Risk Financing and Transfer Strategies for AFT Ltd

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Introduction
AFT ltd is a property owner with 20,000 residential buildings in its portfolio, belonging to the
region of Southern Europe. A certain percentage of the buildings are located in an
earthquake zone and therefore, are prone to earthquake-related damage. Currently, AFT ltd
has insurance coverage in place that is worth around 1.3 billion euros. Over a span of 20
years, the region has experienced a total of 3 earthquakes, with two of which were in the last
five years. AFT ltd has incurred average damage of 2 million euros per earthquake. The
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990Coursework assignment three answer template
depreciation or attritional damage that the portfolio had to bear was around 1 million euros,
excluding the earthquake losses.
AFT Ltd is currently seeking a more equitable solution for risk financing since the current
coverage has experienced an increase of 100% in terms of premium payment. This report
highlights available risk financing and risk transfer solutions that are suitable for AFT ltd,
discussing their pros and cons in the context of AFT ltd and its insurance requirement.
Lastly, it will present a risk financing solution for AFT as a combination of transfer and
financing of risk for its portfolio of residential buildings.
Risk Retention Strategies
There are two available options in terms of risk financing for AFT Ltd. Risk financing refers to
funding that is acquired or accumulated to bear the expenses of unexpected losses that may
occur due to an unexpected event. Such events are usually low frequency in nature but have
significantly high financial costs associated with them. In the case of AFT Ltd, it can use risk
financing to fund the costs associated with earthquakes, considering a certain portion of its
portfolio is present in an Earthquake zone. Following are the two available solutions for risk
financing that AFT Ltd can use.
Terminate
One way of risk financing is through termination of risk. As per the four T's of the risk
management framework, termination refers to cutting down or relieving the source of risk in
entirety. It does entail financial costs; however, yet it is meaningful in terms of the fact that
when the risk cannot be mitigated, termination is the only viable option.
For AFT Ltd, with properties spread out across Southern Europe, the termination of risk
would involve ridding of securities that are situated in the earthquake zone. Of the financial
costs involved, earthquake-related damage can be mitigated to a certain extent through
termination of property holdings in that region. Through proper disposal activities, certain
cashflows can be generated that can then be used to purchase residential real estate in
other locations. It would serve as a diversification of the portfolio by purchasing property in
other locations. Furthermore, it would minimise the catastrophic risk associated with
earthquakes. Since earthquakes are low frequency yet have high severity, termination is a
suitable option to mitigate the risk effectively.
Changing the property holdings is not an easy task and may terminate the catastrophic risk
but could accumulate other forms of risks such as property risk, devaluation risk, etc.
However, compared to the earthquake damage, the costs are substantially lower for the
above-mentioned risks. Therefore, the said risks can be tolerated without added financing or
measures required.
Termination would, therefore, prove to be a useful measure for risk financing, allowing AFT
ltd to mitigate the catastrophic risk to a considerable extent. The treat strategy for risk
financing enables the risk manager to securely and effectively reduce the exposure of the
risk, with the intent to reduce the exposure to almost close to none. By moving the
earthquake zone-based investments to elsewhere with minimal catastrophic risk, AFT ltd can
benefit from this risk strategy at a relatively cheaper rate.
Treat
Treatment is a part of the four T's of risk management related framework that is a
standardised process for risk control. Treatment strategy through risk retention involves
creating financing streams within the organisation to pay for the expected losses that are
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incurred due to risk related events. In the case of AFT ltd, there are two major costs
associated with the building. Firstly, the cost of earthquake-related damage and secondly,
the cost related to attritional activities. For the latter, the company can create financing
through cash flow management within its own organisation. It can generate enough funds to
be able to finance these costs on its own. Furthermore, it can reap investment profits by
realisation of gains on the real estate and have liquid funds or sufficient cash reserves to be
able to cater to the majority of the earthquake-related expenses.
This treatment strategy would, therefore, create a steady income stream for the organisation
and a steady and liquid supply of cash and equivalents, that can then be used for financing
losses that are incurred due to either maintenance and operational costs, and due to
catastrophic events.
AFT ltd currently has a sufficiently large portfolio with residential buildings all across
southern Europe. It can offer the property on the rental and leasing basis and reap benefits
of income stream generated. Such a strategy would also allow it to generate sufficient funds
to finance the costs that are incurred due to operational needs. Users and owners of the
residential property can be invoked to bear the expenses of maintenances, allowing AFT ltd
to further expand its profit stream.
The treatment strategy is beneficial for AFT ltd as a risk financing and risk retention
technique. It provides an internal mechanism for managing the risk without having to rely on
any third party. This is particularly useful in the way that it reduces uncertainty and default
risk of the other party, allowing forecastable losses prevention through self-generated funds.
Risk Transfer Strategies
Risk transfer strategies refer to the involvement of a third-party or another entity to bear or
share the risk into consideration. Risk transfer strategies are particularly useful when the
financial cost of exposure is very high. With another party involved, the risk burden is
lowered, allowing the company to reduce its exposure overall to the said risk. The
repercussions of an event that triggers the risk-related costs can either be financial or non-
financial. In either case, the risk transfer mechanism can be put into place to mitigate, or
more accurately, reduce the exposure of the risk to the company in question, in this case,
AFT ltd. The following are the two available options for AFT ltd to use risk transfer as a risk
control strategy.
Transfer with Insurance
One of the most widely used forms of transfer-based risk management technique is
insurance. Insurance provides coverage to the entity or the policyholder to share the
exposure of the risk with another entity, usually an insurance company, that is better
equipped to handle the consequences of the event being hedged against. Usually, the
insurance company has more potential in terms of resources and finances to handle the
repercussions of the said catastrophic event, in this case, an earthquake.
Using insurance is a professional way of tackling risk mitigation. Insurance companies are
skilled with understanding risk exposures and can also offer guidance for future
circumstances. Furthermore, they are capable of bearing the said expenses and are,
therefore, more reliable than using other forms of third-party related risk management
mechanisms. For AFT ltd, using insurance coverage to offset the losses from the likelihood
of an earthquake is a viable option. However, insurance companies price the premiums on
the probability and impact of the exposure to the risk. Considering the buildings existing in
the earthquake zone, the premia for insurance would, therefore, be higher since the
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