% - 2%
Advise the CFO on the ability to absorb losses and make recommendations to implement a
self-insurance programme. Provide the lower and upper limits per category.
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Financial factor Amount Lower Upper
Net assets R50 000 000 R500 000 R2 500 000
Sales budget R60 000 000 R300 000 R1 200 000
Working capital R2 500 000 R25 000 R625 000
Total R825 000 R4 325 000
Management might be willing to transfer the financial consequences of the risk to an insurer
against payment of an insurance premium but retain a portion of the risk by creating a retention
fund or accepting larger deductibles to stabilise the earnings of the enterprise.
11.5.3. Determine the opportunity and feasibility of retention funding
The enterprise may intentionally or unintentionally decide to retain the financial consequences
of losses for its own account. In the case of funded retention, a special fund or facilities are
created to fund the losses, while unfunded retention implies that losses must be funded from
operating cash flow, bank loans, or cost savings which may put significant strain on the ability
of the enterprise to maintain or expandbusiness operations.
When implementing the retention funding programme, the risk manager must understand the
risk assessment/rating process of insurers that allow for an insured to assume varying degrees
of risk and receive premium reductions or refunds based upon actual losses during the
insurance period. It is possible to stabilise loss exposure over time and to maximise the
effectiveness of the insurance-buying function of risk management. If an insured increases
the number of expected aggregate losses that it will self-insure, it is reasonable to expect a
reduction in insurance premiums. This trade-off should continue as long as a proportional
reduction in premiums continue.
One of the self-funding strategies is the use of deductibles. Other forms of self-funding are
covered in other study units, but for the purpose of this study unit, the discussion will be limited
to deductibles.
11.5.3.1. Deductibles as a self-funding alternative
A deductible is the part of the insured loss which an enterprise retains for its own account. The
deductible is subtracted from the amount with which the insurer reimburses the enterprise in
the case of a loss. A large deductible programme may offer many of the advantages of a self-
funding programme without the increased internal expenses such as the establishment of a
captive insurance company, claims administration and other administration costs.
Deductible programmes also offer the insured cash flow benefits and cash flow protection.
 Cash flow benefits
Under a deductible arrangement, the insurer offers a discount on the full premium cost to the
insured in return for sharing a portion of the loss. It is in the interest of the insurer to transfer
losses at lower levels because of the disproportionate administrative costs associated with
these losses. The benefits to the insured are that they receive immediate savings and an
increased cash flow.
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 Cash flow protection
The capacity to self-fund losses is influenced by liquidity and time. The shorter the time frame,
the lower the tolerance for interruptions to cash flow e.g. the losses a company can fund in a
year is greater than what it c
an fund in a month. The longer time period allows funds to be built up and also reduces the
variability of the loss experience that is encountered monthly. The use of a deductible places
a ceiling on the amount that the company has to contribute to each loss when it is settled. This
reduces the disruption to cash flow. Large deductible programmes can be structured to
incorporate the estimated losses, capacity to retain and risk appetite of the enterprise.
11.5.3.2. Types of deductibles
The concept of the deductible requires that the insured bear a portion of the losses arising
from pure risk exposures. These may be losses from a single event or over a specified period.
Each arrangement has a different effect on the distribution of losses that are retained by the
enterprise. The main forms of deductible are the following:
 Each and every per loss or straight deductible

 Aggregate deductible
 Franchise deductible
The types of deductibles are discussed below.
 Each and every per loss or straight deductible
Each and every per loss or straight deductible is also known as a simple or straight deductible.
The straight deductible applies to each loss and is subtracted before any loss payment is
made. The enterprise experienced an event with damages of R20 000. If a straight deductible
of R25 000 applies, the enterprise will absorb the total loss; however, if the damage was
R50 000, the enterprise will receive payment of R25 000 from the insurer.
 Aggregate deductibles.
Another type of deductible is the aggregate deductible, which applies for an entire year, and
the insured absorbs all losses until the deductible level is reached. At that point, the insurer
pays for all losses over the specified amount. The aggregate and straight deductibles can also
be used simultaneously.
The property insurance policy may have an R50 000 straight deductible, subject to an
aggregate deductible of R1 000 000. With this combination, the enterprise would not pay more
than R50 000 on any one loss and would not absorb more than R1 000 000 in total property
losses during the year. If only a straight deductible of R50 000 were used, the enterprise would
have a potential liability much greater than R1 000 000 if numerous losses less than R50 000
occurred and totalled more than R1 000 000.
Compared with the straight deductible, aggregate deductibles are not as successful in
eliminating the cost of processing small claims because all losses will likely be reported to the
insurer for credit toward meeting the deductible. In addition, as losses may be fully paid after
the deductible is met, the ability to reduce moral hazard is not as great as with the straight
deductible.
 Disappearing deductible
When a disappearing deductible is used, the size of the deductible decreases as the size of
the loss increases. Finally, at a given level of loss level, the deductible completely disappears.
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The reduction in the deductible results from the fact that losses are adjusted according to a
formula such as:
P = (L - D) x (1 + R)
where:
P = payment by insurer
L = loss
D = deductible
R = recapture factor
Example
Consider a policy with an R50 000 deductible and a recapture factor of 4%. All losses under
R50 000 are absorbed by the insured. When a loss of R450 000 is experienced, the
deductible will decrease as follows:
[(R450 000 - R50 000) x (1 + 0,04)] = R416 000. The deductible will be reduced from
R50 000 to R34 000.
The deductible will completely disappear for losses equal to or greater than R1 300 000.
The recapture rate is dependent on the amount set at which the deductible will disappear –
the lower the amount, the higher the recapture factor. The insurance premium will increase
with the increase in the recapture factor.
 Franchise deductible
A franchise deductible is expressed either as a percentage of value or as a rand amount.

Under a franchise deductible, there is no liability on the part of the insurer unless the loss
exceeds the amount stated. Once the loss exceeds this amount, the insurer must pay the
entire claim. In insurance for ships and their cargoes, it is common to use a franchise
deductible expressed as a percentage of the amount insured. Thus, the policy might provide
that there shall be no loss payable unless the loss equals or exceeds 3% of the total value.
But once the loss reaches the 3% level, the insurer is responsible for 100% of the claim.
11.5.3.3. Determine deductible levels
Various deductible selection rules exist in the literature. We will limit our discussion to the least
cost rule. This rule does not take financial capacity explicitly into account. This least cost rule
is based on the proposition that the cost of pure risk to the enterprise is equal to the insurance
premium plus the cost of losses retained under the deductible. The initial formulation of the
rule assumes that losses which occur under the deductible are equal to the full amount of the
deductible.
The rule states that the level of deductible selected should be that which gives the lowest total
expected cost (TEC). Formally, it is expressed as:
TEC = P + qD
where
P = insurance premium
D = deductible level
q = average number of incidents or the average annual cost
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To illustrate the rule in operation, let us consider the following example of the accident and
damage exposure for a commercial fleet of private cars. The premium information is contained
in the following table.
Table 11.1: INSURANCE RATES PER VEHICLE
OPTION PREMIUM DEDUCTIBLE
1 R4 000 -
2 R2 900 R1 000
3 R2 405 R2 500
4 R1 917 R5 000
5 R1 375 R7 000
6 R650 R10 000
To evaluate the value of the deductibles some additional loss data is required, which is. shown
in Table11.2.
Table 11.2: LOSS DATA FOR FLEET VEHICLES: 2013 – 2017 (Adjusted for changes
in fleet and inflation)
YEAR NO OF VEHICLES NO OF INCIDENTS TOTAL COST

2013 2 000 320 R820 000
2014 1 700 200 R70 000
2015 2 100 480 R1 104 000
2016 2 200 640 R1 638 500
2017 2 000 360 R875 000
Total 10 000 2 000 R5 137 500
The analysis of this information reveals the following:
 average number of incidents per annum 400

 average annual cost is R1 027 500
To apply the TEC rule, the value of q has to calculated:
= total number of incidents

total number of vehicles
= 2 000/10 000
= 0,2
or
annual average number of incidents
annual average number of vehicles
= 400/2 000
= 0,2
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Comparison of the expected cost of the various deductible levels.
Table 11.3 COMPARISON OF THE DEDUCTIBLE LEVELS
OPTION PREMIUM (q x DEDUCTIBLE) = TEC (Premium + deductible)
1 R4 000 + .02 x R0 = R4 000
2 R2 900 + .02 x R1 000 = R3 100
3 R2 405 + .02 x R2 500 = R2 905
4 R1 917 + .02 x R5 000 = R2 915
5 R1 375 + .02 x R50 000 = R11 375
6 R650 + .02 x R100 000 = R20 650
According to the TEC rule, option 3 with the R2 500 deductible should be selected as it yields
the lowest TEC. This analysis could also be used to judge the reasonableness of the premium
discounts for each of the deductibles, as in theory, the credits should reflect the expected
value of the losses falling within the deductible. In the example above, the deductible of R1 000
per car produces a premium discount of R1 100 (R4 000 - R2 900).
Loss ratios
It is important to determine the reasonableness of the risk premium in terms of the loss
experience of the enterprise. The risk premium is calculated by the portion of the premium
received by the insurer to meet claims after expenses, and other costs have been deducted.
If an expense ratio of 25% of the gross premium is assumed, the risk premium is
R1 100 x (1 - 0,25) = R825. The insurer is thus charging R825 for R1 000 of cover, which
means that according to the claims experience of the insurer, 82.5% of all losses are less than
R1 000.
The insured can use the risk premium as an indicator to evaluate the premium discount. If the
loss experience of the enterprise indicates that losses less than R1 000 comprise less than
82.5% of the distribution of total losses, the enterprise can consider self-insuring, as the
premium loading is higher for these losses than the actual cost. If the ratio of losses is greater
than 82,5%, insurance cover should be purchased as the costs of insurance is less than the
actual cost of losses. Loss ratios will be discussed in more detail in Topic 5.
11.5.3.4. Deductible funding policies (Contingency Risk Policies)
Deductible funding policies or contingency risk policies are similar to large deductible
programmes except that the premium is deposited in a fund which is used to reimburse the
insurer for losses paid within the deductible layer. The fund earns interest at a predetermined
rate, and at the end of the contract, any excess is returned to the insured. These programmes
are designed as another mechanism to give the insured more cash flow benefits while still
allowing the insurer to earn a reasonable rate of return.
11.5.4. Criteria to evaluate the retention funding strategies
The enterprise should also develop specific criteria to evaluate the retention funding strategy
by having a thorough understanding of their risk-bearing capacity, cost of capital and risk
appetite.
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11.5.4.1. Evaluation of retention funding using the value of the enterprise criterion
The method of evaluating the superiority of retention funding is based on the effect that the
funding may have on the value of the enterprise. When management considers the alternative
sources of financing, the alternative that has the most positive effect on the value of the
enterprise compared to the other options would be the preferred alternative.
The value of the enterprise at any point is:
The sum of the value of operations plus the value of investments
The size of the fund is important. If the size of the fund is too small to cover losses, the burden
will have to be shifted to other forms of funding, including external financing with an associated
increase in finance and transaction costs. If the fund is too large, it reduces the value of the
enterprise because excess funds could have been invested in operations and earned a return.
Transaction costs are an important aspect to consider when evaluating the case for retention
funding. Delay costs such as issue and underwriting costs associated with raising new external
debt or equity in the event of a large loss, as well as interruption costs due to time delays,
should all be regarded as part of the transaction costs. The effect that funding may have on
the cost of capital must also be considered. Funding merely shifts the cost to another
accounting label, and the enterprise remains exposed to the same level of risk of the retained
losses.
11.5.4.2. Evaluation of retention funding under the assumption of no transaction costs
Under the assumption of no transaction costs, the value of the enterprise can be depicted as
an equation appears as the sum of:
value of the commercial non-risk management activities of R 10 000 000

the enterprise
+ value of the retention fund R 500 000
Subtotal Value before losses R 10 500 000
- loss exposure -R350 000
- Unfunded losses - R200 000
Subtotal Losses - R 550 000
Total Value of the enterprise R 9 950 000
The case for establishing a fund then depends exclusively on the relationship between the
risk-adjusted return on the fund assets and the risk-adjusted cost of the fund. Value is only
added if the risk-adjusted return on the fund exceeds the risk-adjusted cost. This may not be
entirely valid as it is incorrect to assume that retention will result in no transaction costs.
Retention is normally associated with the following cost:
 staff
 administration
 debt
 platform costs for various retention instruments
By assuming no transaction costs, the value of the enterprise is over-estimated, which could
lead to a decision to retain when it might not be best to retain. It is best to assume transaction
costs as it is more realistic and prudent.
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11.5.4.3. Evaluation of retention funding under the assumption of transaction costs
Post-loss sources of finance may have associated costs such as underwriting and issue fees
and cost of delays. By introducing transaction cost, the value of the enterprise is the sum of
the:
value from commercial (non-risk management) R 10 000 000

operations
+ value of the retention fund R 500 000
Subtotal Value before losses and transaction cost R 10 500 000
- loss exposure contribution -R350 000
- transaction costs -R50 000
- unfunded losses -R200 000
Subtotal Losses and transaction cost R 600 000
Total Value of the enterprise R 9 900 000
With transaction costs, the value of the fund is dependent on the loss exposure. In the absence
of frictional costs, the effect of a possible favourable loss experience, the timing of cash
outflows, and the possibility of earning more than the cost of capital on the retention fund,
makes retention funding more appropriate than insurance from a value-of-the-enterprise
perspective, even in the absence of transaction costs.
 Distinguish between a straight and a franchise deductible.

 Argue the use of deductibles as the first step to self-funding.
 Argue why a straight deductible can be considered the most effective to use.
SUMMARY
This study unit described the advantages of self-funding and indicated which risks should be
self-funded based on their frequency and severity. The methods that can be used to determine
the levels of self-funding were also discussed. This study unit discussed the various forms of
deductibles and how the most appropriate deductible level can be determined. The following
study unit will discuss contingency capital.
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Annexure A
Methods based on loss distribution statistics
The MPY calculation method based on loss distribution statistics utilises the mean, variance
and, in some cases, the skewness of the total loss cost distribution. Skewness indicates the
extent of the departure of the loss distribution from symmetry.
Suppose that there is n number of possible outcomes for total annual losses, that Xi denotes
the possible outcome (i = 1, 2, 3, ..., n), and that the probability of the ith outcome is denoted by
Pr(x), (x represents the random variable: total annual losses). Then, the following equation can
be used to determine the mean, variance and skewness of the total loss distribution:
The mean or expected value: (X)
E(X) = ∑N
i=1 xi ⋅ Pr (xi )
The variance 2(x):
2(x) = ∑Ni=1 [(xi – E(X)]2Pr(xi)
The standard deviation is the square root of the variance:
(x) = √𝜎 2 (𝑋)
The skewness,1 (X) is developed by using the formula:
∑𝑁 3
𝑖=1 [𝑥𝑖 −𝐸(𝑋)] ⋅𝑃𝑟 (𝑥𝑖 )
1 (X) =
𝜎 3 (𝑋)
To calculate a value for the MPY from one of the approximation formulae, do the following:
1. Determine/select a probability level

2. Calculate the loss distribution statistic
3. Calculate the MPY by selecting the appropriate formula
Three methods of approximation are discussed below.
11.5.4.4. The normal approximation
This approximation assumes that the distribution of total losses can be approximated by a
normal probability distribution. Given that an MPY probability of a is chosen (ruin probability
is (1 - )), the MPY estimate is the value on the total loss distribution that is equal to the mean
plus a multiple of the standard deviation. The number of standard deviations is indicated by
Z , which is a point from a standard normal probability distribution (the value of Z is obtained
from a table of the standard normal probability distribution).
The formula for obtaining the normal approximation of the MPY estimate is the
following:
MPYN = E(X) + Z  (X)
Where:
MPYN = the maximum probable yearly aggregate loss estimator utilising the normal
approximation
E(X) = the mean of the distribution of total losses
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(X) = the standard deviation of the distribution of total losses
Z = the standard normal random variable
Z = the value of the random variable z where Pr (Z < Z) = .
If the actual value of the parameter, mean and standard deviation of the total loss distribution
are not known, and estimates are used instead, then the formula must be adjusted for
sampling error. There are two adjustments. One is to replace Z with a comparable value from
a student t probability distribution (because the standard deviation is not known); the other
change adjusts for using an estimate of the mean rather than the actual value.
The problem with this method is that the probability distribution of total losses may not closely
approximate a normal distribution. Although the central limit theorem can be used to show that
the distribution of total losses will approach normality as the number of losses increase, for
the individual losses, the distribution of some losses maybe is so highly skewed that this
causes the total loss distribution to be skewed too. By ignoring the skewness, this method will
underestimate the true MPY.
For the purpose of this module, you will not need to calculate Z or Z, as the values will be
given.
You can refer to a few YouTube videos for more clarity:

https://www.youtube.com/watch?v=NY2zWGBXBhU
11.5.4.5. The Chebyshev method
The MPY calculation formula for the Chebyshev method is similar to that for the normal
approximation, except that the standard deviation is multiplied by a different number. The
formula is as follows:
MPYC = E(X) + kS(X)
Where
MPYC = the maximum probable yearly aggregate loss estimator based on the Chebyshev
theorem
1
k = the solution to the equation k = √(1−𝛼) where is the MPY probability level
For more about k, we recommend that you watch the following videos on YouTube:
Chebyshev’s theorem: https://www.youtube.com/watch?v=OM0K22pmkuY
We strongly recommend that you also read wider on the topic to gain a good understanding.
The purpose of this module is not to examine you on the basic calculations but to apply the
theory to solve problems.
For the purpose of this module, you will not need to calculate k as the value will be given.
11.5.4.6. The normal power method

1
MPYNP = E(x) + [Z + ( )(x)(Z2- 1] (X)
6
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Where
MPYNP = the maximum probably yearly aggregate loss estimator utilising the normal power
method
(x) = the skewness of the total loss cost distribution and where the other terms have the
same interpretation as those provided earlier
The normal power method is the most accurate for estimating MPY for skewed distributions.
The MPY may however be overestimated if the distribution is highly skewed.
You can refer to a few YouTube videos for more clarity:

https://www.youtube.com/watch?v=nqPS29IvnHk
For the purpose of this module, you will not need to calculate Z or Z and (x), as the values
will be given.
27
December 2021
Annexure B
XYZ (Pty) Ltd is a logistics company with a fleet of 100 delivery vehicles. The non-life
insurance policy of the company is due for renewal and the CRO wants to determine the MPY
to use as input in the decision-making process. To calculate the MPY, you need to calculate
the mean, variance and standard deviation for the loss distribution.
The expected loss data for the motor fleet is as follows
N Loss (X) Probability (P)
1 R100 000 .1
2 R120 000 .15
3 R 90 000 .07
4 R130 000 .06
5 R150 000 .05
6 R 80 000 .07
7 R 70 000 .05
8 R120 000 .07
9 R160 000 .08
10 R180 000 .08
11 R270 000 .1
12 R250 000 .13
∑ 1.00
X = expected losses
P = probability
Companies can base the numbers on historical data and past experience and then make
projections on future events. Quite often, they do not have statisticians in-house to develop
models to analyse data and make predictions. Management then uses methods as discussed
in Topic 2 to develop scenarios and form a consensus on potential losses and probabilities.
To calculate the mean, you need to apply the following formula:
µ = E(x) = ∑[xP(x)]
N X P(X) X*P(X)
1 R100 000 0,1 R10 000
2 R120 000 0,15 R18 000
3 R90 000 0,07 R6 300
4 R130 000 0,06 R7 800
5 R150 000 0,05 R7 500
6 R80 000 0,06 R4 800
7 R70 000 0,05 R3 500
8 R120 000 0,07 R8 400
9 R160 000 0,08 R12 800
10 R180 000 0,08 R14 400
11 R270 000 0,1 R27 000
12 R250 000 0,13 R32 500
1.00 µ = R153 000
28
December 2021
The next step is to calculate the variance and the standard deviation.
σ2 = ∑[(x - µ)2P(x)]
N X P(X) (x-µ) (x-µ)2 (x-µ)2P(x)

1 R100 000 0,1 -R53 000,00 2 809 000 000 280 900 000
2 R120 000 0,15 -R33 000,00 1 089 000 000 163 350 000
3 R90 000 0,07 -R63 000,00 3 969 000 000 277 830 000
4 R130 000 0,06 -R23 000,00 529 000 000 31 740 000
5 R150 000 0,05 -R3 000,00 9 000 000 450 000
6 R80 000 0,06 -R73 000,00 5 329 000 000 319 740 000
7 R70 000 0,05 -R83 000,00 6 889 000 000 344 450 000
8 R120 000 0,07 -R33 000,00 1 089 000 000 76 230 000
9 R160 000 0,08 R7 000,00 49 000 000 3 920 000
10 R180 000 0,08 R27 000,00 729 000 000 58 320 000
11 R270 000 0,1 R117 000,00 13 689 000 000 1 368 900 000
12 R250 000 0,13 R97 000,00 9 409 000 000 1 223 170 000
1 σ2 4 149 000 000
σ R64 413
When you do any calculations in assignments or examinations, you must show the
calculations and use tables to present your answer as demonstrated above, enabling the
marker to follow your logic. It is also essential to show the formulae and explain the variables.
To calculate the MPY with the Chebyshev method. Assume a factor of 1.05.
MPYC = E(X) + kσ(X)
MPYC = R153 000 + 1.05(R64 413)
R220 633
BIBLIOGRAPHY
Culp, C. 2006. Structured Finance and Insurance: The ART of Managing Capital and Risk.
Hoboken: John Wiley & Sons.
Cummins, J. & Freifelder, L. 1978. A Comparative Analysis of Alternative Maximum Probable

Yearly Aggregate Loss Estimators. The Journal of Risk and Insurance. Vol. 45, No. 1, 27-52.
Brockett, P., Cox, S. & Witt, R. 1986. Insurance versus Self-Insurance. The Journal of Risk
and Insurance. Vol. 53, No. 2, 242-257.
Dufresne, F., & Gerber, H. 1989. Three Methods to Calculate the Probability of Ruin. ASTIN
Bulletin, Vol.19 No. 1, 71-90.
Ehrlich, I., & G. Becker,G. 1972. Market insurance, self-insurance and self-protection. Journal
of Political Economy Vol. 80, No. 4: 623–648.
Gollier, C. & , J. 2013. Risk and choice: A research saga. Journal of Risk and Uncertainty. Vol.
47, No. 2, 129-145.
29
December 2021

smoothing and risk management by in The Journal of Risk and Insurance. Vol. 83, No. 3, 719–
734.
McGuiness, J. 1956. Is Probable Maximum Loss (PML) A Useful Concept? Proceedings of

the Casualty Actiarial Society No. 56, 31-40.
Reid, J. 1995. The Cost of Risk and the Concept of Risk Partnership. The Geneva Papers on
Risk and Insurance No. 76, 279-283.
Van Huyssteen, J. 2014. The impact of solvency assessment and management on the short-
term insurance industry in South Africa. Unpublished MCom dissertation, University of South
Africa, Pretoria.
Valsamakis, A., Vivian, R. & Du Toit, G. 2010. Risk Management. 4th ed. Sandton: Heinemann.
30
December 2021
STUDY UNIT 12: CONTINGENT CAPITAL
AIM
The aim of this study unit is to give an overview of contingency capital as a pre-loss risk
financing alternative.
KEY CONCEPTS
Enterprise risk management

Debt
Contingency capital
LEARNING OUTCOMES
At the end of this study unit, you should be able to:
 argue the benefits of debt

 explain the cost of debt
 analyse the business effects of credit downgrades
 explain the concept of contingent capital
 evaluate the key features of contingency capital
 explain the forms of contingency capital
 criticise the strategies the enterprise can deploy to reduce the information cost of capital
31
December 2021
LEARNING MATERIAL
This study unit is based on journal articles that can be sourced from the library and the internet.
12.1. Toward a more complete model of optimal capital structure

This article was downloaded in Par 3.6 in Topic 1.
Heine, R. & Harbus, F. 2002. Toward a More Complete Model of Optimal Capital Structure.
Journal of Applied Corporate Finance. Spring 2002 Volume 15. No.1.
 Introduction
 Measurement of shareholder value under “normal” volatility
 Primary decision variables and typical findings
 Optimal capital structure adjusted for liquidity requirements
 Conclusion
 Appendix: Model flow
 Discuss the model flow of the Deutsche Bank Liability Structure Model.
 Discuss the benefits of debt.
 Discuss the cost of debt.
 What is the business effects of credit downgrades?
12.2. Contingent Capital: Integrating Corporate Financing and Risk

Management Decisions
Culp, CL. 2002. Contingent Capital: Integrating Corporate Financing and Risk Management
Decisions. Journal of Applied Corporate Finance. Spring 2002 Volume 15.1.
 Introduction
 What is contingency capital?
 Forms of contingency capital
 Reducing the information costs of raising capital
 Conclusion
 Explain the concept of contingent capital

 Discuss the key features of contingency capital
 Discuss the forms of contingency capital
 What strategies can the enterprise deploy to reduce the information cost of capital?
32
December 2021
12.3. Raising contingent capital: The case of Cephalon

Chacko, G., Tufano, P., & Verter, G. 2002. Raising contingent capital: The case of Cephalon.
Journal of Applied Corporate Finance. Spring 2002 Volume 15.1.
Read the following sections in the document:
 Introduction
 The business environment and decisions facing Cephalon
 Making the case for contingent capital
 Valuing the Cephalon options
 Was it really a financing decision? Alternative explanation
 Follow-up and implications
SUMMARY
This study unit provided an overview of contingency capital as a risk financing option. Finite
insurance is covered in the next study unit.
33
December 2021
STUDY UNIT 13: FINITE INSURANCE
AIM
The aim of this study unit is to give an overview of finite risk insurance.
KEY CONCEPTS
Finite risk insurance

Structured insurance
Prospective finite risk structures
Retrospective finite risk structure
Pre-loss funded finite risk solutions
Post-loss funded finite risk solutions
Loss portfolio transfers
Adverse development covers
Retrospective aggregate loss covers
LEARNING OUTCOMES
 explain the concept of finite risk insurance

 evaluate the key features of and objectives of finite risk insurance
 explain the finite risk insurance structures and solutions
 argue how the financial needs of an enterprise can be met with a finite risk solution
 distinguish between the features of finite risk insurance and traditional insurance
 explain the nature of liabilities that are typically covered by finite risk programmes
 evaluate pre-loss versus post-loss funded finite risk programmes
 argue the sound principles of finite risk insurance
34
December 2021
LEARNING MATERIAL
This study unit is based on prescribed articles.
13.1. Finite risk insurance: a new product based on an old standard (available
on myUnisa)
 What is finite risk insurance

 Who uses finite risk insurance?
 Prospective finite risk programmes
 Conclusion
 Explain the concept of finite risk insurance

 Describe the characteristics of a candidate for finance risk insurance
 Give examples where finite risk insurance can be of use to an enterprise
13.2. Finite risk insurance as a form of alternative risk transfer

Mostert, JH. & Mostert, FJ. 2008. Finite risk insurance as a form of alternative risk transfer.
Corporate Ownership & Control. Vol. 6, No. 1, available at the following link:
http://www.virtusinterpress.org/IMG/pdf/10-22495cocv6i1c3p2.pdf.
 Key features and objectives of finite risk insurance

 Variants and types of finite risk insurance
 Linking financial needs of enterprises to particular finite risk insurance solutions
 Linking financial needs of insurers to particular finite risk solutions
 Future prospects of finite risk insurance
 Closing remarks
 Explain the key features of and objectives of finite risk insurance

 Explain the concept of loss portfolio transfers
 Explain the concept of adverse development cover
 Explain the concept of spread loss cover
 Explain the concept of quota share reinsurance
 Explain how the financial needs of an enterprise can be met with a finite risk solution
35
December 2021
13.3. The uses and abuses of finite risk reinsurance

Culp, C. 2005. The uses and abuses of finite risk reinsurance. Journal of Applied Corporate
Finance. Vol. 17 No. 3. 18-31.
 Introduction
 The risk management landscape
 A simple example of finite
 Typical finite risk structures
 Opportunities for abuse
 Summary
 Give examples of structured insurance solutions

 Explain the features that distinguish finite risk insurance from traditional insurance
 Explain the nature of liabilities are typically covered by finite risk programmes
 Explain pre-loss versus post-loss funded finite risk programmes
 Explain the products that can be regarded as finite risk products
 Explain the sound principles of finite risk insurance
SUMMARY
This study unit provided an overview of finite insurance as a type of hybrid of risk retention
and risk transfer method. The next study unit will cover captive insurance as a type of self-
insurance or risk retention vehicle.
36
December 2021
STUDY UNIT 14: CAPTIVE INSURANCE
AIM
The aim of this study unit is to give an overview of captive insurance.
KEY CONCEPTS
Captive insurers
Types of captives
Captive design life cycle
LEARNING OUTCOMES
 analyse the purpose of a captive

 evaluate the benefits of forming a captive
 explain the factors that should be considered when evaluating the feasibility study of a
captive
 discuss the types of captives
 explain the captive design life cycle
 evaluate the attributes of a successful captive insurance programme
37
December 2021
LEARNING MATERIAL
This study unit is based on prescribed articles.
14.1. Captive insurance companies (available on myUnisa)
 Introduction
 What is a captive?
 Formalised form of self-insurance
 Why form or join a captive programme?
 Who should consider a captive
 Domiciles (South African insurance companies also offers cell insurance structures
and products – the principles stated in this document are however applicable in
principle)
 Types of captives and risk insured
 Flexibility in insuring risk
 Captive design life cycle
 Application cost, review, and licensing (Regard the cost for illustrative purposes – in
assignments or the examination the cost will be given)
 Successful captive insurance programme attributes
 Conclusion
 Explain the purpose of a captive

 Discuss the benefits of forming a captive
 Explain the factors that should be considered when evaluating the feasibility study of
a captive
 Discuss the types of captives
 Explain the captive design life cycle
 Discuss the attributes of a successful captive insurance programme
14.2. Foreign protected cell insurance companies: a comparative analysis
Foreign protected cell insurance companies: a comparative analysis by W Byrnes available at

the following link: http://www.thesait.org.za/news/101743/Foreign-Protected-Cell-Insurance-
Companies-A-comparative-Analysis-.htm
 Read the article and bear in mind that there are concerns regarding offshore captives
and protected cell companies
38
December 2021
SUMMARY
This study unit provided an overview of captive insurance as a type of hybrid of risk retention
and risk transfer method. The next topic will cover insurance as a risk transfer mechanism.
BIBLIOGRAPHY
Culp, C. 2006. Structured Finance and Insurance: The ART of Managing Capital and Risk.
Hoboken: John Wiley & Sons.
Culp, C. 2005. The uses and abuses of finite risk reinsurance. Journal of Applied Corporate
Finance. Vol. 17 No. 3. 18-31
Cummins, J. & Freifelder, L. 1978. A Comparative Analysis of Alternative Maximum Probable

Yearly Aggregate Loss Estimators. The Journal of Risk and Insurance. Vol. 45, No. 1, 27-52.
Brockett, P., Cox, S. & Witt, R. 1986. Insurance versus Self-Insurance. The Journal of Risk
and Insurance. Vol. 53, No. 2, 242-257.
Dufresne, F., & Gerber, H. 1989. Three Methods to Calculate the Probability of Ruin. ASTIN
Bulletin, Vol.19 No. 1, 71-90.
Ehrlich, I., & G. Becker,G. 1972. Market insurance, self-insurance and self-protection. Journal
of Political Economy Vol. 80, No. 4: 623–648.
Gollier, C. & , J. 2013. Risk and choice: A research saga. Journal of Risk and Uncertainty. Vol.
47, No. 2, 129-145.

smoothing and risk management by in The Journal of Risk and Insurance. Vol. 83, No. 3, 719–
734.
McGuiness, J. 1956. Is Probable Maximum Loss (PML) A Useful Concept? Proceedings of

the Casualty Actiarial Society No. 56, 31-40.
Mostert, JH. & Mostert, FJ. 2008. Finite risk insurance as a form of alternative risk transfer.
Corporate Ownership & Control. Vol. 6, No. 1. 347-356.
Reid, J. 1995. The Cost of Risk and the Concept of Risk Partnership. The Geneva Papers on
Risk and Insurance No. 76, 279-283.
Van Huyssteen, J. 2014. The impact of solvency assessment and management on the short-
term insurance industry in South Africa. Unpublished MCom dissertation, University of South
Africa, Pretoria.
Valsamakis, A., Vivian, R. & Du Toit, G. 2010. Risk Management. 4th ed. Sandton: Heinemann.
UNISA 2021
39
December 2021
Captive
Insurance Companies
What to Consider
When Establishing and
Operating Captives
PAT R I C K T H E R I A U LT, C PA , C P C U , A I A F
Vice President and Director, Client Services
Wilmington Trust SP Services (Vermont), Inc.
The use of alternative risk transfer vehicles, which includes
captive insurance companies, has almost become the norm
rather than an innovation for larger organizations, following
the recent hard commercial insurance market cycle. These
vehicles represent roughly half of the U.S. insurance market;
yet captive insurance companies, or captives, are still
somewhat of a misunderstood alternative for organizations
that do not currently operate one.
Most risk managers or financial executives of mid to large corporations

know the term “captive insurance,” but they are still often unfamiliar with how these
entities are formed and how they affect a company’s day-to-day operations.
Therefore, these executives often rely on their insurance agents or brokers to present
them with the best available alternative. Unfortunately, while most insurance
agencies and brokerage firms of a certain size have captive specialists on staff, many
of the agents and brokers in the field are uneasy with recommending the captive as
an alternative risk transfer (ART) vehicle, or are not fluent enough to identify when
a captive should be considered. The following discussion will provide some basic
information about captive insurance companies, the steps required to determine
whether a captive might be an attractive solution, and information on how a captive
is formed and managed.
Captive Insurance Companies
What is a captive?
There are many definitions used to describe a captive insurance company. This is
primarily due to the different ways in which a captive can be structured and utilized
by its owners or insureds. The American Institute of Certified Public Accountants and
Towers Perrin provide the following definitions:
• “Wholly owned subsidiaries created to provide insurance to the parent

companies.” (AICPA Audit and Accounting Guides)
• “A closely held insurance company whose insurance business is primarily

supplied by and controlled by its owners, and which the original insureds are
the principal beneficiaries. A captive insurance company’s insureds have
direct involvement and influence over the company’s major operations,
including underwriting, claims management policy, and investment.”
(Towers Perrin)
By reading between the lines, one can deduce that at the end of the day a captive is
really one form of alternative risk financing, or in other words, a formalized form of
self insurance. Previously restricted to large corporations, the recent creation of new
captive structures, clarification around tax and accounting implications of captive
participation, and the insurance market cycles have led organizations ranging from
publicly traded companies, to mid and large privately held and tax exempt entities, to
groups of individuals, to look to captive insurance companies as a possible solution to
their insurance problems.
P 2
Formalized Form Why Form or Join
of Self Insurance a Captive Program?
Just like other self insurance mechanisms, such as So why do so many companies now have a captive
policy self insured retention (SIR) and large subsidiary? What are the key reasons or benefits of
deductible programs, a traditional captive arrange- forming a captive?
ment allows an organization to retain part of its
• Reduced insurance costs:
risk internally. However, unlike these common risk
During the recent hard market, many
management tools, a captive insurance program will
companies saw double digit increases in their
require pre-funding of the risk. Once formed,
insurance premiums even though their loss
a captive will operate more or less just like a
experience remained virtually unchanged. By
commercial insurer, issuing an insurance policy and
using a captive they were able to continue
therefore assuming the risk of its parent/owner in
charging themselves a premium equal to their
exchange for the payment of a predetermined
historical loss experience.
insurance premium. The captive will be licensed as
an insurance company in its “domicile” and, though • Stabilized insurance budgets:
not unlike commercial insurers subject to insurance
While the use of alternatives such as large
regulation, will have a more flexible regulatory
deductible programs and SIRs helps to reduce
environment. In this era of Sarbanes-Oxley and
overall insurance costs, it may also subject the
increased emphasis on internal controls and
users to large year-over-year swings in their
transparency, the regulatory environment in which
insurance budget, depending on their claims
captive insurance companies operate can bring a
experience. By using a captive, an entity may be
significant additional level of comfort to executives
able to set insurance reserves equal to ultimate
across all industries, ensuring that their retained risks
expected losses, therefore providing for some
are accounted for properly in their financial
consistency in insurance expense. From a
statements.
subsidiary’s perspective, the captive provides for
more consistent year-over-year insurance
premiums, as retained earnings in the captive
are used to absorb worse-than-expected results
in bad years.
• Coverage availability:
The recent medical malpractice and other
industry crises have resulted in several
commercial insurers pulling out of certain • Possible tax benefits:

states or lines of coverage altogether, leaving Captive insurance taxation is a very
insureds with no insurance options. Many of complex topic, but in short, there are some tax
these insureds have grouped together and advantages available only to insurance
formed captive insurers to step in and replace companies. Under the right sets of facts and if
the commercial market. structured properly, these advantages may be
available to a captive program.
• Direct access to the
reinsurance market:
• Profit center creation:
A captive provides insureds with direct
While captives are typically used to insure
access to a market they could not access other-
the risk of its parent(s), under the right
wise, or at least not in a very efficient basis—
circumstances and depending on the risk
the wholesale reinsurance market. Since
appetite of the captive owner, the entity could
reinsurers have lower costs of operation and
be used to insure third party or controlled
regulatory barriers, they can often provide
unrelated risk such as risk of customers,
coverage at more affordable rates.
vendors, or franchisees. If managed properly,
• Improved claims handling insuring unrelated risk could become a very

and data collection: profitable endeavor to a captive owner.
Under a fully insured or large deductible
• Negotiation tool:
program, insureds often rely, or are required to
Once formed, the greatest benefit of
rely on, their insurer to keep a historical
owning a captive is probably the additional
database of their claims activity. Insureds too
negotiation power it provides during
often discover several years later that the
discussions with the commercial market. An
information was not kept in a very useful
insured can easily and rapidly decide to insure a
format or is very difficult to access, especially if
risk or a portion of a risk in its captive if it is in
they are no longer doing business with the
a situation of being overcharged by the
insurers. By using a captive, insureds can often
commercial market. It is not unusual to see an
un-bundle claims administration services to
insurer adjusting its rates downward when
Third Party Administrators (TPAs), who
faced with the likelihood of losing a piece of
specialize in the lines of coverage insured and
business to a captive, since once a risk is insured
take control internally of when, what, and how
in a captive, it very rarely returns to the market.
information is reported.
P 4
Who should consider
a captive?
A risk manager of a large organization recently said
the following to a group of his peers at a conference,
while explaining what a captive brought to his
organization: “Just like a carpenter, a risk manager
must have all the right tools in his tool box in order to “Just like a carpenter,
be able to build the best risk management program.
a risk manager must
A captive is one of those tools.” What he meant is that
have all the right tools
most organizations can benefit from having a captive
today or at some point down the road; not having such in his tool box in order
a facility available when the need arises is like having to be able to build the
a tool missing from a tool box. best risk management
That being said, since a captive does require a program. A captive is
commitment of time and resources, a captive
one of those tools.”
program may not make perfect business sense in all
situations. There are a few key variables a prospective
captive owner should analyze when evaluating the
feasibility of a captive program. The more of the
following variables that are present, the more likely a
captive will bring material benefits to its owner:
• Premium size:
While there are specialized captive
structures that may provide interesting benefits
for smaller programs, in order to overcome the
start-up costs and ongoing operating expenses
most captive programs will require annual
premiums of $1 million or more.
• Good historical loss experience:

While most insurance buyers feel they are
being overcharged by the commercial insurance
market, it is surprising how often a detailed
analysis of their loss experience actually shows make sense, many captive projects will not get
that this might not be the case. An insured with off the ground or evolve without the presence
a good historical loss experience, who is of a dedicated project leader within the
experiencing premium increases resulting from prospective captive owner’s organization. This
the commercial insurance market cycles, is an project leader should have senior management
ideal candidate for a captive program. credibility.
• Commercial market availability: Domiciles

Lines of insurance or industries that have Historically, captive insurance companies have been
become disfavored by the commercial market associated with various offshore locations such as
are good candidates for captive insurers. Bermuda, the Cayman Islands, and Barbados.
Disfavored industries, such as medical However, recent events such as September 11th, the
malpractice insurance in recent years, suffer Enron debacle, and the recent medical malpractice
from a supply and demand misbalance and are crisis have resulted in onshore locations gaining in
typically overcharged or not provided the popularity. This is so much true that the United
amount of insurance required to properly States has recently replaced Bermuda as the number
operate the business. A captive can help bring one captive domicile in the world, with over one
back the balance. thousand active captive insurance companies. This
recent trend of favoring onshore locations has
• Risk retention appetite: resulted in an explosion of the number of states
While captives are real insurance allowing the formation of captives, and in a level of
companies, at the end of the day they are really competition between domiciles never seen
a formalized form of self insurance, especially previously. There are now roughly 25-30 states with
in the case of single parent captives. Adverse some form of a captive statute on their books.
results at the captive level will negatively Vermont remains the true onshore leader with more
impact the results of its parent. Therefore, if active captives than all other states combined, but a
your organization is risk averse, a captive may handful of other states have reached a level of
not be right for you. credibility with more than 50 active captives and a
dedicated regulatory staff.
• Dedicated project leader:
With the number of options continuing to increase,
A captive is a complex entity subject to
what are the key factors to consider when choosing a
accounting, tax, and regulatory guidelines that
captive domicile? The first step of the domicile
may be unfamiliar to the organization
analysis is probably to narrow it down between
considering the captive. While a captive might
offshore or onshore locations.
P 6
Why Offshore? • Tax benefits:
An offshore domicile would most often be retained While most of the tax benefits that fueled
for three leading reasons: third party risk; regulatory offshore captive formation in the early days
flexibility; and tax benefits. have now been greatly reduced or eliminated,
• Third party risk: some possible advantages may still exist and
should be considered. While the premium tax
Onshore domiciles typically limit their
rates charged by most onshore domiciles are
captives to insuring the risk of their owner(s)
very low1, large captives might nevertheless be
and risk from controlled unrelated business.
able to obtain tax savings in excess of $100,000
Controlled unrelated business would be limited
by locating their operations in an offshore
to risks such as joint ventures or customers
domicile that has no premium tax. Some
where the parent has a significant amount of
carefully designed offshore captives might also
influence on the risk management or loss
provide income tax advantages to tax exempt
control process. Any risk that would not meet
organizations or help individuals reduce the
the definition of controlled unrelated business
effects of double taxation of profits. Captive
would most likely have to be insured in an
insurance taxation is a very complex subject
offshore captive.
matter and as such, owners should seek advice
• Regulatory flexibility: from their tax advisors early in the structuring
Offshore is usually synonymous with and formation process.
increased flexibility in the captive arena. This

Why Not Offshore?
flexibility is sometimes real but at times just a
perception. Flexibility might arise in terms of • Lines of coverage:
the ownership structure, operation, and allow- Some types of risk cannot be insured in an
able investments, but the two main drivers are offshore captive. For example, the Department
usually capitalization and regulation. Offshore of Labor (DOL) recently provided that
domiciles tend to have lower minimum capital corporations wishing to insure employee
requirements and do not typically perform benefits regulated under the Employee
regulatory examinations, relying instead on the Retirement Income Security Act (ERISA) in
work of Certified Public Accountants. As their captive must locate the captive in an
stated previously, in this era of increased focus onshore jurisdiction.
on internal controls and Sarbanes-Oxley, some
1
A couple of onshore domiciles such as Arizona and Utah do not
companies may actually favor the slightly currently charge any premium tax, instead charging a slightly higher
higher level of regulation offered by onshore annual license fee. Other domiciles such as Hawaii also do not charge
premium tax on premiums that have already been subject to a
domiciles. premium tax (i.e. assumed reinsurance).
• Access to Federal programs: • Accessibility and ease of operation:

Some benefits offered through Federal Depending on the location of the captive’s
Government programs or laws are only parent and its management, it can often be time
available to onshore insurers. Two examples are consuming and expensive to travel to many of
the Terrorism Risk Insurance Act of 2002 the offshore locations, although the same can
(TRIA) and the formation of risk retention be said for the two leading onshore domiciles,
groups under the Liability Risk Retention Act. Vermont and Hawaii. Now that at least half of
the states have captive laws on their books, it
• Tax disadvantages:
may be possible for a corporation to form a
While offshore domiciles are associated captive in its own backyard.
with tax benefits, they may actually result in
higher taxes in some instances. For example, • Reputation/perception:
premiums paid to an offshore captive may be Whether real or not, there is still a tax
2
subject to the Federal Excise Tax (FET) . FET haven stigma attached to many of the offshore
is charged, when applicable, at a rate of 4% or jurisdictions. Several of the leading offshore
1% for direct and reinsurance premiums, domiciles have long established reputations as
respectively, a rate much higher than the insurance or financial centers, while others are
premium tax charged by onshore captive more known as exotic tourist attractions.
domiciles. Captives electing to be taxed as U.S. Corporations need to evaluate this based on
entities should be aware of the “Dual their own internal philosophy and industry
Consolidation Loss Rule,” while those choos- particulars.
ing not to make this election could subject
The bottom line is that there is no one “right”
themselves to significant punitive taxes if
domicile. Every prospective owner should
deemed to be doing business in the U.S.
perform a domicile analysis as part of the
• Higher cost of operation: captive feasibility study. The domicile should be
Operating expenses can vary significantly selected in light of the organization’s particulars
from one domicile to another, but it is not and specifics by ranking the various options
unusual for the cost of services such as captive available using pre-determined, weighted
management, audit and legal fees, and others to variables. The most common key variables used
be as much as 10-20% more in some of the during the domicile selection process are:
more established offshore domiciles. reputation and perception, regulation and

infrastructure, cost of operation, tax implica-
2
Offshore Captives may avoid being subject to FET by, if available to
tions, and logistics and ease of operation.
them, making an election to be taxed as an U.S. insurance company
(i.e. 953(d) election).
P 8
Types of Captives • Group Captives:
and Risk Insured Many group captives operate much in the

The forms and types of captive structures available same manner as single parent captives except,
continue to evolve every year. A new trend is also to as the name implies, they are owned and insure
combine existing forms into more complex single or a group of entities or individuals. This captive
multi captive structures or to explore potential form is typically chosen because the par-
benefits of using atypical corporate legal structures in ticipants are not large enough to form their
captive arrangements. That being said, most captives own single parent captive, to achieve a higher
still fall under one of three main groupings: level of buying power with the reinsurance
market or other providers by aggregating their
• Single Parent or Pure Captives:
risk, or to achieve a certain level of true risk
Single parent or pure captives represent the
transfer 3. Group captives encompass many
great majority of active captives (probably
different structures, including: Industrial
somewhere around 70% - 80% or more). They
Insured Captives, Association Captives, Risk
are typically stock corporations owned 100% by
Retention Groups, and Reciprocals.
their insured parent. Their sole purpose is to
insure the risk of the parent, affiliates, or • Rent-a-Captives:
subsidiaries. A recent subset of the pure captive In certain respects, rent-a-captives are a
is the branch captive. Branch captives are relatively new type of captive and have grown
formed and regulated in more or less the same significantly in popularity in recent years. They
manner as a pure captive in the domicile where are comprised of a combination of the
they are licensed, but are more like a division of characteristics of both the single parent and
an existing captive (i.e. not a separate group captives. They typically consist of a stock
corporation). The most typical use of a branch company owned by an insurance company or
captive is in situations where a parent of an other large provider of insurance products. As
offshore captive would like to insure employee the name implies, rent-a-captives allow third
benefit risk regulated under ERISA. Since the parties to insure their own risk in the captive
Department of Labor requires that the risk be
insured in an onshore captive, the parent
3
creates an onshore branch captive rather than Since single parent or pure captives are wholly owned subsidiaries
of their parent insured, their results would typically be consolidated
forming a new pure captive in order to achieve with the results of their parent. Group captives however, depending
on their legal structure and the ownership level of the insured or
capital and cost of operation efficiencies. captive participant, may be treated as off-balance sheet transactions,
therefore resembling more the purchase of insurance from the
commercial market from an accounting perspective. This topic is
outside the focus of this paper. Please contact Wilmington Trust SP
Services for more information.
for a fee. The rent-a-captive owner provides the Flexibility in Insuring Risk
upfront capital and surplus required for the The type of legal structure available varies by
underwriting of risk and also typically provides domicile, but generally, captives can be formed as
many of the services required for the stock corporations, as mutual insurers, as limited
administration of the program. They are ideal liability corporations, as non-profit organizations, or
for entities too small to form their own captives as reciprocals.
or for entities interested in getting their feet
One of the greatest benefits of a captive is its
wet before deciding to form their own program.
ultimate flexibility as to the type of risk it can insure.
The biggest advantages of rent-a-captives are:
Basically, the sky is the limit and anything that
ease of access, as they are typically turnkey
makes good business sense could most likely be
operations; lower start up costs, as no capital
approved by the domicile regulators and as such,
infusion is required; and possible lower ongoing
insured by a captive, if structured and financed
cost of operation from pooling of services.
adequately. That being said, the great majority of
However, rent-a-captive users are relinquishing
captives are still used to insure standard property and
a large part of the management control of their
casualty risks such as all risk property, workers
program to the rent-a-captive owner, and there
compensation, general and auto liability, professional
is very little case law around the tax treatment
liability, and product liability. More recently, large
of these structures, if challenged. Also, while no
captive owners have begun using captives to insure
start-up capital is required, the rent-a-captive
some employee benefit risks such as group life, long
owner may require significant levels of
term disability, and medical stop loss. Many believe
collateral or guarantees against insurance losses
that pension and postretirement benefits are just
being worse than expected.
around the corner.
— The late 1990’s introduced a new form of rent-a- It should be noted that while there is little restriction
captive referred to as protected cell, segregated cell, or per se, the type or location of a captive vehicle used
sponsored captives. They operate virtually the same way may limit the type of risk that can be insured. For
as their rent-a-captive siblings except that the risk of the example, risk retention group captives can only
participants or users is kept separate from one other. As insure liability risks as defined under the Liability
such, the assets of one participant cannot be used to pay Risk Retention Act and, as stated previously, ERISA
the losses of another in the event of adverse results. It employee benefits can only be insured by an onshore
should be noted that while most experts believe that the captive program.
segregation aspect would hold if tested, this has yet to be
challenged in the courts.
P 10
Captive Design Life Cycle
All new captives will go through some form of
program design life cycle.The actual number of steps
required and how long each phase will take to be
completed vary depending on the complexity and
severity of the issues faced by the organization
considering the captive. In some very severe
situations where a captive might be the only available
solution, all five phases may be completed in 45 to
90 days. In the case of very complex organizations
evaluating a range of viable options, the process
could take as much as 12 to 24 months.
It is worth expanding on three key steps :
• Pre-feasibility analysis:
The pre-feasibility analysis consists of
a back-of-the-envelope assessment of the
viability of a captive program. Normally per-
formed by a captive manager or a captive
consultant, it is a quick review of the issues
being faced, the current insurance program,
historical loss experience, corporate structure, Captive Design Life Cycle
and organization/industry hurdles. Typically
completed in a few days or weeks at no or
limited cost to the prospective captive owner,
its main goal is to eliminate obvious obstacles
that would not make a captive a viable vehicle
before embarking into a time consuming and
often expensive full blown captive feasibility
study.
• Feasibility study: appropriate amount of capital required for the

Captive feasibility studies are often captive to assume the risk contemplated.
mistaken to be an actuarial analysis. While an The actuarial report will also be a very important
actuarial review of the lines of coverage component of the captive application filed with the
considered for the captive is a very, if not the domicile regulators, if a decision is made to form the
most, important part of the analysis, a captive captive.
feasibility study would not be complete if it did
—Financial and operations evaluation. The financial
not also incorporate a financial and operations
and operations evaluation, normally performed by a
evaluation of the proposed captive and its
captive manager or consultant, will focus on
parent(s)/insured(s).
reviewing financial and industry information of the
—Actuarial study. The actuarial study, performed by prospective captive owner including, but not limited
a third party actuary, consists of a detailed review to: an organizational chart and most recent available
of the prospective captive owner’s loss exposure annual report or financial statements; industry
information, historical loss patterns, frequency and specific regulatory hurdles or barriers; scheduled or
severity of loss activity, and schedule of large losses. anticipated insureds and their current deductible or
In order for the analysis to provide credible self insured retention levels; current accounting and
information, the actuary must have access to a tax situation; and philosophy.
minimum of three to five years of very detailed loss This analysis should provide the potential captive
information. The actuary will complement the owner with pro forma financial statements for the
information available with related industry data. captive; a net present value cash flow analysis of the
The product of the actuary’s work is a report captive compared to alternative options and status
typically providing four main products: per quo; a report showing the effects of the captive on
occurrence and aggregate stop loss retention consolidated earnings before income tax, interest,
evaluation; coverage premium determination; depreciation, and amortization (EBITDA); and a
confidence level analysis; and capitalization schedule of operation and other non-financial
requirements. In other words, the actuarial report benefits or shortcomings of the captive program.
will provide the actuary’s best projection of the In short, while the actuarial analysis will identify
premium to be charged and ultimate incurred losses whether the prospective captive owner is being
under various different scenarios. At a minimum, the overcharged by the commercial market, therefore
analysis will project the numbers under both an suggesting a higher retention of risk, the financial
expected and an adverse scenario. This range of and operations review will determine whether the
possible outcomes will be used to compute the higher retention of risk can be best managed within
a captive structure.
P 12
In addition to the above, a captive feasibility study
should, if it reaches the conclusion that a captive
program would best achieve the goals and objectives
previously identified, provide for consideration of
one or a few proposed structures, including a
comparison of captive domiciles and available
ownership configuration. The feasibility study report
will be the building block of the Executive Summary
to be provided to upper management leading to the
Go or No-Go decision and, if it is decided to go
forward, to the captive application and its formation.
Many variables such as the number of lines of

coverage under consideration, the number of parties
involved, the quality and accessibility of loss and
financial information, and the level of commitment
of the prospective captive owner to the project will
affect the time and expense of the feasibility study.
Very simple studies could cost as little as $20,000
and take roughly six weeks. More complex studies
could take 12 months or more and cost in excess
of $100,000.
• Captive application and formation: Captive Formation and Implementation

Service providers can be broken down in
two main groups: the required providers and
the suggested providers.
REQUIRED PROVIDERS. Most captive domi-

ciles require their captive owners to retain a captive
manager, an actuary, a financial auditor, and a bank.
—Captive Managers. The captive manager, indivi-

dually or as a firm, must typically be either approved
or licensed by the domicile where the captive
operates. The captive manager will generally
maintain the books and records of the captive, will cash, be deposited in a bank account in the name of
manage the work of the other service providers, and the captive.
will be the primary contact for the domicile
SUGGESTED PROVIDERS. Depending on the
regulators.
type of captive program and the domicile chosen, a
—Actuaries. The actuary, also typically approved by captive may be required, or would greatly benefit
the domicile, will prepare the annual reserve from the services of a domicile or consulting
certification required by the domicile and/or the attorney, an (re)insurance broker or intermediary, a
financial auditors. The loss certification is a third party administrator (TPA), an investment
confirmation that the reserves carried in the captive’s manager, and a tax advisor or other consultants.
financial statements are appropriate. The actuary will
The cost of retaining the above service providers can
also often prepare an annual report used as basis for
vary significantly depending on the type of captive,
the setting or the renewal of premiums.
the size and complexity of the captive, the domicile
—Financial Auditors. The financial auditor will chosen, and the frequency and timing of financial
issue an opinion on the adequacy of the financial reporting. The table below provides a rough range of
information issued by the captive under Generally what most captive owners should expect during the
Accepted Accounting Principles, or other approved early years of operation of their captive.
basis of accounting. An annual audit, and
The information required for a captive application
corresponding opinion, is required by all captive
varies slightly from domicile to domicile, but will
domiciles. The financial auditors will also often
consist generally of the following components:
prepare the captive’s income tax returns.
– Domicile application form signed by a
—Bank. All domiciles will require that the captive’s director of the captive
capital and/or operating funds, if held in the form of
P 14
– Certified copy of certificate of incorporation, description of how they will be compensated.
articles of association, and bylaws Finally, the business plan should include a narrative
– Biographical affidavit or resumes of all summarizing the findings of the feasibility study and
directors and officers
the projected financial results.
– Feasibility study or actuarial report
Once approved, and when the certificate of authority
– Captive business plan and financial pro forma
has been issued, any departure from the original
– Listing of service providers with description
of fee arrangement business plan will generally have to be pre-approved
– Parent company audited financial statements by the domicile regulators before it can be
– Shareholders’/members’ agreement for group implemented. This process, referred to as a change in
captives business plan, is typically much simpler than the
– Copy of proposed insurance policy/rein- original captive application review and can
surance agreement sometimes be approved in as little as a few days.
– Applicable filing and application review fees
—Financial pro forma projections. The financial
The three main key documents that will determine
pro formas, typically prepared by the third party
whether the application/business plan is approved by
actuary or the captive manager, consist basically of
the domicile regulators and a captive license is
the standard financial statements (Balance Sheet,
issued, are the feasibility study, as previously
Income Statement, Cash Flow Statement, Financial
discussed, the captive business plan, and the financial
Statements Notes) projected over a period of five
pro formas.
years under both an expected and adverse scenario.
—Business Plan. Normally drafted by the captive The loss information presented under both scenarios
manager, the business plan should depict in great should be consistent with the underlying feasibility
detail the proposed structure and the lines of study or actuarial projections. The pro formas should
business to be covered by the captive at inception or also present the basis for growth over time of
soon after. It should describe the type of captive and premiums and operating expenses including
its proposed ownership, the program rating inflation factors. Investment income should be
methodology or how premiums will be derived and calculated using conservative and realistic rates of
allocated, the loss control and safety programs to be returns for the type of risk to be insured and based
established, whether the program will be fronted or on projected invested assets. Any unusual amounts
written direct, the type and amount of reinsurance and management response to the adverse scenario
protection if any, and the proposed capitalization. (i.e. premiums increased, recapitalization, etc.)
The business plan should also detail the proposed presented in the pro formas should be explained in
management of the captive and provide a listing of the captive business plan.
the proposed service providers, including a
Application Cost, Review, in 30 days early in the year may take much
and Licensing longer during busy periods.
The cost of preparing the captive application,

• Market cycles:
generally prepared by the captive manager with the
The number of captives formed often
help of a domicile attorney, can sometimes be
increases significantly during hard market
included in the cost of the captive feasibility
cycles. Most domiciles have limited staff
preparation. If contracted separately, preparation of
dedicated to the captive division and can get
the captive application will range between $5,000
overwhelmed during hard market cycles.
and $20,000 for the captive manager and between
$5,000 and $15,000 for legal work depending on the • The domicile chosen:
type of captive, the complexity of the program, and
Be aware of what is happening in the
the components to be completed.
domicile you favor. Does the domicile review
Captive application filing and review fees will range the full application internally or do they hire
between $3,000 and $10,000 depending on the out some of the review? Have they experienced
domicile chosen. Offshore domiciles tend to have significant growth recently? Have they been
higher application review and annual license fees. subject to recent staff turnover? Does the
Most domiciles state that an application will be domicile have a history of preferring certain
reviewed in no more than 30 to 60 days. The actual captive structures over others? Prospective
amount of time required will depend on the captive owners with tight deadlines should
following variables: inquire with local service providers regarding
their domicile of choice to make sure they are
• Complexity of the captive program:
in a position to review an application under the
A single parent captive writing one line of
time frame they advertise.
business should be reviewed in no more than 30
days. A group captive or risk retention group Once the application has been approved and a
writing several lines of business will most likely license has been issued, captive owners should never
take at least 45 or 60 days and possibly more. forget the following:
• The time of the year: Once licensed, a captive is only authorized to do

business in its location of domicile.
Most domiciles tend to be very busy in the
fourth quarter as many prospective captive As such, a Cayman or Vermont captive, for example,
owners are trying to have their program once licensed, cannot open an office in Illinois and
implemented for the January 1 insurance begin selling insurance in Illinois. This does not
renewals. An application that could be reviewed mean that a Cayman or Vermont captive cannot
P 16
insure Illinois risk, but it may only do so under focused on the risk they understand the best—
specific situations such as by using a licensed their own—insuring the “working” layer where
commercial insurer as front. The captive manager extensive data is available and premiums and
and/or consultant should review the various losses can more easily be actuarially
alternatives available with the prospective captive determined. Successful captives will also have a
owner during the feasibility study process. good spread of risk either by having a sizeable
enough exposure base for the law of large
numbers to operate,, or by incorporating a
Successful Captive Insurance number of lines of coverage with limited
Program Attributes correlation.
The success of a captive program will be judged at its
onset against the goals and objectives identified early • Good loss experience
and loss control program:
in the feasibility study process. However, due to its
often somewhat high start-up cost and the level of The success of a captive program can only
regulatory oversight it will be subject to, very rarely be as good as its underlying loss experience.
should a captive be formed solely to solve a short- The best way to manage underwriting results is
term problem. A captive will provide its greatest via targeted and rigid loss control and safety
benefit if it is designed with a focus on mid- to long- programs. Poorly managed risk programs are
term objectives with an emphasis on its ability to probably better insured by the commercial
adjust. markets, no matter how over-priced the market

might appear.
If looked at carefully, most successful captive
programs will have a few or most of the following • Fronting and reinsurance support,
attributes. Some can or should be identified at as required:
inception while others should be managed and Some captive programs cannot operate or
achieved over time. grow without adequate fronting and/or
reinsurance support. As such, captive owners
• Spread of risk with predictable losses:
should look to identify fronting insurers or
Most captive owners are experts at things
reinsurers with whom they can partner and
other than insurance. This is a big reason why
enter into a long-term relationship, even if this
several captives failed miserably some years ago
might mean paying slightly more in any given
when they attempted to compete against their
year. The captive owner needs to be
commercial insurer counterparts, and began
comfortable that the front or reinsurer will be
insuring significant amounts of true third party
there next year and the year after, through good
business. Successful captive owners will remain
and not so good years.
• Financially stable parent(s): • Long-term commitment

from management:
Most successful captive programs have
financially strong or stable parent(s)/insureds The true success of a captive program
that are able to pay the amount of premium cannot be ascertained until after it has been in
required for the risk insured year after year, and existence for 5, 10, or more years, depending on
that are in a position to provide the additional the lines of coverage insured. The captive
capital required to allow the captive to grow or should be managed in a manner consistent with
to weather bad years. A captive should not be other subsidiaries or affiliates and viewed as an
viewed as a piggy bank that can be plundered ongoing concern entity. With the current
whenever a new pet project comes along or narrow business focus of meeting next quarter’s
other divisions are experiencing difficulties. budget targets, this can often be a difficult
proposition.
• Good non-tax business purpose:
• Positive financial return to
Captive programs formed solely for tax
the corporate family:
reasons very rarely stick around for very long.
While many captive programs are primarily
Successful captives are formed for true and
cost centers, they should be constantly
identified risk management reasons. Tax
evaluated against the financial or cash flow
benefits obtained, if any, should be viewed as a
benefits they provide to the organization as a
bonus.
whole, and these benefits should be material. If
• Strong business partners: opportunities to convert the captive as a profit
Very few captives are self managed. As center become available, they should be
stated previously, captive owners are very rarely evaluated very carefully. Only captive programs
in the business of insurance in the first place. with positive financial returns will be able to
As such, it is crucial that a prospective captive achieve full support from upper management
owner retain the right business partners. Strong and be provided the resources needed to reach
business partners should have a good their full potential.
understanding of the captive industry in

general and how it is evolving, as well as the
industry of the captive’s parent. They should be
innovative and focused solely on the success of
the captive itself.
P 18
• Continuous re-evaluation of business
purpose and growth opportunities:
Corporations of all sizes constantly change
and evolve. Similarly, the captive program
should also be constantly challenged and re-
evaluated by its management to assure it
continues to fulfill its primary purpose: to more
Captive insurance is
efficiently manage organization-wide retained
risk. Risks originally retained by the captive
now part of every good
could possibly now be more economically risk manager or executive
insured by the commercial markets. officer’s vocabulary. In
Alternatively, risks previously non-existent or the right situation a
deemed immaterial might have arisen or grown
captive can provide
and are now ideally positioned for a captive
structure. This could not be identified without significant benefits to its
frequent strategic planning exercises for the parent(s) organization.
captive program.
Conclusion
Captive insurance is now part of every good risk
manager or executive officer’s vocabulary. In the
right situation a captive can provide significant
benefits to its parent(s) organization. Its review
and implementation should, however, not be
taken lightly as they are complex structures
subject to rigorous regulatory environments.
Only a well planned and managed captive
program will achieve full potential and be in a
position to adjust to its parent(s) needs.
Patrick Theriault, CPA, CPCU, AIAF
Vice President and Director, Client Services Delaware (Corporate Headquarters)
Wilmington Trust SP Services (Vermont), Inc. Wilmington 302.636.6766
New York
Patrick is responsible for the supervision of captive insurance company client New York City 212.751.9500
accounting and regulatory functions, implementing creative solutions for client

Nevada
services, and overseeing staff and operations for the Vermont office. His duties Las Vegas 702.866.2200
also include the design, implementation, formation, and ongoing management
services required by captive insurance company clients. South Carolina
Charleston 843.723.0418
Patrick has over a decade of experience in captive management, insurance
accounting, and consulting services, with particular expertise in overseeing Vermont
Burlington 802.865.4331
captive programs for single parent firms, risk retention groups, and publicly
held admitted insurance carriers. His captive domicile experience includes Cayman Islands
Arizona, Bermuda, Cayman, Maryland, South Carolina, Tennessee, and Grand Cayman 345.946.4091
Vermont.
Channel Islands
Patrick holds a bachelor’s degree in Accounting and Finance from Clarkson Jersey 4415.3449.5555
University. He currently serves on the Board of Directors of the Vermont
UK
Captive Insurance Association, the largest state captive insurance industry
London 4420.7614.1111
association in the United States. Patrick has served on the boards and as an
officer of multiple captive insurance programs. He also volunteers his time as Ireland
Dublin +353 (0)1.612.5555
a coach for local youth hockey and soccer teams.
Germany
Frankfurt +4969.2992.5385
This article is for information purposes only and is not intended as an offer or solicitation for the sale of any
financial product or service or a recommendation or determination by Wilmington Trust that any investment
strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any
investment strategy based on the investor’s objectives, financial situation, and particular needs. This article is not
designed or intended to provide legal, investment, or other professional advice since such advice always requires
consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the
services of an attorney or other professional advisor should be sought. The products discussed in this article are
not insured by the FDIC or any other governmental agency, are not deposits of or other obligations of or
guaranteed by Wilmington Trust or any other bank or entity, and are subject to risks, including a possible loss of
principal amount invested.
© 2006 Wilmington Trust Corporation. Affiliates in California, Connecticut, Delaware, Florida, Georgia, Maryland,
Nevada, New Jersey, New York, Pennsylvania, South Carolina, Vermont, London, Dublin, Cayman Islands,
and Channel Islands.
wilmingtontrust.com
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RSK4803 TOPIC 4: RISK FINANCING – RISK RETENTION

RSK4803: RISK FINANCING

TOPIC 4: RISK FINANCING – RISK RETENTION

At the end of this topic, you should be able to:

Study unit 11: Risk retention

STUDY UNIT 11: RISK RETENTION

You must be able to:

11.1. Risk retention versus transfer

Maximum risk transfer No/minimum risk transfer

Risk transfer Intermediate Risk retention

Full insurance Standard insurance Self-insurance

11.2. Risk retention and self-financing

Loss experience Scenario analysis

Figure 11.2 Risk financing alternatives as adapted from Young (2014:143)

11.3. Risk retention strategies

11.3.1. Unfunded retained risk

 risks that are insurable but retained

11.3.2. Funded retained risk

11.3.3. Self-insurance and self-protection

Self-protection refers to activities implemented to reduce the probability of a loss.

Self-insurance refers to reducing the magnitude of a loss.

Download the following article:

Hofmann, A. & Peter, R. 2016. Self-insurance, self-protection, and saving: On consumption

Study the following sections in the document:

11.4. The advantages and disadvantages of risk retention and self-funding

11.4.1. The advantages of risk retention and self-funding

 To reduce insurance costs

 To improve cash flow

 To provide the opportunity to earn investment income

 To increase the scope of risks funded

11.4.2. The disadvantages of risk retention and self-funding

The potential disadvantages of self-funding are:

11.5. Steps to implement a retention programme

11.5.1. Analyse the data

11.5.2. Determine the risk retention capacity

11.5.3. Determine the risk retention alternatives

11.5.4. Select the most optimal risk retention strategy

11.5.1. Analyse the data

11.5.1.2. Sources of data

11.5.1.3 Probability Distributions

Normal distribution: https://www.youtube.com/watch?v=IhtmW28slDw

Poisson distribution: https://www.youtube.com/watch?v=BbLfV0wOeyc

Binomial distribution: https://www.youtube.com/watch?v=_FbZI9mtSSM

Probability distributions: https://www.youtube.com/watch?v=b9a27XN_6tg

11.5.1.4. Decisions under uncertainty

Study the following sections of the article:

 Explain the difference between situations of risk with situations of uncertainty.

Included in the lectures in Topic 2 is the Rational Decision Making DSC2602

You can refer to the specific chapters in the study guide:

11.5.1.5. Methods to determine the potential total losses

 Probable Maximum Loss (PML)

Definition: Probable Maximum Loss (PML)

- Determine the value of the property

The value of a property = R5 000 000

Risk mitigation factors assessed to reduce the expected losses by 20%

PML = R5 0000 000 x (1-.20) = R4 000 000

 Estimate Maximum Loss (EML)

Definition: Estimated Maximum Loss (EML)

Applications of estimated maximum loss (EML)

 Maximum Probable Yearly Aggregate Loss (MPY)

Definition: Maximum Probable Yearly Aggregate Loss (MPY)

Definition: Probability of ruin

This statement can be mathematically described as follows: