Problems involved in Risk Financing through the use of contingency fund

 

 

 

Sometimes, some organizations desire to retain risks internally to cope up with large and unpredictable losses  and charge them against operating costs. 

 

The idea is to spread out the losses of a longer period. Such a fund can be financed by either the transfer of a capital sum to the fund or by paying in periodic contributions like insurance premiums. The disadvantage is that these periodic contributions are not tax deductible.

 

As the contingency funds need to be kept readily available, transfer of a capital to this fund would mean foregoing some other ventures or some expansion plans. 

 

Therefore, the amount that an organization will be willing to set aside, will depend on its size of liquid reserves and the expected returns from alternative use. 

 

How much an organization can afford to contribute to the contingency fund or to pay out the insurance premium directly depends on its net annual cash flow, i.e the surplus of earnings over costs. 

 

An organization that cannot afford to contribute to a contingency fund each year, or pay out insurance premiums, will not be able to sustain in the long run. In the shorter term, it might sustain depending on certain judgements and decisions. 

 

E.g, it may concentrate for providing for the risks with very high potentials and low frequency, or concentrate for providing for those risks with high probability but of low potential. 

 

If the annual net cash flow varies from year to year, the internal funding of risk has an advantage over insurance as the size of the annual contributions can be varied accordingly, which is not possible in case of fixed insurance premiums. Funding also has an advantage over the charging of losses to current operating costs. In a large diversified organization composed of a number of profit centres, the monthly and yearly cash flows of the individual operating units are likely to vary more than the net cash flow for the group. 

 

Therefore, risks which individual profit centres themselves cannot afford to handle as operating costs nor could deal with creating an internal fund can seek the advantage of the group contingency fund. Flexibility can be allowed to each profit centre to contribute according to its current financial circumstance.