# A new look at financial insurance products.

RECENTLY, SEVERAL REINSURance companies have begun to design and
market financial insurance products. Typically, these products are sold
to corporations to provide coverage for either environmental impairment liabilities that are difficult to insure through the traditional market,
exposures for which adequate limits are unavailable, excess layers that
carry substantial premiums relative to the policy limit, or any
combination of these reasons. According to the prevailing wisdom,
financial insurance products provide certain benefits to their
purchasers; besides the transfer of risk, these products are said to
smooth the company's earnings over time, thus protecting the price
of the company's stock from an unexpected dip in earnings, to
provide a prefunding mechanism for coverage in the event of a large
loss, and to provide a cash flow benefit.

However, due to a number of financial factors, the risk transfer element in these products constitutes the primary benefit to the corporation. Therefore, because some companies may regard the purchase of financial insurance as a way to reap financial benefits, risk managers should take a close look at these products and understand exactly how they work. Although a wide array of products are known aS financial insurance, for purposes of this article, the products discussed have a premium that may be paid over several years to fund a substantial portion of the policy limits. A fund, which is established with the premium, earns investment income and is then returned when the policy is canceled minus any loss payments; a fund deficit that arises because losses are paid in excess of the fund is at least partially reimbursed by the insured, perhaps over several years. Because these products contain a small element of risk transfer, they are sometimes referred to as "finite risk" insurance.

PRODUCT BENEFITS

Besides the minor amount of risk transferred, one benefit usually cited for financial reinsurance products is related to the cash accumulation in the fund. In the event of a substantial loss, funds are available to pay for the loss without using lines of credit that have been established for normal operations. This benefit is sometimes enhanced by having the funds accumulate in a non-controlled foreign corporation; income tax on the investment income earned by the fund is then deferred until the funds are repatriated. Furthermore, if the premium is tax deductible, the loss fund amounts to a corporate IRA, since the fund is established with before-tax dollars, and the interest is tax deferred.

A second benefit of the product is to smooth reported income. The objective here is to avoid an extreme jolt to net income in the accounting period when the loss is discovered and its amount is determined. If the premium is paid over several years and is expensed as it is paid, the earnings are smoothed, and the jolt is avoided when the loss occurs; this benefit is aimed at preventing a sharp reduction in earnings that results in a dramatic decline in the price of the company's stock. Financial insurance products are usually purchased because of their funding and earnings smoothing features rather than the limited amount of risk transfer that they provide.

STOCK PRICE FACTORS

Since financial insurance products have also been regarded as a way to protect a company's stock price, it is important to take a look at the factors that determine this price level. The price of a company's stock is related to several factors that are summarized in two numbers, earnings per share, E, and a price earnings multiple, M. The price earnings multiple times earnings per share yields the price of the firm's stock, P = M x E.

There are several possible earnings per share numbers that could be used to calculate the price of the stock; these are the reported earnings for the latest period, the anticipated earnings for the next period, or the long-term trend earnings for the next period. The latest reported earnings is not used because in many cases this is negative and the stock price is positive. Since investors are trying to assess the value of the company for the long run, they use the long-term trend earnings as the earnings estimate in the pricing formula, or expected earnings from continuing operations. This measure of earnings is given the symbol E.

Typically, one-time charges for specific events are discounted or ignored, depending on their severity and their anticipated impact on future earnings. Suppose, however, that a company experiences a large loss that will represent a one-time cost without an effect on future earnings. The effect of this loss on the company's stock price can be estimated with the help of a few observations or assumptions. First, assume that the above expression for price applies, and E is expected earnings under normal conditions excluding the one-time charge or expense, P: M x E. Next, assume the value of the stock is reduced by the per share cost of the one-time expense, P: M x E - L, where L is the loss. Now express L as a proportion, k, of E, L: k x E, and substitute this into the price equation, P: (M x E) -(k x E) = (M- k) E.

An example using typical values will help clarify the effect of a large loss on the price of a company's stock. Suppose the price-earnings multiple, M, is 15, and L equals one-half a year's earnings (k: .5), L = .5 x E. The impact on the price of the company's stock of this large loss could be calculated to be P = (15-.5)E -- 14.5 x E. The price-earnings multiple is reduced from 15 to 14.5, which is a 3.3 percent decline in the price of the stock. Therefore, in this situation a loss of one-half a year's earnings will result in a 3.3 percent impact on the company's stock price. Since losses are tax deductible, the loss amount in this example is one-half of pre-tax earnings, which translates in an earnings reduction for the year of one-half of after-tax earnings. The implication is that a substantial hit to earnings should have a minor impact on a company's stock price unless the loss causes expected earnings in the future to decline.

There are a number of factors that influence the size of the price-earnings multiple such as interest rates, the expected growth in earnings per share and the volatility of these earnings. Generally, the greater the volatility of earnings, the lower the price-earnings multiple. The purchase of a financial insurance product may increase the volatility of earnings per share and decrease the earnings multiplier.

To see how this could happen, note that one factor that increases the volatility in earnings per share is an increase in the amount of debt in the firm's capital structure. This is referred to as an increase in financial leverage. Since funding for the loss contingency with financial insurance increases the cash requirements of the firm, an increased cash requirement financed by debt will result in an increase in the volatility of earnings per share and a reduction in the earnings multiplier.

Another typical effect of financial insurance on the company's stock price is to reduce expected earnings per share. Buying financial insurance increases the total cash requirements of the company, and these increased requirements are usually financed by additional borrowing. The increased borrowing boosts the interest expense for the company and reduces its net income and earnings per share. An example will illustrate this point. Assume a company has $80 million in operating income and $100 million in debt at an average interest cost of 10 percent. (See Chart A for the company's current income statement.)

If this company funds a policy with a limit equal to one-half its operating earnings, and it borrows the funds at 10 percent interest, it will reduce its earnings per share by 5 percent. Given a 5 percent reduction in earnings, the stock price should decline by an equivalent amount. This is an annual loss in earnings and not a one-time reduction. Although the annual cost is much smaller than the one-time loss, its impact on the company's stock is greater than the impact of the one-time loss, which was estimated to be about 3.3 percent for a company with a price-earnings multiple of 15.

In summary, the acquisition of financial reinsurance will probably reduce expected earnings per share, and the price-earnings multiplier. The price of the company's stock is the product of these two factors, P: M x- E. And, since both are decreased, the price of the company's stock is lowered. As a result, the financial insurance product, which is purchased in order to protect the company's stock price, will probably cause the stock price to decline by more than the decline produced by the one-time expense that is being insured.

FUNDING EFFECTS

Another alleged benefit of financial insurance is that, in the event of a large loss, funds will be available to pay for that loss. There are several effects of prefunding, including the impact on the current borrowing capacity of the company, the effect on the firm's future borrowing capacity and, as was discussed earlier, the impact on the earnings of the company, which influences the price of the company's stock.

Companies do not have unlimited borrowing capacity. One financial ratio that is used to judge the riskiness of a company's debt is the ratio of operating profits (earnings before interest and taxes, EBIT) to interest payments, EBIT/I. As interest payments increase and the ratio of operating profits to interest becomes smaller, banks and other lenders become reluctant to lend additional money to the company, because the probability of the company defaulting on its interest payments increases. Buying financial insurance absorbs some of the company's borrowing capacity and earmarks the borrowed funds to an account that may never be used. Judged by this criterion, financial insurance is an inefficient use of credit capacity, which is a scarce resource.

Another measure used by lenders to determine a company's creditworthiness is its ratio of debt to equity. Looking first at the numerator, investors are willing to lend a limited amount of money as a ratio of the company's equity. The timing aspect of this borrowing is not important; by borrowing early to fund the exposure, the company reduces its later borrowing capacity. If the borrowing had been postponed until after the loss, the same borrowing capacity would be available. In fact, it can be argued that greater borrowing capacity would be available if the borrowing is postponed until funds are required for payment. Due to the early borrowing, income is lowered by the amount of the after-tax interest payments, thus reducing retained earnings, a component of equity, by the same amount. With smaller equity in order to reach the same debt-to-equity ratio, the amount of debt must be smaller. Therefore, by prefunding, the company has decreased its future borrowing capacity.

Continuing with the earlier example, assume the company pays shareholders a $25 million dividend. (See Chart B.) If this. company pays shareholders a $25 million dividend, it adds $17 million to retained earnings. If the company borrowed an additional $40 million, its earnings would be reduced to $40 million. If the company maintains its same dividend of $25 million, its addition to retained earnings is reduced to $15 million. Over several years, this loss of additions to equity will result in a noticeable reduction in borrowing capacity.

These examples are germane to all types of prefunding. It is important to realize that companies rarely borrow funds until the funds are needed for payment. This is an important aspect of cash management. Prefunding carries a cost, and if it is undertaken there should be benefits to offset the cost.

CASH FLOW FACTORS

The cash flow effect of financial insurance on a company's balance sheet is dependent on several factors. One factor is whether the product is deemed to be insurance by the IRS. If the product is classified as insurance, the premium is deductible in the year or years that it is paid. If loss experience is favorable and there is a balance in the loss fund at the end of the contract period that is returned to the insured, the policy dividend is taxable income. However, if the product is not classified as insurance by the IRS, the premiums are not deductible, but any loss payments are deductible. In either case, it is assumed that interest earned by the loss fund is not taxable income until it is paid to the insured. If the interest income is used for claim payments, then it never becomes taxable income for the insured.

Another factor influencing the cash flows is-the loss payment under the policy and the timing of the payment. If the loss is less than the premium, then self-insurance has a lower present value cost regardless of the tax status of the premium and of the timing of the loss payment. If the loss is paid before the premium and the premium is tax-deductible, self-insurance can provide the benefits of an early deduction of the loss payment as opposed to the premium payment and a smaller total cost.

If the loss is paid after the premium, the reinsurer's margin and the financing cost associated with the early payment of the premium relative to the loss payment will more than offset any benefit gained by an early tax deduction of the premium. Thus, if the loss is smaller than the premium, the present value cost of self-insurance is always less than the present value cost of financial insurance.

A third combination of factors influencing the cash flows is the amount of risk transfer in the policy and the insurer's charge for the risk assumption. Without risk transfer, self-insurance always has a smaller cost than the insurance product. The insurance policy provides a lower cost alternative only when the risk transfer exceeds the insurer's charge. Therefore, the greater the risk transfer and the smaller the charge for the transfer, the greater the chance that the insurance will be less costly than self-insurance.

The last group of factors is associated with financing costs. Among these are the cost of borrowing, the investment yield of the loss fund, the cost of letters of credit to secure the deficit in the loss fund should one occur, and the company's marginal tax rate.

To study the cash flow characteristics of financial insurance, simulations of cash flows associated with a policy with typical provisions are postulated.

The main provisions of the example policy are summarized as follows: the contract has a five-year term with a policy limit of $100 million in paid claims. The premium, which is $60 million, is paid in five installments of $12 million each at the first of each year. The reinsurer's charge is $6 million, which is deducted from the first premium payment; the remainder of the premium is used to establish a loss payment fund that earns 7 percent interest per year. The last four premium payments are added to the loss fund. If a balance remains in the loss fund at the end of the fifth year, it is returned to the insured. If claim payments exceed the loss fund, the insured must pay an additional premium equal to 80 percent of the fund deficit, and collateral in the form of a letter of credit must be established for these payments. The supplemental premium payments are made in three annual installments beginning at the first of the sixth year.

These simulations have been performed in order to determine the conditions under which financial insurance has a smaller net present value cost than funding the loss through self-insurance. The cash flows associated with losses of $10 million to $100 million in $10 million increments were simulated. For each loss amount, the payment dates were varied from the date of policy inception to the last day of the policy period in annual intervals.

For example, if a policy limit loss is paid before the last premium payment is made, the insurance alternative has a slightly smaller net present value cost than self-insurance. The reason is that investment income is not earned during the fifth year, and the loss payment fund is smaller; 20 percent of the deficit, which is assumed by the insurer, provides a benefit that offsets the reinsurer's margin and the early payment of the premiums.

Generally, if it is unlikely that a loss will be paid before the end of the third year, the loss must exceed $75 million (75 percent of policy limits) before the insurance produces a lower net present value cost than self-insurance if the premiums are not tax deductible.

If the premiums are tax deductible, the results of the simulations are similar to the non-deductible scenario. As in the non-deductible case, if the loss will not be paid before the end of the third year, financial insurance has a cash flow advantage only if the loss payment exceeds $75 million. As a result, the cash flow benefits of this program are almost entirely due to the risk transfer component of the program.

In summary, the simulations indicate that the loss must exceed $50 million - 50 percent of policy limits before the cost of financial insurance will be less than the cost of self-insurance; this is true even if the loss is paid early in the policy term. If it is unlikely that a large claim will be paid before the end of the third year, the present value cost of financial insurance will be less than the cost of self-insurance only if the loss payment exceeds 75 percent of the policy limit, regardless of the tax status of the premium.

THE EFFECTS OF FINANCIAL INSURANCE

This article has focused on some of the probable financial effects of acquiring a particular type of financial insurance product. The first benefit, which is related to smoothing the earnings of the company and, thus, protecting the price of the company's stock from an unexpected dip in earnings, is not likely to occur; this is due to the fact that the reduction in the price of the company's stock that results from the purchase of the insurance is likely to be larger than a price reduction caused by a large claim payment.

The second benefit is related to the advantage of prefunding so that funds are readily available to pay for a large claim should one occur. However, prefunding is typically not a cost-efficient risk funding technique because it utilizes current borrowing capacity for a purpose that may never require cash. In addition, prefunding will typically reduce future borrowing capacity.

The third benefit is a cash flow gain whose size is associated with the tax deductibility of the premium payments and the size and timing of the payment of the loss. Some view the product as a way of accelerating the deduction for claim payments; the thought here is that the premium will generally be paid before the claim is paid, thus resulting in an accelerated tax deduction for the loss:

However, the simulations demonstrate that the greatest benefit occurs if the loss is paid early in the policy period. The reason for this is due to the fact that the loss is funded by the insured over a long period of time, and the insurer pays for a greater percent of the loss cost. If a loss is paid late in the policy period, the cash flow benefits are nonexistent unless the loss is large.

Richard M. Duvall, Ph.D., is president of financial and actuarial consulting for Sedgwick James Inc. in Nashville, TN.

However, due to a number of financial factors, the risk transfer element in these products constitutes the primary benefit to the corporation. Therefore, because some companies may regard the purchase of financial insurance as a way to reap financial benefits, risk managers should take a close look at these products and understand exactly how they work. Although a wide array of products are known aS financial insurance, for purposes of this article, the products discussed have a premium that may be paid over several years to fund a substantial portion of the policy limits. A fund, which is established with the premium, earns investment income and is then returned when the policy is canceled minus any loss payments; a fund deficit that arises because losses are paid in excess of the fund is at least partially reimbursed by the insured, perhaps over several years. Because these products contain a small element of risk transfer, they are sometimes referred to as "finite risk" insurance.

PRODUCT BENEFITS

Besides the minor amount of risk transferred, one benefit usually cited for financial reinsurance products is related to the cash accumulation in the fund. In the event of a substantial loss, funds are available to pay for the loss without using lines of credit that have been established for normal operations. This benefit is sometimes enhanced by having the funds accumulate in a non-controlled foreign corporation; income tax on the investment income earned by the fund is then deferred until the funds are repatriated. Furthermore, if the premium is tax deductible, the loss fund amounts to a corporate IRA, since the fund is established with before-tax dollars, and the interest is tax deferred.

A second benefit of the product is to smooth reported income. The objective here is to avoid an extreme jolt to net income in the accounting period when the loss is discovered and its amount is determined. If the premium is paid over several years and is expensed as it is paid, the earnings are smoothed, and the jolt is avoided when the loss occurs; this benefit is aimed at preventing a sharp reduction in earnings that results in a dramatic decline in the price of the company's stock. Financial insurance products are usually purchased because of their funding and earnings smoothing features rather than the limited amount of risk transfer that they provide.

STOCK PRICE FACTORS

Since financial insurance products have also been regarded as a way to protect a company's stock price, it is important to take a look at the factors that determine this price level. The price of a company's stock is related to several factors that are summarized in two numbers, earnings per share, E, and a price earnings multiple, M. The price earnings multiple times earnings per share yields the price of the firm's stock, P = M x E.

There are several possible earnings per share numbers that could be used to calculate the price of the stock; these are the reported earnings for the latest period, the anticipated earnings for the next period, or the long-term trend earnings for the next period. The latest reported earnings is not used because in many cases this is negative and the stock price is positive. Since investors are trying to assess the value of the company for the long run, they use the long-term trend earnings as the earnings estimate in the pricing formula, or expected earnings from continuing operations. This measure of earnings is given the symbol E.

Typically, one-time charges for specific events are discounted or ignored, depending on their severity and their anticipated impact on future earnings. Suppose, however, that a company experiences a large loss that will represent a one-time cost without an effect on future earnings. The effect of this loss on the company's stock price can be estimated with the help of a few observations or assumptions. First, assume that the above expression for price applies, and E is expected earnings under normal conditions excluding the one-time charge or expense, P: M x E. Next, assume the value of the stock is reduced by the per share cost of the one-time expense, P: M x E - L, where L is the loss. Now express L as a proportion, k, of E, L: k x E, and substitute this into the price equation, P: (M x E) -(k x E) = (M- k) E.

An example using typical values will help clarify the effect of a large loss on the price of a company's stock. Suppose the price-earnings multiple, M, is 15, and L equals one-half a year's earnings (k: .5), L = .5 x E. The impact on the price of the company's stock of this large loss could be calculated to be P = (15-.5)E -- 14.5 x E. The price-earnings multiple is reduced from 15 to 14.5, which is a 3.3 percent decline in the price of the stock. Therefore, in this situation a loss of one-half a year's earnings will result in a 3.3 percent impact on the company's stock price. Since losses are tax deductible, the loss amount in this example is one-half of pre-tax earnings, which translates in an earnings reduction for the year of one-half of after-tax earnings. The implication is that a substantial hit to earnings should have a minor impact on a company's stock price unless the loss causes expected earnings in the future to decline.

There are a number of factors that influence the size of the price-earnings multiple such as interest rates, the expected growth in earnings per share and the volatility of these earnings. Generally, the greater the volatility of earnings, the lower the price-earnings multiple. The purchase of a financial insurance product may increase the volatility of earnings per share and decrease the earnings multiplier.

To see how this could happen, note that one factor that increases the volatility in earnings per share is an increase in the amount of debt in the firm's capital structure. This is referred to as an increase in financial leverage. Since funding for the loss contingency with financial insurance increases the cash requirements of the firm, an increased cash requirement financed by debt will result in an increase in the volatility of earnings per share and a reduction in the earnings multiplier.

Another typical effect of financial insurance on the company's stock price is to reduce expected earnings per share. Buying financial insurance increases the total cash requirements of the company, and these increased requirements are usually financed by additional borrowing. The increased borrowing boosts the interest expense for the company and reduces its net income and earnings per share. An example will illustrate this point. Assume a company has $80 million in operating income and $100 million in debt at an average interest cost of 10 percent. (See Chart A for the company's current income statement.)

If this company funds a policy with a limit equal to one-half its operating earnings, and it borrows the funds at 10 percent interest, it will reduce its earnings per share by 5 percent. Given a 5 percent reduction in earnings, the stock price should decline by an equivalent amount. This is an annual loss in earnings and not a one-time reduction. Although the annual cost is much smaller than the one-time loss, its impact on the company's stock is greater than the impact of the one-time loss, which was estimated to be about 3.3 percent for a company with a price-earnings multiple of 15.

In summary, the acquisition of financial reinsurance will probably reduce expected earnings per share, and the price-earnings multiplier. The price of the company's stock is the product of these two factors, P: M x- E. And, since both are decreased, the price of the company's stock is lowered. As a result, the financial insurance product, which is purchased in order to protect the company's stock price, will probably cause the stock price to decline by more than the decline produced by the one-time expense that is being insured.

FUNDING EFFECTS

Another alleged benefit of financial insurance is that, in the event of a large loss, funds will be available to pay for that loss. There are several effects of prefunding, including the impact on the current borrowing capacity of the company, the effect on the firm's future borrowing capacity and, as was discussed earlier, the impact on the earnings of the company, which influences the price of the company's stock.

Companies do not have unlimited borrowing capacity. One financial ratio that is used to judge the riskiness of a company's debt is the ratio of operating profits (earnings before interest and taxes, EBIT) to interest payments, EBIT/I. As interest payments increase and the ratio of operating profits to interest becomes smaller, banks and other lenders become reluctant to lend additional money to the company, because the probability of the company defaulting on its interest payments increases. Buying financial insurance absorbs some of the company's borrowing capacity and earmarks the borrowed funds to an account that may never be used. Judged by this criterion, financial insurance is an inefficient use of credit capacity, which is a scarce resource.

Another measure used by lenders to determine a company's creditworthiness is its ratio of debt to equity. Looking first at the numerator, investors are willing to lend a limited amount of money as a ratio of the company's equity. The timing aspect of this borrowing is not important; by borrowing early to fund the exposure, the company reduces its later borrowing capacity. If the borrowing had been postponed until after the loss, the same borrowing capacity would be available. In fact, it can be argued that greater borrowing capacity would be available if the borrowing is postponed until funds are required for payment. Due to the early borrowing, income is lowered by the amount of the after-tax interest payments, thus reducing retained earnings, a component of equity, by the same amount. With smaller equity in order to reach the same debt-to-equity ratio, the amount of debt must be smaller. Therefore, by prefunding, the company has decreased its future borrowing capacity.

Continuing with the earlier example, assume the company pays shareholders a $25 million dividend. (See Chart B.) If this. company pays shareholders a $25 million dividend, it adds $17 million to retained earnings. If the company borrowed an additional $40 million, its earnings would be reduced to $40 million. If the company maintains its same dividend of $25 million, its addition to retained earnings is reduced to $15 million. Over several years, this loss of additions to equity will result in a noticeable reduction in borrowing capacity.

These examples are germane to all types of prefunding. It is important to realize that companies rarely borrow funds until the funds are needed for payment. This is an important aspect of cash management. Prefunding carries a cost, and if it is undertaken there should be benefits to offset the cost.

CASH FLOW FACTORS

The cash flow effect of financial insurance on a company's balance sheet is dependent on several factors. One factor is whether the product is deemed to be insurance by the IRS. If the product is classified as insurance, the premium is deductible in the year or years that it is paid. If loss experience is favorable and there is a balance in the loss fund at the end of the contract period that is returned to the insured, the policy dividend is taxable income. However, if the product is not classified as insurance by the IRS, the premiums are not deductible, but any loss payments are deductible. In either case, it is assumed that interest earned by the loss fund is not taxable income until it is paid to the insured. If the interest income is used for claim payments, then it never becomes taxable income for the insured.

Another factor influencing the cash flows is-the loss payment under the policy and the timing of the payment. If the loss is less than the premium, then self-insurance has a lower present value cost regardless of the tax status of the premium and of the timing of the loss payment. If the loss is paid before the premium and the premium is tax-deductible, self-insurance can provide the benefits of an early deduction of the loss payment as opposed to the premium payment and a smaller total cost.

If the loss is paid after the premium, the reinsurer's margin and the financing cost associated with the early payment of the premium relative to the loss payment will more than offset any benefit gained by an early tax deduction of the premium. Thus, if the loss is smaller than the premium, the present value cost of self-insurance is always less than the present value cost of financial insurance.

A third combination of factors influencing the cash flows is the amount of risk transfer in the policy and the insurer's charge for the risk assumption. Without risk transfer, self-insurance always has a smaller cost than the insurance product. The insurance policy provides a lower cost alternative only when the risk transfer exceeds the insurer's charge. Therefore, the greater the risk transfer and the smaller the charge for the transfer, the greater the chance that the insurance will be less costly than self-insurance.

The last group of factors is associated with financing costs. Among these are the cost of borrowing, the investment yield of the loss fund, the cost of letters of credit to secure the deficit in the loss fund should one occur, and the company's marginal tax rate.

To study the cash flow characteristics of financial insurance, simulations of cash flows associated with a policy with typical provisions are postulated.

The main provisions of the example policy are summarized as follows: the contract has a five-year term with a policy limit of $100 million in paid claims. The premium, which is $60 million, is paid in five installments of $12 million each at the first of each year. The reinsurer's charge is $6 million, which is deducted from the first premium payment; the remainder of the premium is used to establish a loss payment fund that earns 7 percent interest per year. The last four premium payments are added to the loss fund. If a balance remains in the loss fund at the end of the fifth year, it is returned to the insured. If claim payments exceed the loss fund, the insured must pay an additional premium equal to 80 percent of the fund deficit, and collateral in the form of a letter of credit must be established for these payments. The supplemental premium payments are made in three annual installments beginning at the first of the sixth year.

These simulations have been performed in order to determine the conditions under which financial insurance has a smaller net present value cost than funding the loss through self-insurance. The cash flows associated with losses of $10 million to $100 million in $10 million increments were simulated. For each loss amount, the payment dates were varied from the date of policy inception to the last day of the policy period in annual intervals.

For example, if a policy limit loss is paid before the last premium payment is made, the insurance alternative has a slightly smaller net present value cost than self-insurance. The reason is that investment income is not earned during the fifth year, and the loss payment fund is smaller; 20 percent of the deficit, which is assumed by the insurer, provides a benefit that offsets the reinsurer's margin and the early payment of the premiums.

Generally, if it is unlikely that a loss will be paid before the end of the third year, the loss must exceed $75 million (75 percent of policy limits) before the insurance produces a lower net present value cost than self-insurance if the premiums are not tax deductible.

If the premiums are tax deductible, the results of the simulations are similar to the non-deductible scenario. As in the non-deductible case, if the loss will not be paid before the end of the third year, financial insurance has a cash flow advantage only if the loss payment exceeds $75 million. As a result, the cash flow benefits of this program are almost entirely due to the risk transfer component of the program.

In summary, the simulations indicate that the loss must exceed $50 million - 50 percent of policy limits before the cost of financial insurance will be less than the cost of self-insurance; this is true even if the loss is paid early in the policy term. If it is unlikely that a large claim will be paid before the end of the third year, the present value cost of financial insurance will be less than the cost of self-insurance only if the loss payment exceeds 75 percent of the policy limit, regardless of the tax status of the premium.

THE EFFECTS OF FINANCIAL INSURANCE

This article has focused on some of the probable financial effects of acquiring a particular type of financial insurance product. The first benefit, which is related to smoothing the earnings of the company and, thus, protecting the price of the company's stock from an unexpected dip in earnings, is not likely to occur; this is due to the fact that the reduction in the price of the company's stock that results from the purchase of the insurance is likely to be larger than a price reduction caused by a large claim payment.

The second benefit is related to the advantage of prefunding so that funds are readily available to pay for a large claim should one occur. However, prefunding is typically not a cost-efficient risk funding technique because it utilizes current borrowing capacity for a purpose that may never require cash. In addition, prefunding will typically reduce future borrowing capacity.

The third benefit is a cash flow gain whose size is associated with the tax deductibility of the premium payments and the size and timing of the payment of the loss. Some view the product as a way of accelerating the deduction for claim payments; the thought here is that the premium will generally be paid before the claim is paid, thus resulting in an accelerated tax deduction for the loss:

However, the simulations demonstrate that the greatest benefit occurs if the loss is paid early in the policy period. The reason for this is due to the fact that the loss is funded by the insured over a long period of time, and the insurer pays for a greater percent of the loss cost. If a loss is paid late in the policy period, the cash flow benefits are nonexistent unless the loss is large.

A Before After Operating Earnings(EBIT) $80 $80 Interest (I) 10 14 Taxes at 40% (T) 28 26 Net Income (NI) $42 $40 B Before After Net Income INI) $42 $40 Stockholder Dividend (D) 25 25 Increase in Equity $17 $15

Richard M. Duvall, Ph.D., is president of financial and actuarial consulting for Sedgwick James Inc. in Nashville, TN.

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Author: | Duvall, Richard M. |
---|---|

Publication: | Risk Management |

Date: | Nov 1, 1992 |

Words: | 3310 |

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