WHAT IS 'Finite Risk Insurance'

Finite risk insurance is a transaction between an insurer and insured in which the insured pays a premium that constitutes a pool of funds for the insurer to use to pay losses. The insured does not actually transfer much or any risk of loss per occurrence to the insurer. If losses are lower than the premium, the insurer returns most or all of the premium to the insured. If the losses exceed the premium, the insured pays additional premium to the insurer.

BREAKING DOWN 'Finite Risk Insurance'

Standard insurance arrangements, as opposed to finite risk insurance, have the insured transferring a liability associated with a specific risk to an insurer, and for this service the insurer earns a premium or fee. The insurer maintains a loss reserve with its own funds and is able to keep any income that it makes. Finite risk insurance is an alternative risk transfer type of insurance product, with features of both excess insurance and self-insurance. It allows the insured to spread out payments for losses over time, while retaining the ability to receive a refund of some of its premiums and investment income if losses are less than anticipated.

Limits and deductibles in finite risk insurance

The insurer provides a standard insurance policy, but modifies the limits and deductibles in a specific way. The total limit and retention, on a per-occurrence and aggregate basis, are a function of the total premium. The insurer computes total premium as the losses that will be paid, discounted for investment income. The insurer issues the policy and segregates the premium, net of fees, into a dedicated account for the insured. The account accrues interest which belongs to the insured, net of an insurer fee. If at the end of the policy period funds remain in the account, the insured may claim them. If at some point during the policy period losses exhaust the account, the insured either pays additional premium, or the transaction ends.

Companies may use finite risk insurance to cover liabilities that have long durations. While the company may save money by self-insuring for these risks, especially if there are no losses, a finite risk insurance contract provides an element of risk transfer. A company may enter into a finite insurance agreement to cover excess losses over other policies, including its own self-insurance strategy. Companies may use finite risk insurance for product warranties, environmental or pollution risks, and intellectual property risk. By entering into a multi-year agreement, the insured is better able to match the amount of money it sets aside for liability protection to the estimated liabilities that it expects to face.

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