The perception of risk amid the insurance corporations has significantly changed over the past couple of decades. Not long ago, that the view of the financial risk was a straight forward issue that did not merit the rigorous analysis presently witnessed. However, over the years, the industry has developed the numerous techniques for use in the resolution of the risk financial setback. Among this ensemble of methods are the outstanding ones like captive insurance and self insurance.
By definition, self insurance is the protection from the possible fiscal loss through unremitting earmarking of portions of earnings to safe guard from the occurrence of a risk event. On the other hand, captive insurance is a method of financial risk management where a given insurance corporation or groups of corporations forms an insurance company with the essential goal of covering their risks and assets (Klingenschmid, 2008). This research paper looks at these two methods of financial risk management in detail. It compares and contrasts their core values and their potential benefits in the current volatile global fiscal environment.
Justification of the Topic
The present volatile fiscal environment motivated the choice of this topic. The past few years has witnessed massive financial tribulations amid numerous multinationals across the globe. Plentiful industries filed for bankruptcy while others resorted to fiscal help from government and chief global financial markets to aid the industry in restructuring and return to the profitability. In my view, such events were largely due to the insurance failures in predicting the events coupled with poor financial risk management (Randal, 2009). This evoked in me a need to take a study of the two major methods of the financial risk management, captive insurance and self insurance, assessing their individual benefits and significance in the constantly changing fiscal market.
In my view, they form a bench mark in the solution of several fiscal uncertainties. Their rich traditions in reinsurance and self insurance are worth investigating.
According to Randal (2009), captive insurance is a comparatively mature phenomenon. He noted that the insurance industry has practiced it since the late 1980s. This humble beginning was attributable to the enforcement of the indemnity in the overall clatter of insurable risks. This proposition led to the creation of indemnity organizations which aided the full adoption of this technique in a number of insurance organizations. Randal (2009) observes that it was not until the middle of the preceding century that the practicable captive insurance companies were established. According to Randal (2009), the turn of the century saw massive developments of more than a few captive institutions across the globe. This increment in the numbers of captives reached its climaxing during the recent global fiscal meltdown. Randal (2009) notes that prior to the fiscal situation preceding year, about 40% of American multinationals had captives.
Klingenschmid (2008) defines captive insurance as a reinsurance company whose core business is to guarantee the financial and asset security to its forming members. These members are insurance companies with a large capital outlay and prefer the direct control of their insurers. Klingenschmid (2008) reports that owners are responsible for the company's business activities and crucial decisions like the outlay decisions. He also added that there exist dissimilar types of captive insurance companies.
According to Klingenschmid (2008), examples of captive insurances may include: solitary parent, straight forward or fronted, restricted or international, organizational captive, risk maintenance group, essential or multi layer captive and many more. He also noted that the corporations address the certain distinct function form most captives. This has resulted in the development of thousands of captives globally with such varied functions.
Damodoran, Groth, & Shimko's (2011) are indicative of the different functions performed by the captive insurance institutes in line with the particular need of the owner corporation. Reportedly, the agency captive organization is one formed by the founding organization to act as their better agencies' sole reinsurance firm. Evidently, the owners and the insured are not similar. This objective of the corporation aims at achieving the finical isolation of their associate partners industries from the general reinsurance provided. Consequently, there are special captive insurance institutions known in some sectors as the transformer equipment. These are captives with the specific responsibility of converting catastrophic incidences into the marketable securities such as investment grade bonds. Reportedly, their centre of interest is the capital markets concerns with insurance markets in financing risks (Damodoran, Groth, & Shimko's, 2011).
Damodoran, Groth, & Shimko's (2011) denote that there are numerous motivations behind the formation of the captive insurance companies. This is in line with Randal (2009) observations that the motives behind the formation of captive insurance companies are not stagnant but evolve as the demands of the owners also evolve. Such changes are attributable to the intermittent market changes.
However, the establishment of the captive institutes is to among other reasons: reduce cost, increment of owner capacity through guaranteed access to reinsurance (Randal 2009). Randal (2009) noted that there was the need to exercise the extra control over the rampant insurance market and to ensure provisions of coverage to the owners and subsidiaries. Moreover, the captive institution provided much sort after freedom from rate and form and the establishment of an avenue for excellent. Reportedly, the owners of the captive would enjoy the advantage of constantly standardized account. Finally, captive institutes afforded owners the ability to recapture the investment income through an accelerated cash inflow, (Randal 2009).
Damodoran, Groth, & Shimko's (2011) noted that captive had three basic structural components which were monetary operational and people. Fiscally, captives institutions duel in premiums, capital and investment income. The contribution of premiums and capital is realizable through the direct or non-direct investment apparatus such as letter of credit. However, the financial outlay must suffice in regard to the capitive's legal role as insurance or a re-insurance institute. Furthermore, the fiscal strengths must afford it the ability to extend a sensible augmentation levels. Ultimately, the monetary ability should enable it expedite expenses settlements over its operational duration, (Damodoran, Groth, & Shimko 2011). From the aforementioned text, it is evident that the capitive's financial strength must allow it to optimally provide reinsurance services while at the same times affording it sufficient funds to extend its asset portfolio.
According to Randle (2009), the practicality of captive’s operation is in similarity with the normal insurance organizations. Like any insurer, it issues policies to its insured and collects premiums pays claim. Additionally, captive has a special reserve set aside to aid in the resolution of nay arising legal obligations its poly agreements with its insured. It is solely responsible for its operational expenses and deservedly earns investment income from invested assets.
Policy Issues for Captive Insurance
Damodoran, Groth, & Shimko's (2011) identified the three related functional groups which are responsible for the operation of a captive. These individuals include, the captive's own executives, support service providers and a board of directors. However, only the handful captive organizations have the permanent staff. In most cases, founding multinational puts in place a hired management team that oversees its daily activities. Similarly, such skeletal institutions hardly have any board of directors. It is therefore necessary that appropriate policies be put in place to enable the captives to stop relaying on fronted officers from founding corporations to make crucial decisions and to enable them to be self sufficient (Randle, 2009).
The other variety of critical policy issues regarding the weaknesses of captives have been identified by Klingenschmid (2008). He particularly underlined the issue of actuarial protuberance. He emphasized that the policies guiding the national insurance regulations should put more emphasis on the need for actuarial analysis of any performed feasibility appraisal, (Klingenschmid, 2008). The approval of such appraisals significantly contributes to the confidence levels in the captive by its services providers, reinsurers and tax officers. Klingenschmid (2008) observes that a continued analysis is vital especially in monitoring the institutes reserve position.
There should also be policies guiding the service providers and other numerous cornered institutions to further enhance the operations of captive. Klingenschmid (2008) denotes that a captive's expenses should not exceed 20% of its premiums. Similarly, its investment results are supposed to reflect the present monetary values. Additionally, the captive is required to obtain the valid information on the changing tax rates to enable it to adhere to the regional and institutional regulations.
Klingenschmid (2008) suggest that it is vital for a corporation to thoroughly evaluate the ability of the captive in providing the solutions to the present fiscal and asset risks. Klingenschmid (2008) proposes the initial performance of a feasibility study followed by the development of a desirable business plan. According to Klingenschmid (2008), the feasibility studies should carry out an intensive quantitative and qualitative evaluation of critical facets of the enterprise by focusing on its present operations and cots. He explains that the quantitative aspects of the study may include the company's premiums, capital, coverage, projected claims, present reserves, expenses, reinsurance, investment proceeds and levy (Klingenschmid, 2008).
According to Klingenschmid (2008), the feasibility study has three building bocks. The initial one is concerned with the design and makeup of the coverage and the dealings for insurance and reinsurance. The second component is concerned with the estimation of the fiscal responsibility needed to aid the design. Lastly, is the determination of the after tax costs amid the dissimilar programs followed by the evaluation of outstanding issues.
Klingenschmid (2008) explains that the business plan is significant in determining the foundations of a progressive institution. Notably, these significant building blocks are established by the feasibility study. This has the implication that the founding components of the subsequent business plan have its basis in the established feasibility study (Captives, 2011). According to Lang & Jagtiani (2010), the purpose of the business plan is to serve as a platform from where the owners and customers can evaluate the performance of the enterprise. The plan is equally significant in the attainment of approval from the regulators.
Lang & Jagtiani (2010) note that an excellent business plan should take into consideration the overriding purpose of the captive, the anticipated progress and the administrative structure of the intended institute. Additionally, the plan should state the coverage and limits of the business, its anticipated fiscal resources, planned risk and reinsurance management and claims. Furthermore, it put intended plans for claims management, safety and loss avoidance and the proposed management and services providers.
Self Insurance Technique
According to Saga (2011), Self Insurance Technique is an insurance technique where an individual institution takes it upon to recurrently set aside a given predetermined size of money for protection against future loss. Business enterprises opt for this kind of financial risk technique, when after consideration self insurance determinately is more economical compared to the present conventional insurance policies. According to Saga (2011), such funds’ find may assist the insurance companies in settling the emerging fiscal issues such as wide-ranging liabilities and workers' compensation. Reportedly, trade associations have used such financial arrangements to pool the resources. Self insurance practices have in the past involved the corporate sponsoring insurance investments through overseas subsidiaries (Saga, 2011).
Cummins & Weiss (2009) indicate that numerous corporations have used such methods of self funding to pay medical expenses to the employee, instead of the standard health care system. In such cases, funding is obtainable directly from the established trusts or reserve accounts which the corporation had already established. Reportedly, the amount remitted to such account or trusts by the corporation are usually equivalent to the amount considered by the company as capable of resolving any future financial risks.
According to Brainard (2008), self insurance is sufficient for any insurable risk. Such risks are determined through the rigorous qualitative and quantitative examination and are a curtained by the risk specialist. The premium paid is equally professionally determined to avoid any future error. Brainard (2008) denotes that the consideration for any risk must reflect the possibility of future event over which the insured has no control. Additionally, such insurable events may present themselves hidden in an ensemble of risks which permit the use of the law of the large numbers to estimate it its scale and its probability of future occurrence. However, like any insurable risk, if the risk is catastrophic it might compel the corporation to seek the assistance of the whole sale underwriters.
APRA (2005) observes that the full exclusiveness of self insurance is uncommon except for dismal business enterprises. Reportedly, a large organization which takes up the self insurance combines it with the conventional insurances policies. According to Risk Loss Management Division (2011), the adoption of the self insurance by the extensive corporations is to address a certain peculiar need of the business. Evidently, such self insured risks are of a privet matter to the corporation. However, others take the form of employee benefits such as the health funds.
According to risk Loss Management Division (2011), individuals are owing to high cost of premiums which makes them unaffordable practise self insurance. However, on its own, it is a rather clumsy way of managing the future financial risks.
Captive versus Self Insurance
The forgone literature has briefly examined the two types of risk management commonly used across the globe by both individuals, and business enterprises ranging from the small retail outlets to multinationals with a global presence. While self insurance offers a sound flexible and cheap way of accessing the insurance service, it lacks the ability for wider application in large businesses. The present global financial state is volatile that appropriate prediction requires constant observations and adjustments of premiums in accordance to the prevailing fiscal situation. This concept lacks in self insurance as it derives its basis on the remittance of constant premiums with slight alterations brought by variations in exchange rates and inflation. This limits its applications to the personal insurance plans and specific saving schemes in corporations.
Captive insurance has found plentiful application in a wide range of corporate organizations. It has for durations of time forms the backbone of major corporate organizations due to its absolute risk handling capabilities. The ability to work as an independent insurance institution has made it attractive financial risk management tool to many. In my view, for the absolute financial security, organizations should take the advantage of the benefits of both the self insurance and captive insurance as they provide the unique solutions to the risks encountered in business enterprises.
Over the past quarter century, captive popularity has continuously increased. This popularity is attributable to its proven role in the management of the financial risk. However, the technique has not proved valuable to all enterprises. A good number of their applications lack the necessary technicalities of managing risks. On the other hand, the use of self insurance has equally continued to rise though at a relatively slower pace than captive insurance. However, they both offer the substantive solution to the financial risks.