A special type of insurance company set up by a

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A special type of insurance company set up by a parent company to insure its own risks ii. Parent company is not in the insurance business iii. Two types: 1. Single parent 2. Group captive a. Owned by a group of companies b. Associated captive Advantages of a captive: Helps firms with “hard markets” o Underwriting and pricing cycles Regulatory and income tax benefits o Often located in Bermuda and Canyon Island o Also various states: VT, DE… Captives provide access to reinsurance markets o Reinsurance: insurance for insurance companies May insure third party risks b. Risk Retention Groups (RRGs) i. Hard to place liability risks. ii. Ex.: 1. Cabs 2. School buses 3. Ambulances Formed by federal Act: pre-? State insurance law requiring insurer to be licensed in every state in which it sells All members/owners must be from the same industry All members/owners must be insured by RRG Severity Loss reduction Insurance Loss reduction Captive or RRG Loss prevention Avoidance Retention (unfunded) Retention (funded) Loss prevention
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Frequency Chapter 7: Decision Making Under Uncertainty: Selection of RM Alternatives Loss matrix: Shows possible $ values associated with each combination of Risk management alternatives, and Future states of the world (outcomes) Ex.: o Building value: $424,000 Assume two possible future states of the world: Loss OR no loss Assume that a loss is a total loss (no partial loss) Possible RM options: 1. Retention 2. Retention + safety measures (loss prevention to decrease frequency) a. Cost = $12,000 for safety measures 3. Full insurance: a. Face amount = $424,000 b. Premium = $20,000 States of the world Loss No Loss Retention After tax $424,000 $254,400 $0 $0 Retention + safety After tax 424,000 + 12,000 $261,600 12,000 $7,200 Full insurance After tax $20,000 $12,000 $20,000 $12,000 Tax deductible expenses: Insurance premiums Cost of safety programs Cost of uninsured losses Side example: Firm A has: Revenues = $2000 Expenses = $0
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Taxable income = revenues – expenses = 2000 Tax rate = 40% Tax obligation = 2000X.4 = 800 Firm B has: Revenues = $2000 Insurance for $400 Taxable income = revenues – expenses = 2000-400 = 1600 Tax obligation = 1600X.4 = 640 Tax savings = 800-640 = 160 After-tax cost of insurance = 400-160 = 240 After-tax cost of a tax deductible expenditures of $X = ($X)(1-tax rate) = ($400)(1-.4) = $240 An additional example: Income = $100,000 Expenses = $10,000 Tax rate = 40% 1. Assume expenses are not deductible a. 100,000(1-.4) = 60,000 = after-tax income b. 60,000-10,000 = 50,000 = after-tax + expenses income 2. Assume expenses are deducible a. 100,000-10,000 = 90,000 = taxable income b. 90,000(1-.4) = 54,000 = income after taxes + expenses Probabilities: Without safety: P(loss) = 3% P(~loss) = 97% With safety: P(loss) = 1% P(~loss) = 99% After-tax expected losses for each option: 1. Retention: 254,400(.03) + 0(.97) = $7,632 2. Retention + safety: 261,600(.01) + 7,200(.99) = 9,744 3. Full insurance: 12,000 with probability = 1 (known loss) If decision rule is: choose the alternative that minimizes expected cost, we choose retention
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Retention < retention + safety < full insurance However, each decision (alternative) actually has two types of costs: Monetary cost (expected loss) Non-monetary cost o Cost of uncertainty o Worry value (WV) – cost associated with decision making
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  • Fall '12
  • M.M.
  • Risk Notes

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