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Are risk managers playing word games?

Tax authorities around the world agree that a risk financing mechanism that does not entail risk transfer cannot be genuine insurance. They also agree that tax deductibility for risk financing costs is only permissible for insurance premiums. That may very well be the reason for the curious nomenclature risk managers have developed to distinguish among the range of alternative risk financing techniques. They want these arrangements to sound as if they are varieties of insurance to get a tax break. How else can one justify using the term "self insurance" to describe no insurance at all?

If risk transfer is an essential characteristic of insurance-that it makes insurance really insurance then the term self insurance is a misnomer. It makes no sense to say that a company can transfer risk to itself.

What Is Self Insurance?

It is surprising that such a flawed and misunderstood term is so widely used throughout the industry. Does self insurance refer to an insurance deductible, and if so, why is the term deductible used instead of retained risk? What is the difference between risk retention and self insurance? Is self insurance only self insurance when an internal fund is established to pay uninsured losses? Is owning a captive only an exercise in self insurance, or risk retention, as tax authorities have argued?

The truth is that any answer is as valid as the next because there is no consensus on these questions.

Yet how the industry describes risk retention does matter, that is, unless those in it actually believe that the way to win the confidence of tax authorities is to practice blatant deceptions. Indeed, if you start by telling the taxman something that is obviously impossible that the company self insures-the battle is lost at the outset.

But the argument is not just a matter of semantics. It is still not unusual for risk managers to talk privately and publicly about self insuring with their captives. Since it is impossible to transfer risk to yourself, how can risk be transferred to yourself via your captive?

Self insurance alternatives are as varied as they are plentiful, and all of them are more aptly described as risk financing. The popular belief that the case for tax deductibility of funds set aside for retained risks will fall apart if such funds are not termed "self insurance" does not hold water because self insurance is devoid of meaning. The tax battle should be fought over the right to deduct "risk retention" funds. This would sharpen the dividing line between captive insurance, which is often incongruously described as a form of self insurance, and non-insurance risk financing options.

The tax privileges that insurers have enjoyed, combined with the legal definitions of what constitutes real insurance, prevent industry from managing and controlling its most threatening expense: the so-called fortuitous loss costs. Strangely, this anomaly is tolerated by, for example, the U.K. government whose rationale over the past decade has been to stimulate business activity by sweeping away restrictive and bureaucratic obstacles.

Allowing insurers the privilege to provide risk financing services on a tax-efficient basis but excluding a captive or a corporate risk retention fund from that same privilege is simply unfair. It compares with forbidding companies from taking a tax deduction for the cost of their in-house lawyers or accountants, while encouraging a deduction for those hired on retainer. This scenario sounds as ridiculous as forcing companies to finance risk with unrelated organizations.

Get Its Act Together

It is clearly in the best interest of the economy to grant industry's risk retention funds the same risk financing tax break that insurers enjoy. Industry should get its act together, stop fudging the issue by referring to risk retention as self insurance and put forth a case based on the right to equality under the law.

On the same note, how many risk managers truly comprehend the scope of risk financing opportunities available to a large corporation? At a London conference earlier this year, a risk manager outlined his financial director's approach to risk financing.

The risk manager said that after he had explained to his board the logic behind risk financing-dedicated funds to match expected claims costs-his financial director asked why the company should put large funds aside earning only money market interest rates when those funds could be used to start a new company that would earn a far larger return? The board's view of risk financing was, if the big claim does occur, we can always sell a company to pay the bill, but if it doesn't, we will have earned a lot more money than we would have by setting up a risk retention fund. Chris F. Best is editor of Foresight, a London-based insurance and risk management journal published by Risk and Insurance Group Ltd.
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Title Annotation:London Perspective
Author:Best, Chris F.
Publication:Risk Management
Date:Sep 1, 1991
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