Chapter · January 998 doi: 10. 1007/978-1-4615-6187-3 10 citations reads 2,488 author: Some of the authors of this publication are also working on these related projects
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10.Retentionandcaptiveinsurance (1)
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- Figure 10.1 The Retention Decision
Table 10.1 Factors Affecting the Retention Decision Information on loss exposures Maximum probable loss
Severity and frequency distributions
Variability in the frequency of losses
Cost-saving alternatives Cost of risk control
Cash-flow , cash balances and funding
arrangements
Tax considerations
Management objectives Dividend policy
Capital structure and cost of capital
Aversion towards risk Agency costs
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Figure 10.1 The Retention Decision
HIGH | SEVERITY |
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| INSURANCE
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| SELF-INSURANCE
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LOW
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SEVERITY
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PURE RETENTION
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LOW FREQUENCY
HIGH FREQUENCY
The words self and insurance seem to be contradictory. 5 of insurance is to transfer the financial risk to another entity called the insurer. However, the basis for applying the insurance mechanism is the existence of a large number of independent homogeneous exposure units. Self-insurance is only possible when the potential self-insurer has a sufficient volume of loss exposures to permit reasonable predictability of the loss experience. 6
As a consequence of this assumption, self-insurance cannot be unfunded. There are semantic problems associated with the definition 7
since in some cases self insurance is defined as no-insurance. It appears as if the term "self-insurance" has been substituted for "self-funded retention." 8 We assume the same definition in this chapter.
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RETENTION | ________________________________________
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No-Insurance (Pure retention) Self-Insurance
- post-loss internal financing - pre-loss internal funding - post-loss external financing
- pre-loss external funding
(Captive insurance)
Of course, the self-insurer is not exposed to the moral hazard problem because it has an incentive to minimize losses. The aggregate limit of all retained loss exposures will be affected by three main factors: (1) the predictability of this limit, (2) the availability of protection for catastrophic losses, and (3) the financial strength of the self-insurer. The possible advantages and disadvantages of self- insurance are presented in Table 10.2. 9
As explained by Doherty (1985, p. 295), some other financial problems may exist because of the existence of a retention fund. What is the appropriate return for the fund compared to the expected return for the firm? Or what is the opportunity cost of maintaining a fund for the shareholders? How to account for the value of the fund when calculating the value of the firm? If the transaction costs associated with the existence of a fund are significantly lower than those prevailing for alternative sources of loss financing, then the existence of a retention fund may be justify.
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