Auto insurance in Jay D, once adopted, is difficult to discontinue. This really is so since there is a potential for a “double cash outflow” when the plan’s discontinued, because the self-insurer would be paying both current year’s insurance premium and the loss runoff from the previous self-insurance years.
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Reserves. The size of the reserve fund is basically the purpose of the number and size expected claims. In any event, reserve funds must be isolated from the other capital of the firm and committed to savings certificates, treasury bills or other liquid money equivalents. Bank credit ought to be obtainable in coming of need, and also the self-insurer should know where other back-up financing can be acquired. Interest income is expected to be earned around the funds set aside to pay claims. Here the time value of money could be substantial since claims against a fund are not all paid at once.
Retention Levels. The criterion accustomed to measure the potential impact of the self-insurance loss is currently based upon a set of general rules of thumb. These rules include: 0.17 of annual revenues; 17 of working capital; 17 of shareholders equity, and 57 of pr e t ax earnings. Non-profit institutions, for example hospitals, often fix the limit of retained losses in a number of their annual budget, because the figure accurately relates to their yearly financial operation.
Another way of determining risk retention levels would be to choose the auto insurance in Alabama program which minimizes the risk-adjusted cost. This requires quantifying a company’s conservatism in a so-called “risk aversion level,” which is based on a recognised theory known as the Risk Preference (Utility) Theory. A company’s risk aversion level relates to its self-insurance capacity (SIC), that’s, the amount of unexpected aggregate loss it can absorb in one year, over all exposures. A company’s risk aversion level is determined based on the formula: r = 1/SIC. For example, where a firm’s self-insurance capacity is expressed in million dollar units, a $100,000 SIC equals $0.1 million, so r = 1/10 = 10 millionths.
Once a risk manager has quantitatively determined a firm’s willingness to bear risk, it is then possible to assess the Risk Adjusted Price of risk retention. Risk Adjusted Price is defined as $ 1 quantity which measures just how much a company could be prepared to pay to get rid of its risk exposure. This is more than the Expected Loss but under the Maximum Possible Loss, and includes unexpected losses to become paid, plus budgeted items such as the expenses of loss settlement. In that sense, it’s roughly comparable to a premium.15