LEARNER GUIDE

Unit Standard Title: Demonstrate knowledge and

understanding of the fundamental
principles of risk finance in order
to propose an insurance solution

Unit Standard No: 242562

Unit Standard Credits: 5

NQF Level: 5

This outcomes-based learning material was developed for Graduate Institute of Financial Sciences
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242562 Learner Guide

Demonstrate knowledge and understanding of the fundamental

principles of risk finance in order to propose an insurance solution

On completion of this module, the qualifying learner will be able to:

• Explain the concept of risk transfer as opposed to insurance.
• Explain the limits of insurance and risk retention/risk transfer parameters.
• Explain the different facilities involved in risk transfer.
• Propose an insurance solution to transfer risk in a business entity

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Introduction
Prior to the eve of the year 2000, thousands of people flocked to the stores, stocking
up on numerous supplies. They feared that something catastrophic was going to
take place once the clock struck midnight, and if so, they wanted to be prepared. Is it
not a form of insurance? Sure – in its basic definition. The supplies they purchased
would act as reimbursement in the case of loss.
In order for the concept of insurance to arise, a pre-payment of some type is
required. In the case of typical, everyday general vehicle, health and life insurance,
for example, the pre-payment is in the form of a premium.

In the 19th century, many societies were founded to insure the life and health of their
members. Fraternal orders were created to provide low-cost insurance strictly for
their members. Today, many of these fraternal orders and labour organizations still
exist. Most employers offer group insurance policies for their employees, providing
them with life insurance, sickness and accident benefits, and pensions.
Insurance was the accepted thing to do. Everybody needed to protect themselves
against the many risks in life. Farmers wanted crop insurance.
People wanted deposit insurance at their banks. Travellers wanted travel insurance.
Everybody turned to insurance companies to give them peace of mind.
And really, isn’t that what insurance is – the paying of a premium to protect against
some form of loss?

In everyday usage, risk means ‘the danger (or uncertainty) of injury, damage or loss’.
In a financial services environment, risk refers to the uncertainty of achieving the
expected rate of return on an investment, or of suffering a physical or financial loss –
quantified in terms of the probability of these outcomes.

The short-term insurance sub-sector addresses the risk of damage to, or loss of
physical assets, and the financial consequences. However, insured parties cannot
gain from short-term insurance contracts, which only indemnify them against loss.
Investors may gain (more than they expect) from risky investments, but they may
also suffer a serious loss, perhaps even losing their capital.
(Substantial gains or losses are most likely in high-risk investments.)

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Module 1
The concept of risk transfer as opposed to insurance

This module looks at:

• Reasons why an organisation would seek to transfer risk, with examples
• The underlying principles of risk transfer with examples
• Possible indicators of risk tolerance in a business in order to determine
ways of mitigating risk

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1.1 Reasons why an organisation would seek to transfer risk, with

examples
In the terminology of practitioners and scholars alike, the purchase of an insurance
contract is often described as a "transfer of risk." However, technically speaking, the
buyer of the contract generally retains legal responsibility for the losses "transferred",
meaning that insurance may be described more accurately as a post-event
compensatory mechanism.
For example, a personal injuries insurance policy does not transfer the risk of a car
accident to the insurance company. The risk still lies with the policy holder namely
the person who has been in the accident. The insurance policy simply provides that if
an accident (the event) occurs involving the policy holder then some compensation
may be payable to the policy holder that is commensurate to the suffering/damage.

Some ways of managing risk fall into multiple categories. Risk retention pools are
technically retaining the risk for the group, but spreading it over the whole group
involves transfer among individual members of the group. This is different from
traditional insurance, in that no premium is exchanged between members of the
group up front, but instead losses are assessed to all members of the group.
For those charged with the responsibility of transferring risks of loss to others, you
know it can be a thankless task. Do risk management / transfer have a meaningful
role in your organization's contracting process, or is it an afterthought? Is input from
risk management expected without full knowledge of the big picture? Do you see the
whole contract or just the insurance and indemnification provisions? Are business
agreements loosely worded without the benefit of legal or risk management review?

Whether it's the risk manager or the chief financial officer with the added
responsibility for risk management, the practice of transferring risk is often still
perceived as a roadblock to business deals rather than the creation of a safety net
for the organization.

If your organization is (1) allowing its premises to be used or leased by others, (2)
contracting with others to perform services or (3) acquiring another organization,
opportunities exist to transfer risks of loss to others that control the loss exposures.
Too often, however, the importance of the deal takes precedence, and risk transfers

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are not properly effected, making your organization potentially responsible for loss
exposures for which others should be responsible. You should be vigilant in your
risk-transfer efforts so your insurance and self-insurance programs are not
needlessly used because of the negligence of others!

Proper risk-transfer techniques include the imposition of reasonable insurance and

indemnification requirements on the parties creating the loss exposures. Risk-
transfer provisions must also include a detailed means of verifying that the other
party to the contract is meeting your risk-transfer requirements.
This is accomplished by requiring the other party to provide you with proof to clearly
demonstrate compliance with all insurance requirements. In addition to requiring
additional insured status under a general liability policy, for example, you should
require a copy of the additional insured endorsement or policy provision to be
attached to the proof in order to provide better documentation of the transfer. Such
requirements should be specified in the contract or agreement.

Incorporating requirements into formalized contracts to effectively transfer the risks

of loss to the parties that control or create the loss exposures will help reduce your
cost of risk. Your insurance underwriters will look more favorably upon your business
if such transfers are routinely accomplished, which should result in more favorable
pricing.

Your loss experience will also improve if the parties responsible for injuries or
damage are the ones required to insure against such injuries or damage, thereby
reducing your costs.

Although risk-transfer efforts may occasionally create delays or impediments to

programs, activities or business relationships desired or needed by your
organization, be assured that there is a value to these efforts. The risk-transfer
process yields benefits to companies every year, and all levels of the management
team should embrace and support this process.

The transfer of risk is the underlying principle behind insurance transactions. The
purpose of this action is to take a specific risk, which is detailed in the insurance

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contract, and pass it from one party who does not wish to have this risk (the insured)
to a party who is willing to take on the risk for a fee, or premium (e.g., an insurer).
For example, whenever someone purchases home insurance, he or she is
essentially paying an insurance company to take the risk involved with owning a
home. In the event that something does happen to the house, such as property
damage from a fire or natural disaster, the insurance company will be responsible for
dealing with any resulting consequences.

In today's financial marketplace, insurance instruments have grown more and more
intricate and complex, but the transfer of risk is the one requirement that is always
met in any insurance contract.

Risk of loss may be transferred by one entity to another in a variety of ways. All
methods of transfer fall into three basic categories
• Insurance - transfer to an insurer under an insurance contract
• Judicial - transfer to another party by virtue of a successful legal action
• Contractual - transfer to another party under contracts other than insurance

1.1.1 Standard Contractual Liability Exclusions

When reviewing liability assumed under contract, you have to remember that your
liability is insured only to the extent of the coverage provided by the policy. A
standard Contractual Liability endorsement carries more than a dozen specific
exclusions and usually won’t automatically apply to all contracts.
When you transfer your risk to another party, the same concern may be appropriate
with respect to the adequacy of insurance protection carried by the other party.
Unless the indemnitor is a very large, very profitable firm, its financial ability to
assume the risk transferred will be dependent on whether it has insurance applicable
to the type of loss involved. In the absence of adequate insurance coverage, the
indemnification that you have received may not be worth the paper it's printed on.

1.1.2 What risks of loss can be transferred?

• Construction - A company anticipating the construction of a new plant or
plant addition may wish to pass some or all of the risk involved on to a general

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contractor. The construction contract he signs will determine the degree to

which risks of loss inherent in the venture will be retained or transferred. The
transfer of the following risks should be considered:
Ø Damage to the building under construction
Ø Construction cost overruns
Ø Employee injuries
Ø Theft of building materials and equipment
Ø Third party injuries
Ø Lost income due to delay in building completion
Ø Loss due to failure to comply with government regulation

• Leases - A lease agreement determines the apportionment (between lessor

and lessee) of risks of loss arising out of:
Ø Damage to the real or personal property leased
Ø Consequential loss arising out of such damage
Ø Third party injuries
Ø Fluctuations in building (and rental) value

• Bailee and Carrier Agreements- Some risk of loss to property placed in the
custody of a wide variety of bailees and carriers is almost always transferred.
The extent to which it is transferred varies greatly, however.
Bailees and carriers have specifically limited liability under law for property
entrusted to them (this is especially true where carriers for hire are
concerned). Their responsibility for loss varies greatly depending on the
nature of the loss and the conditions under which loss occurs. Under these
circumstances, it's obvious that some knowledge of statutory terms and
conditions must be acquired before you can determine what risks of loss exist
and are subject to transfer in a given situation.
Transfer of risk in the following areas might be considered under specially
drawn contracts between involved parties.
Ø Responsibility for loss caused by acts of nature
Ø Responsibility for loss caused by enemy nations
Ø Responsibility for non-negligent loss

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Ø Responsibility for loss of sale or decline in market value due to delayed

delivery
Ø Responsibility for loss of profits due to damage to property involved

1.2 The underlying principles of risk transfer with examples

Risk transfer, defined as shifting the responsibility or burden for disaster loss to
another party through legislation, contract, insurance or other means, can play a key
role in helping to manage natural hazard risk and mitigate or minimise disaster
losses.
As the international community places increasing emphasis on disaster risk
reduction, there is growing interest in the potential of risk financing solutions, of
which risk transfer is a major component, as part of an overall disaster risk
management strategy.
Recent developments in this field include the use of a range of risk transfer
mechanisms such as catastrophe bonds, catastrophe pools, index-based insurance
and micro-insurance schemes.
Social protection programmes such as safety nets and calamity funds can also
provide effective financial instruments for managing risk and dealing with natural
disaster shocks.

The purpose of applying the principles of risk transfer at every level are:
• identifying and evaluating risks;
• avoiding or eliminating them where practical and;
• minimizing, controlling or contractually transferring them when possible.

The main underlying principles of risk transfer can be summarized as follows:

• When practical, retain risk that can be self-insured from current funds without
seriously affecting the financial condition of the organization.
• Purchase insurance coverage when:
I. the risk is catastrophic in nature or beyond the capacity of the

organization to absorb from current funds and when the purchase of

insurance is permitted by law for a state agency; or
II. the expenditure for premiums is justified by services incidental to the

insurance contract, or other expected benefits; or

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III. required by law or contract.

The procurement of insurance shall be limited to the availability of coverage at a

reasonable cost and be subject to the practicality of adopting programs of self-
insurance, or self assumption, in whole or in part, consistent with the probable
frequency, severity and impact of losses on the financial stability.
Risk transfer is the shifting of the responsibility for meeting one’s own losses from
oneself to someone else. The transfer of pure risk can take two forms:

1.2.1 The transfer of responsibility for paying losses

The transfer of activity risk is most usually undertaken by sub-contracting that activity
– that is, by hiring another enterprise to do the job. In civil engineering contracts for
example, underwater works and pile-driving are often sun-contracted.
The whole purpose of the exercise is for the sub-contractor, and not the hirer, to be
responsible for losses. The hope is that the sub-contractor will be better able to do
the work, with fewer losses, because of his specialist knowledge.

The transfer of responsibility to pay for losses may be undertaken either by

insurance or via special clauses placed in contracts of sale, purchase, employment,
rent, etc.

Clauses excluding one party to the contract from responsibility for any losses arising
in connection with that contract, no matter how caused, are known as exclusion or
indemnity clauses, depending on their specific construction.
Exclusion clauses have the effect of relieving one party of liabilities that he might
otherwise incur towards another. Indemnity clauses place an obligation on one part
to indemnify the one for losses, however caused, that arise out of the performance of
the contract.

Insurance is the most common methods of transference of risk. By paying a

premium, the insured can transfer the risk of loss to the insurer. The policyholder
purchasing full insurance can therefore substitute the unknown cost of losses for a
known cost. Often, however, less that full (partial) insurance is purchased. Insurance
has several advantages as a method of risk transfer. They include:

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• the insured can transfer risk for unexpectedly larger than expected or frequent
losses to the insurer
• the insured can substitute a known cost (the premium) for an unknown cost
(the losses)
• in any one financial period, premiums paid will only represent a very small
proportion of values exposed to the risk of loss
• insurance acts smooth out the payment of losses over time
• in addition to the risk transfer mechanism, the insured also benefits from the
insurer’s subsidiary functions – specialist advice on claims handling, risk
reduction, etc.
• Insurance has several disadvantages:
• not all risks are insurable; in particular, speculative risk
• insurance rarely provide a full compensation for losses – for example, no
compensation is paid for use of management time or loss of goodwill
• not all premiums are certain in timing and amount, and they may vary widely
from year to year
• in the very long run, the insured will pay more in premiums than he receives in
claims

1.3 Possible indicators of risk tolerance in a business in order to

determine ways of mitigating risk
What Does Risk Tolerance Mean? Risk tolerance is the degree of uncertainty that
an investor can handle in regard to a negative change in the value of his or her
portfolio.

An investor's risk tolerance varies according to age, income requirements, financial

goals, etc. For example, a 70-year-old retired widow will generally have a lower risk
tolerance than a single 30-year-old executive, who generally has a longer time frame
to make up for any losses she may incur on her portfolio.

Proper asset allocation is dependent upon two inputs: (1) expected capital market
returns and (2) the individual client’s desire and ability to tolerate risk. Though much

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has been done to explain capital market returns, little has been added to our
understanding of the factors which influence client risk tolerance.
As money managers begin the task of allocating a client’s money into various
investment vehicles they face two potential problems.
First, the money manager may poorly allocate the funds. This can lead to the client
either not having the required funds at a desired point in the future or perhaps lead to
a loss of client wealth.
The second problem stems from the first; the money manager may be held liable for
poor performance.

Individual asset allocation is a twofold process. First, the expected capital market
returns must be estimated and second, the risk tolerance of the client must be
determined.

Proper measurement of client risk tolerance is essential for suitable asset allocation.
To date, asset allocation studies typically possessed the risk measures related to the
market, but not the proportions to be invested in the various assets.
There is an ongoing debate exists between psychologists and economists as to what
drives the risk tolerance of individuals. Psychologists tend to believe, “that
individuals’ choices are primarily determined by factors unique to the particular
decision setting, whereas economists assume that there is some individual-specific
mechanism playing a common role in all economic decisions.”
This research, advances a quantitative model for asset allocation which incorporates
features of psychological and economic paradigms. The model hypothesizes client
risk tolerance to be a function of time horizon, salary, expected salary growth, age,
gender, marital status, and number of children.
The hypothesized relationship between perceived client risk tolerance and horizon,
client salary, and projected salary growth, are all positive. The longer the planning
horizon, the greater the client’s salary, and/or the higher the projected salary growth,
the more risk the client should be able to tolerate.

Time horizon is often thought to be the most important variable in the allocation
process. The fundamental logic underlying this hypothesis is the longer the time
period between initial investment and need for monies from the portfolio, the greater

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the probability the client can recoup any temporary loss in wealth. Therefore greater
risk (with its promise of greater returns) can be assumed by the portfolio.
Client risk tolerance should also be an increasing function of both the client’s salary
level and anticipated salary growth. Client’s with these characteristics should be
capable of tolerating a short term loss of principal,and hence capable of accepting
higher risk within the portfolio.

Studies which have addressed gender and client risk tolerance, have concluded that
men tend to seek out greater risk than do women. Additional factors included in the
model relate to marital status and number of children. Being married, divorced,
widowed, and/or having children are factors hypothesized to reduce the risk
tolerance of the client.
Thus, as marital status moves from that of being single, and/or as the number of
children becomes greater than zero, the risk tolerance of the client should decrease.

While conventional wisdom holds that increased risk should lead to increased
returns, little work has been done which specifically addresses those elements which
identify the determinants of individual risk.

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Module 2
The limits of insurance and risk retention/risk transfer parameters

This module deals with:

• Aggregate annual losses using probability theory
• A distribution graph in relation to risk retention and risk transfer
• The risks in an entity to determine which risks could be transferred to
insurance (covered in the assessment)
• Knowledge of the cost of insurance to determine risk retention
• The difference between a provision and a reserve with examples

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2.1 Aggregate annual losses using probability theory

Probability can be defined as a measure of the likelihood that an event in the future
will actually happen.

Let's look at an experiment. A spinning wheel has four equal sectors, yellow, blue,
green and red. What are the chances that the wheel will stop on blue after being
spun? What are the chances of the wheel stopping on red?

Yellow Blue

Green Red

The chances of stopping on blue are 1 in 4, or one fourth.

The chances of stopping on red are 1 in 4, or one fourth.
The chances of stopping on yellow are 1 in 4, or one fourth.
The chances of stopping on green are 1 in 4, or one fourth.

In the experiment, the probability of each outcome is always the same, that is, the
outcomes are all equally likely to occur.

Let's now look at an experiment in which the outcomes are not equally likely to
occur.
In the next page, a glass jar contains six red, five green, eight blue and three yellow
marbles. You have to choose a single marble from the jar.
What is the probability that you will choose a.red marble, a green marble, a blue
marble or a yellow marble?

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We can calculate the probability as follows:

P (red) = Number of red marbles = 6 3
Total number of marbles 22 11

P (green) = Number of green marbles = 5

Total number of marbles 22

P (blue) = Number of blue marbles = 8 4

Total number of marbles 22 11

P (yellow) = Number of yellow marbles = 3

Total number of marbles 22

The outcomes in this experiment are not equally likely to occur. You are more likely
to choose a blue marble than any other colour. You are least likely to choose a
yellow marble.

In the next experiment you must choose a number at random from one to five. What
is the probability of each outcome? What is the probability that the number chosen is
even? What is the probability that the number chosen is odd?

We can calculate the probability as follows:

P (1) = Chances of choosing 1 = 1
Total number of numbers 5

P (2) = Chances of choosing 2 = 1

Total number of numbers 5

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P (3) = Chances of choosing 3 = 1

Total number of numbers 5

P (4) = Chances of choosing 4 = 1

Total number of numbers 5

P (5) = Chances of choosing 5 = 1

Total number of numbers 5

P (even) = Chances of choosing an even = 2

number 5
Total number of numbers

P (odd) = Chances of choosing an odd = 3

number 5
Total number of numbers

The chances that you might choose 1,2,3,4 or 5 are equally likely. However, the
probability that you might choose even numbers is not the same as the probability
that you might choose odd numbers, since there are three odd numbers and only
two even numbers from one to five.

Now look at the following three methods of measuring probability:

A priori (using logic) - we can express the probability of rolling a two with a six-sided
dice as 1 ÷ 6 = 0,17

Empirically (by observing) - if 1 in 100 items produced by a machine is known to be

defective, the probability that a randomly selected item will be defective is expressed
as
1 ÷100 = 0,01

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Subjectively (using judgement) - in many cases, managers must use their

experience to judge a likely outcome. For example, if we do this, there is a 0,3
probability that we will produce a similar product within 12 months.
Probability values may range from 0 to 1. If the value is 0, there is zero probability
that a particular investment will yield the estimated return. If the value is 1, there is
complete certainty that the investment will yield the estimated rate of return.

These probabilities are typically subjective estimates based on the historical

performance of the investment or similar investments, and modified by the investor's
expectations for the future.
For example, you may know that about. 30% of the time the rate of return on this
particular investment has been 10%. Using this information, along with future
expectations regarding the economy, you can derive an estimate of what might
happen in the future. We can analyze the effect of risk by means of an example
where the investor is absolutely certain of a 5% return.

The figure below illustrates this scenario.

Probability distribution for a risk free investment

1

0.8

0.6
Probability
0.4

0.2

0
-0.05 0 0.05 0.1 0.15
Rate of Return

Source: Investment Analysis and Portfolio Management, Frank K. Reilly, Keith C.

Brown 1997
Figure Probability distribution for a risk-free investment
Few investments provide returns that are perfectly certain. Perfect certainty allows
only one possible return. The probability of receiving that return is 1.

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You can also calculate several rates of return depending on different possible
economic conditions. Let's look at an example. In a strong economic environment
with high corporate profits and little or no inflation, the investor might expect the rate
of return on common stocks during the next year to be as high as 20%. In contrast, if
there is an economic decline with a higher-than average rate of inflation, the investor
might expect the rate of return on common stocks during the next year to be - 20%.
With no major change in the economic environment, the rate of return during the
next year would probably approach the long-run average of 10%.

The figure below illustrates this scenario.

Probability distribution for a risky investment with

three possible rates of returns

0.8
0.7
0.6
Probability 0.5
0.4
0.3
0.2
0.1
0
-0.3 -0.2 -0.1 0 0.1 0.2 0.3
Rate of Return

Source: Investment Analysis and Portfolio Management, Frank K. Reilly, Keith C.

Brown 1997
Figure Probability distribution for a risky investment with three possible rates
of return.

The aggregate annual loss can be defined as the summated losses in rands, for a
specified financial year. A diversity of analytical approaches is emerging in industry,
combining and weighting these inputs in different ways. Most current approaches
seek to estimate loss frequency and loss severity to arrive at an aggregate loss
distribution. Institutions then use the aggregate loss distribution to determine the
appropriate amount of capital to hold for a given soundness standard.
Scenario analysis is also being used by many institutions, albeit to significantly
varying degrees. Some institutions are using scenario analysis as the basis for their
analytical framework, while others are incorporating scenarios as a means for

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considering the possible impact of significant operational losses on their overall

operational risk exposure.

The primary differences among approaches being used today relate to the weight
that institutions place on each input. For example, institutions with comprehensive
internal data may place less emphasis on external data or scenario analysis. Another
example is that some institutions estimate a unique loss distribution for each
business line/loss type combination (bottom-up approach) while others estimate a
loss distribution on a firm-wide basis and then use an allocation methodology to
assign capital to business lines (top-down approach).

The figure below illustrates a scenario where an investment has ten possible
outcomes ranging from -40% to 50%, with the same probability for each rate of
return.

Probability distribution for a risky investment with

ten possible rates of returns

0.15
0.13
0.11
Probability 0.09
0.07
0.05
0.03
0.01
-0.01
-0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4 0.5

Rate of Return

Source: Investment Analysis and Portfolio Management, Frank K. Reilly, Keith C.

Brown 1997
Figure Probability distribution for a risky investment with ten possible rates of
return.

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2.2 A distribution graph in relation to risk retention and risk transfer

Risk retention involves accepting the loss when it occurs. True self insurance falls in
this category. Risk retention is a viable strategy for small risks where the cost of
insuring against the risk would be greater over time than the total losses sustained.
All risks that are not avoided or transferred are retained by default.
This includes risks that are so large or catastrophic that they either cannot be
insured against or the premiums would be infeasible. War is an example since most
property and risks are not insured against war, so the loss attributed by war is
retained by the insured.
Also any amounts of potential loss (risk) over the amount insured is retained risk.
This may also be acceptable if the chance of a very large loss is small or if the cost
to insure for greater coverage amounts is so great it would hinder the goals of the
organization too much.

Risk transfer means causing another party to accept the risk, typically by contract or
by hedging. Insurance is one type of risk transfer that uses contracts. Other times it
may involve contract language that transfers a risk to another party without the
payment of an insurance premium.
Liability among construction or other contractors is very often transferred this way.
On the other hand, taking offsetting positions in derivatives is typically how firms use
hedging to financially manage risk.
Some ways of managing risk fall into multiple categories. Risk retention pools are
technically retaining the risk for the group, but spreading it over the whole group
involves transfer among individual members of the group.
This is however different from traditional insurance, in that no premium is exchanged
between members of the group up front, but instead losses are assessed to all
members of the group.

The normal distribution, also called the Gaussian distribution, is an important family
of continuous probability distributions, applicable in many fields. Each member of the
family may be defined by two parameters, location and scale: the mean ("average",
µ) and variance (standard deviation squared) s2 , respectively. The standard normal
distribution is the normal distribution with a mean of zero and a variance of one. Carl
Friedrich Gauss became associated with this set of distributions when he analyzed

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astronomical data using them, and defined the equation of its probability density
function. It is often called the bell curve because the graph of its probability density
resembles a bell.
The importance of the normal distribution as a model of quantitative phenomena in
the natural and behavioral sciences is due in part to the central limit theorem. Many
measurements, ranging from psychological to physical phenomena (in particular,
thermal noise) can be approximated, to varying degrees, by the normal distribution.

While the mechanisms underlying these phenomena are often unknown, the use of
the normal model can be theoretically justified by assuming that many small,
independent effects are additively contributing to each observation. The normal
distribution is also important for its relationship to least-squares estimation, one of
the simplest and oldest methods of statistical estimation.

-2 -1 μ 1 2

Source: Statistical Techniques in Business & Economics, Robert D. Mason, Douglas

A. Lind 1996

A normal distribution (a bell-shaped curve)

The normal distribution also arises in many areas of statistics. For example, the
sampling distribution of the sample mean is approximately normal, even if the
distribution of the population from which the sample is taken is not normal. In
addition, the normal distribution maximizes information entropy among all
distributions with known mean and variance, which makes it the natural choice of

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underlying distribution for data summarized in terms of sample mean and variance.
The normal distribution is the most widely used family of distributions in statistics and
many statistical tests are based on the assumption of normality. In probability theory,
normal distributions arise as the limiting distributions of several continuous and
discrete families of distributions.

2.3 Knowledge of the cost of insurance to determine risk retention

Prior to the risk retention act, risk retention groups already existed, but it was
hard for them to form and compete with insurance companies. The act was
designed to change the rules to make it easier for groups to form. The overall
goal was to lower premiums for all businesses through competition between
retention groups and insurance companies.

There are some other good reasons to retain some risk instead of transferring it all to
an insurance company.

• High premiums. Part of the premiums you pay go toward the cost of the
insurance company doing business. Why pay them if you don't need to?

• Small claims are expensive. One benefit to transferring all risk to a company
is to deal with the all the small claims that come up during your normal
business operations. The problem is that managing small claims can be
expensive, to the point where it may be better to just pay the claims.

• Small claims can increase your premiums. By letting your insurance

company handle--and pay for--small claims, you risk having your premiums
go up even more.

• You already retain some risk. Even if you think you have "full coverage" you
really don't. You retain certain risks through having a deductible, for example,
or by not purchasing coverage for natural catastrophes.

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This involves accepting the loss when it occurs. True self insurance falls in this
category. Risk retention is a viable strategy for small risks where the cost of insuring
against the risk would be greater over time than the total losses sustained. All risks
that are not avoided or transferred are retained by default.
This includes risks that are so large or catastrophic that they either cannot be
insured against or the premiums would be infeasible. War is an example since most
property and risks are not insured against war, so the loss attributed by war is
retained by the insured. Also any amounts of potential loss (risk) over the amount
insured is retained risk. This may also be acceptable if the chance of a very large
loss is small or if the cost to insure for greater coverage amounts is so great it would
hinder the goals of the organization too much.

Risk retention activities can be executed in various ways:

• by charging to current operating costs, i.e., by paying losses out of net profit
• by selling other assets to replace other assets that are lost
• by building up a fund or pool of near-cash assets, known as a contingency
• by arranging loan facilities to be taken up in the event of loss
• by forming a captive insurance company, specifically to cover its parents’
insurance

It is evident that various options exist within the various risk management options,
i.e. risk transfer and risk retention. What is important is for t he financial advisor to
analyse the risks in an entity to determine which risks could be transferred to
insurance.

2.3.1 Cost of insurance

The first cost to consider is of course the premium that is going to be paid to get the
cover needed to transfer enough risk as to justify the premium paid. This explicit
cost, however, is not the only one that should be considered.
There is also the loss of the time value of money, which is lost if funds are paid to the
insurer, as well as the loss of investment potential and growth, should the funds be
reinvested in the company.

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Other costs, like that of the long term payments, compared to the long term returns
from insurance, should be considered as a cost of insurance.

2.4 The difference between a provision and a reserve with examples

In financial accounting, provision is a word that creates an ambiguous account title.
In laymans terms, a provision can be described as a present obligation which
satisfies the rest of the definition of a liability, even if the amount of the obligation has
to be estimated.

Example:
Whole Call Provision
A type of call provision on a bond allowing the borrower to pay off remaining debt
early. The borrower has to make a lump sum payment derived from a formula based
on the net present value (NPV) of future coupon payments that will not be paid
because of the call.
The issuer doesn't expect to have to use this type of provision, but if the issuer does,
investors will be compensated, or "made whole." Because the cost can often be
significant, such provisions are rarely invoked.

Both provision and reserve are proactive methods in managing risk and the potential
impact they might have on the entity. Provision refers to actions taken to transfer risk
i.e. providing for potential loss by taking out insurance. Reserve refers to actions
taken to retain risk i.e. providing for potential risk by creating a contingency fund.

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Module 3
The different facilities involved in alternative risk transfer

This module deals with:

• The concepts of risk retention and risk transfer with reference to degrees
of risk
• Available options for retention and transfer of risk with examples
• The difference between risk transfer and alternative risk transfer with
examples

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3.1 The concepts of risk retention and risk transfer with

reference to degrees of risk
The degree of risk is the extent or level of uncertainty in a given situation—the
likelihood of the actual result being different from the estimated result. The concepts
of risk retention and risk transfer was explained earlier in this module.

3.2 Available options for retention and transfer of risk with

examples
The degree of risk that the entity is exposed to must be assessed and a position
must be established. The financial advisor must then evaluate the various options for
risk retention and transfer and choose the most appropriate method.

3.3 The difference between risk transfer and alternative risk

transfer with examples
As previously discussed, risk transfer means causing another party to accept the
risk, typically by contract or by hedging. Insurance is one type of risk transfer that
uses contracts. Other times it may involve contract language that transfers a risk to
another party without the payment of an insurance premium.

Alternative Risk Transfer (often referred to as ART) is the use of techniques other
than traditional insurance and reinsurance to provide risk bearing entities with
coverage or protection. The field of ART grew out of a series of insurance capacity
crises in the 1970s through 1990s that drove purchasers of traditional coverage to
seek more robust ways to buy protection.
Most of these techniques permit investors in the capital markets to take a more direct
role in providing insurance and reinsurance protection, and as such the broad field of
ART is said to be bringing about a Convergence of insurance and financial markets.
Alternative risk transfer is the collective name given to devices of seeking risk
protection using non-traditional routes, that is, other than through traditional
insurance companies.
Apart from insurance risk securitisation, the other usual methods are captive
insurance companies, renting of insurance companies, etc.

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3.3.1 Key Areas of ART Activity

A major sector of ART activity is risk securitization including catastrophe bonds and
Reinsurance Sidecars.
Standardization and trading of risk in non-indemnity form is another area of ART and
includes Industry Loss Warranties.

In addition, a number of approaches involve funding risk transfer, often within the
structures of the traditional reinsurance market. Captive Insurance Companies are
formed by firms and re/insurers to receive premiums that are generally held and
invested as a "funded" layer of insurance for the parent company.
Some captives purchase excess of loss reinsurance and offer coverage to third
parties, sometimes to leverage their skills and sometimes for tax reasons. Financial
reinsurance in various forms (finite, surplus relief, funded, etc.) consists of various
approaches to reinsurance involving a very high level of prospective or retrospective
premiums relative to the quantity of risk assumed. While such approaches involve
"risk finance" as opposed to "risk transfer," they are still generally referred to under
the heading of ART.

ART is often used to refer to activities through which re/insurers transform risks from
the capital markets into insurance or reinsurance form. Such transformation can
occur through the policy itself, or through the use of a transformer reinsurer.
This type of activity has been important in credit risk markets, hard asset value
coverage and weather markets. Reinsurers were notable participants in the early
development of the synthetic CDO and weather derivative markets through such
activities.

A subset of activities in which reinsurers take capital markets risks is dual-trigger or

multiple trigger contracts. Such contracts exist between a protection buyer and a
protection seller, and require that two or more events take place before a payment
from the latter to the former is "triggered."
For example, and oil company may desire protection against certain natural hazards,
but may only need such protection if oil prices are low, in which case they would
purchase a dual trigger derivative or re/insurance contract. There was a great deal of

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interest in such approaches in the late 1990's, and re/insurers worked to develop
combined risk and enterprise risk insurance.

Reliance Insurance extended this further and offered earnings insurance until the
company suspended its own business operations. This area of ART activity
diminished after the general hardening of the commercial insurance and reinsurance
markets following the 9-11 terrorist attacks.

Life insurance companies have developed a very extensive battery of ART

approaches including Life Insurance Securitization, full recourse reserve funding,
funded letters of credit, surplus relief reinsurance, administrative reinsurance and
related approaches.
Because life reinsurance is relatively more "financial" to begin with, there is less
separation between the conventional and alternative risk transfer markets than in the
property & casualty sector.

Emerging areas of alternative risk transfer include intellectual property insurance,

automobile insurance securitization and life settlements.

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Module 4
Proposal of an insurance solution to transfer risk in a business
entity

This module deals with:

• The prices of risk transfer and risk retention (compared) to determine the
most cost effective solution for a specific entity
• A short term insurance solution proposed for a specific entity (covered in
the assessment)

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4.1 The prices of risk transfer and risk retention (compared) to

determine the most cost effective solution for a specific
entity
Insurance carries little or no risk, since losses are paid by the insurer; risk retention
may carry considerable risk, since the company leaves itself exposed to every
possible loss. On the other hand, full insurance is likely to be more expensive than
risk retention, since the insurance premiums must cover the insurer’s administrative
expenses and profits.

The decision whether to ensure fully or to retain risk completely or in part is

complicated, and there is no easy rule or formula that can be used. In some
instances the purchase of a minimum amount of insurance is compulsory, but
companies might want to buy more than the minimum level. Usually, however,
everything depends on the company’s overall attitude to risk.

The more the company dislikes risk or uncertainty, the more likely it is to buy full
insurance. If the company’s attitude to risk is neutral, it will take its decision on purely
monetary grounds – that is, it will choose the cheapest method. The most sensible
approach is to evaluate the monetary costs of the various methods of financing risk,
to arrange these in ascending order of cost, and then to work down the list, asking in
turn: “Does this method carry too great a risk?”

4.2 Guidelines for proposing a short term insurance solution

for a specific entity / client
When proposing an insurance solution to a client, always take the following
guidelines into consideration:
• Be prepared when putting forward the proposal to your client
• Have all relevant facts readily available
• All proposals should be done in writing, so that no discrepancies can occur at
a later stage
• Make sure that your proposal meets all your client’s possible needs
• Take the affordability of your proposal for the client into consideration

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• Make sure that your proposal is professionally done. A proposal that does not
look professional will reflect poorly on you and your company
• Make sure the content and pricing of your proposal is market related: do not
over quote or under quote a client

Glossary of terms
Insurance term Meaning

Bailee Bailment describes a legal relationship in common law

where physical possession of personal property (chattels)
is transferred from one person (the 'bailor') to another
person (the 'bailee') who subsequently holds possession of
the property
Bottom-up An approach which means that the adviser takes the
needs and wishes of the would-be entrepreneur as the
starting point, rather than a market opportunity
Continuous A probability distribution is called continuous if its
cumulative distribution function is continuous. That is
equivalent to saying that for random variables X with the
distribution in question, Pr[X = a] = 0 for all real numbers
Discrete For a discrete probability distribution one could say that an
event with probability zero is impossible, this cannot be
said in the case of a continuous random variable, because
then no value would be possible
Indemnitor Indemnity is a sum paid by A to B by way of compensation
for a particular loss suffered by B
Normal distribution The standard normal distribution is the normal distribution
with a mean of zero and a variance of one
Raison d'être A phrase borrowed from French where it means simply
"reason for being"; Reinsurance A means by whic h an
insurance company can protect itself against the risk of
losseswith other insurance companies
Scenario Analysis A process of analyzing possible future events by
considering alternative possible outcomes (scenarios).

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Insurance term Meaning

Ubiquitous Seeming to appear everywhere at the same time

Bibliography

IMFUNDO Learning Material

INSETA Learning Material
www.wikipedia.co.za
"Office of the Comptroller of the Currency, International Banking and Finance division (202)
874-4730"
Supervisory Guidance on Operational Risk Advanced Measurement Approaches for
Regulatory Capital, July 2, 2003
Diacon, S.R. & Carter, R.L. (2003). Success in Insurance (3rded.). London: John Murr

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