Current Assets

Company with sufficient cash flow should use its current assets to cover left on their own holding losses. This method is appropriate only if the company has a positive working capital. (Recall that the current assets consist of cash and other liquid assets that can or will be converted into cash within one year.

Working capital is current assets minus current liabilities.) Relying on cash flow and on the sale of its current assets to cover left on the net retention of losses, the company has nefinansirusmy loss plan (unfunded Loss Retention Plan) , left on his own holding.

Take the case of "KYZtehnologii" shown earlier. Balance sheet "KYZtehnologii" (see. table ) shows that current assets amount to 617.5 million dollars., and reserves to cover left on their own holding losses - $ 4.5 million. Working capital "KYZtehnologii" equal to 247.0 million dollars . Therefore, "KYZtehnologii" has more than enough value of current assets, which the company can sell to cover left on the net retention loss when it becomes necessary.

Some organizations create internal fund to cover left on their own holding losses. When an organization uses internal fund (Internal Fund) , it outlines the liquid assets, such as cash or marketable securities to cover left on their own holding losses. This type of plan is a funded plan own deduction of losses {Funded Loss Retention Plan) , because the assets are set aside specifically to cover left on their own holding losses.

Assets pending in the domestic fund are recorded in the balance of the organization separately. In some cases, an external organization, such as an insurance company, to create a fund on behalf of the organization, leaving on their own hold their losses. When this happens, the fund is external to the organization and method of accounting determined by the parties, so it may not be reflected as an asset on its balance sheet. When the fund is not reflected in the balance of the organization, it relates to off-balance (off-balance Sheet Fund) .

When an organization maintains current assets or off-balance sheet uses the fund to cover left on their own holding losses, it is the opportunity cost because the funds are linked to assets. Otherwise, the funds could be used to reduce capital requirements. This phenomenon will be explained hereinafter.

The Financing Risks

Managers of any organization usually several financial goals. They plan the movement of resources and use cash to maintain adequate cash flow or liquid assets for your organization. They also struggle to maintain the solvency of the organization and to avoid its bankruptcy. In addition, managers of companies whose shares are quoted on the stock exchange, trying to maximize the market value of the company.

The primary financial objective of most public organizations is to increase the market valuation (capitalization) of the company by maximizing the present value of future cash flow ( cash inflow minus cash outflow ). Theoretically, investors assess the public authority, trying to determine the size of future cash flows. Then they discount the expected cash flows to the present time to assess the current market value of the organization. If the organization is developing a successful new product, investors are likely to increase the current market assessment of the entity's shares, based on the assumption that the future cash flow from the production will be much greater.

Risk level (degree of Risk) , or volatility (volatility) , associated with the future cash flows will also affect the market value of public organizations. The higher the risk, the higher the discount rate, which investors use when planning the expected future cash flow of the organization. (This is especially true when assessing systemic risk that investors can diversify by buying shares of many companies of various types.) The higher the discount rate, the lower the present value of the cash flow of the organization and below the current market assessment of the organization. Consequently, there is an inverse relationship between the risk associated with cash flow organization, and its market value.

Financing risk - an integral part of the overall financial management of the organization, so that most of the financing of risk should be derived from the financial goals of the organization and support them. To increase its market valuation (value), a public organization must carefully manage costs for risks, which include minimizing costs per unit transferred and left on their own risk retention when the result should be a sufficient return on the risky asset.

Income (return) from the left on the net retention of net risk can be measured as the cost savings associated with the transfer of risk (assuming that the organization has the option to transfer or leave your own risk). Private and non-profit organizations must also manage their costs to compensate for the risk, taking into account that their primary financial goal - providing the necessary services - more significant than the increase in its market value. In any case, the organization must keep the risk at a level where it can take the possible variability of the results of losses (Loss Outcomes of variability) .

To manage their costs associated with the risks and maintain an acceptable level of uncertainty left on the net retention risk, an organization must manage all the sources of their risks by integrating them (associations). As will be described later in this chapter, this approach is preferable to other methods to help organizations define their goals financing risk.

Why should I Risk Financing?

Financing risks consumes resources of the organization. For example, the specialist company's risk management will have to spend some time to develop, implement and manage risk financing plans. Various risk carriers (bearer of risk) and service providers, including insurance companies, prescribed rates for their services at a level sufficient to cover their overhead costs (costs of the proceedings) and profit. Override the benefits of the development and implementation of the financing plan risks these costs?

Risk financing plan is needed for different categories of companies, especially for small and medium business, for which the weight loss will inevitably lead to a halt or bankruptcy of the organization. Also, non-profit organizations like the Red Cross, have to fund their losses in order to remain solvent and to ensure the provision of necessary public services.

But how is the situation at the companies whose shares are traded on the open market? Do they have to expend the resources necessary to develop and implement a plan of financing risks (formal Risk Financing Plan) ! In theory, shareholders can diversify the risk of loss associated with ownership of shares of a company ( unsystematic risk ), independently by its inclusion in the portfolio of assets (acquisition) of shares of enterprises of different types. Will shareholders and the economy as a whole to function better if the company whose shares are traded on the open market, will not divert resources to finance the risks?

Many of the companies whose shares are traded on the open market, adhere to a conservative approach to risk financing. In many cases, the management of these companies believe in the fact that it can maximize the market value of the shares of the company, demonstrating to investors in their reports steadily growing income and stable cash flow. Management of the company transfers the risk of occurrence of losses so as to stabilize the reported earnings in order to maximize the market value of the company. Conservative approach to financing risk management can also be explained by the desire of management to receive compensation. Often, management receives additional financial compensation for a steady increase in the market value of the company.

For organizations economic feasibility transfer their risks is the emergence of the process-related special benefits. Avoid bankruptcy protects the owners of the company and other shareholders of the additional costs, such as attorneys' fees and court costs arising in the course of doing business due to bankruptcy. If the company is subject to a progressive tax, the reporting of sustainable income subject to taxation, allows to save on taxes in time rather than a demonstration of unstable income. Another economic factor - the emergence of the companies additional incentives to the implementation of various investment projects in the case of transfer to third parties mostly associated risks.

Bob Hedges (Bob Hedges), professor emeritus at Temple University (Temple University), in one of his works in 1964 made the following comments regarding the transfer of risk:

"There are critical values. When the damage exceeds these values, negative consequences occur. Hence the principle of fair conclusion "significant losses" (large Loss Principle) : the effect of minor damage is limited to damage itself. Therefore, the use of insurance payments can be quite clearly defined amount received dollars. If the underwriter knows his stuff, it can not be expected that this number will regularly exceed the premium collected. However, if direct damage causes deterioration of assets - enough to cause damage to the financial integrity of the business, then get insurance compensation benefits for the company are not limited to the amount actually received dollars. Benefits may be so great that reach the value of the business. "

The key to a successful program is the allocation of risk financing sufficient resources for its implementation in order to maximize the benefits of the excess over cost. In the next chapter will be studied in more detail issues related to the benefits and costs of financing programs risks.

Evolution of the Financing Risk

The practice of financing losses arising from the implementation of the risk of danger {hazard risk), has undergone over the past 30 years, significant changes, among which should be noted three main points:

Increasing the share of losses financed by large corporations at their own expense (left large companies on the net retention).
Increasing the use of risk management techniques, alternative to traditional insurance.
The inclusion of several types of risks - operational and financial / market risk with the risk of danger - in program funding.
In the 1970s, the cost of risk the dangers faced by most of the large corporations has increased considerably. The result of this process was to increase the size of premiums on property insurance and liability insurance. In an effort to reduce costs, large companies increased their share of the risks being left on their own retention program financing risks.

Many corporations are saved by increasing the level of uncompensated losses on insurance contracts (franchise). A significant proportion of companies in the Fortune 500, to carry property insurance risk by creating a captive (captive insurance companies) insurers - subsidiaries focused on insurance risk parent company and affiliated entities. In addition, during the same period were developed and implemented a program of self-insurance (self-insurance plans), as well as other methods of financing risks.

Development of alternative methods of insurance continued in the 1980s. In 1986, the availability of liability insurance crisis provided the impetus to the further spread of captive insurance companies , the development of self-insurance programs and other alternative risk financing techniques insurance. Also in 1986, a group of companies established excident own insurer ( own excess Liability Insurer ) under the name of ACE, Ltd., whose task was the implementation of the liability insurance of the parent companies in case of occurrence of losses exceeding $ 100 million. By establishing such a group captive insurer specified group of companies, in fact, prefer to carry out mutual insurance , rather than relying on the traditional insurance market.

A similar type of insurer group (group insurer) called XL, Ltd. was established shortly thereafter to cover losses liability of more than 50 million dollars. At the end of the 1980s, this trend was reinforced by the creation of an additional group of captive insurance companies, serving the interests of corporate groups.

In addition, at the end of the 1980s, the company began to acquire long-term insurance policies for comprehensive insurance (multiline insurance policies), called the plans of the overall risk (integrated risk plans). Companies, therefore, given the opportunity, saving on insurance premiums, to purchase a single insurance policy that gives coverage for several years on the spectrum of risk, rather than the annual conclusion of separate contracts of insurance for each source of risk. Such multi-year programs have allowed companies to determine the cost of insurance for several years ahead.

In the late 1980s and in the 1990s, with the spread of the practice of holding and risk management, insurance premiums decreased compared to total insurance payments made ​​insurance industry. Within the framework of the so-called soft market (soft market) costs associated with net retention of insurance risks, costs exceeded the transfer of such risks to third parties. Nevertheless, in spite of the continuing decline all insurance rates, the organization continued to maintain a significant share of the risk on their own holding. Such alternative risk financing programs, as captive insurance and self-insurance, are also widely used by many companies in this period, and their continued growth and expansion.

Currently, most of the large organizations it is more convenient to keep a significant portion of insurance risks on their own holding and developing administrative methods to manage this process.

Most companies will continue to use similar programs of their own and hold in the future, therefore, probably never to return to traditional insurance mechanisms for risks left on his own holding. Accordingly, much of this work is devoted to the analysis of risk financing programs, alternative to traditional insurance.

Retention and Risk Transfer

Organizations use two main methods of risk financing to cover their losses - retention and transfer. We compare these two methods.

Retention (retention) means that an organization uses its own resources to cover their losses. The source of funds to cover the losses may be notes of cash, current assets, borrowings or deposits of shareholders in exchange for the right to participate in the organization. The amount of funds required to cover the losses, left on their own holding, is uncertain, so these losses can significantly reduce the net profit of the company, its net worth and cash flow. Speculative risks are left on their own holding, in contrast to pure risk can bring organizations benefit from some positive outcomes of these risks.

Typically, the organization chooses the risks on their own holding, but sometimes this choice is mandatory. For example, car insurance in case of damage: insurers shall establish a minimum level of franchise policy that encourages the insured to participate in the minimum amount of damages. Other types of insurance policies - such as the majority of insurance policies against earthquakes, necessarily contain a condition whereby the policyholder alone covers a fixed percentage of the value of the insured property or losses incurred on each risk.

Transfer (transfer) means that the transmitting entity (transferor) uses the resources of another host (Iransferee) , the organization for payment or offset its losses. An organization that adopts a risk receives compensation in exchange for the payment of future losses on the risk. For the organization, the transmission losses as a result of its speculative risks, the cost of transmission losses compensated partially or completely through some wins that may occur in the event of a positive outcome of these risks.

Compensation (reimbursement) loss arising on the transfer of risks, can take many forms. For example, a company can receive cash benefits directly from the organization accepting the risk. In order to recoup their losses the company may also use a positive change in the value of financial instruments in which it has invested.

For risk hazard the most common method of risk transfer is their insurance. Insurance companies receive premiums in exchange for the payment of compensation by the insurer (or for the benefit of policyholders) in the event of any loss on the insured risk.

Organizations often enter into contracts that are not related to insurance, in order to transfer their risk of loss. For example, shops selling toys at retail, often require their suppliers (manufacturers of toys) to reimburse them for any damages arising from trade toys that are related to products liability. (In this case, difficult to accurately determine the amount of compensation that should be paid the organization that takes the risk, so this requirement becomes an integral part of the transaction between the seller and the manufacturer.)

Another form of non-insurance contract (Contract noninsurance) , which organizations use to transfer risk - derivative security or derivative (derivative) . The derivative of a chain of paper - a financial instrument whose value is based on the value of another asset, called source (Underlying Asset) . To submit your own risk, an organization must buy a derivative security whose value is positively correlated with a specific category of loss organization.

The organization uses a positive change in value of derivative securities to cover their losses. Hedging with derivative securities is most often used by organizations to cover their risks arising from these financial / market risk as currency and interest rate risks as well as risks associated with changes in commodity prices. Hedging can also be used to cover losses on the risks of danger.

Securities with an insurance component (Insurance-linked Securities) - another form of non-insurance contract that organizations use to transfer the risk of danger. Together with the securities and the insurance component of the investor receives the occasional risk of loss associated donated paper. To date, insurance securities exist mainly in the form of catastrophe bonds (BONDS Catastrophe ), used by insurers to transfer their risks associated with disasters.

Note that loans are a form of self-retention risks. Even despite the fact that the funds to cover losses are taken from other organizations (such as, for example, a bank), the borrower must promise to return the funds, and so we can assume that it uses its own funds to cover the losses.

In practice, most organizations to cover losses uses a combination of net retention and risk transfer. In the example, the store vehicles mentioned above, we assume that the organization has bought an insurance policy with a deductible (deductible) . The presence of a franchise is a method of self-retention, so shop car yourself pokryvaetlyubye losses within the franchise and therefore pays for the losses of their own financial resources. Insurance (over the franchise) is a method of risk transfer, where the store pays a premium car and uses the insurer to pay the part of any risk covered by insurance, which exceeds the deductible.

The following describes the various types of retention and risk transfer to finance them. Although all of these plans can be used by large organizations, many of these techniques can also utilize medium sized organizations. The following table compares the methods of retention and risk transfer.