Self-insurance

This concept, in which one retains the financial risk of certain events rather than seek third party insurance, has been introduced above. It is used where it is more economic to 'self-insure' than to pay insurance premiums to a third party insurer. It can take several forms.

At the simplest level self-insurance involves recognising that certain types of operational loss are an inevitable cost of doing business. These regular, predictable levels of loss are simply built into the annual budget and show up as cost items on the organisation's profit and loss account.

Self-insurance can also take the form of the 'excess' on an insurance policy, in which a sustainable level of loss is not transferred to the insurer, thus reducing the premiums paid. The value of the excess is set at a level of loss that the insured party feels able to sustain without undue discomfort.

For certain types of catastrophic loss, which are not easily or economically insured, and which are far beyond the 'comfort zone' of the policy excess, it is sometimes appropriate to allocate capital reserves on the balance sheet of the organisation. This means setting aside capital that is not used for any other purpose (other than being invested in an easy access deposit account) but which is then available to cover the cost of any large unplanned and unpredicted loss events.

Yet another form of self-insurance is to set up insurance policies with an insurance organisation that is owned by the organisation. Such schemes are known as 'captives'. A 'single parent captive' is an insurance organisation owned and controlled by one organisation and is used to insure only that organisation and its subsidiaries. A 'group captive' is an insurance organisation owned and controlled by two or more non-affiliated organisations that the captive insures. In theory all 'mutual insurance' companies are group captives owned by their policyholders. Also intergovernmental insurance pools are captives owned by the public agencies that they insure.

A variation of the captive concept for those companies not large enough to form their own captive is a 'rental captive'. In this case someone sets up a captive using a front organisation and rents it out to other companies needing insurance. This rent-a-captive approach is perfectly legal and provides a viable alternative.

There are now many alternatives to conventional insurance based upon products offered by the capital markets. These include a variety of hedge funds, bonds, options and derivatives specially linked into certain types of risk. This enables an organisation to construct a special portfolio of risk financing structures especially tailored to its own risk profile and its needs for insurance.