Financial Insurance

FINANCIAL INSURANCE

Financial insurance (also known as Finite Risk insurance) is enjoying a revival in popularity as larger organizations search for ways to reduce their loss-payment timing risk and to control risk-related financial aspects of their business. Financial insurance is similar to chronological stabilization plans, which have been around for 30 years or more.

A primary purpose of these plans is to stabilize an organization's financial position by transferring timing risk to an insurer. Timing risk is the chance that loss payments will come due in a way that adversely affects the organization's finances. Examples could include a single catastrophic loss event or an unusual series of losses that demand quick payout. Usually, the organization's expected losses are obvious but subject to timing fluctuation. An organization that could afford to self-insure these losses under normal payout time lines might not be able to handle a sudden demand for cash caused by timing variations. Transferring the timing risk to an insurer reduces or eliminates the sudden-demand risk.

Risks that this technique addresses include Product Liability (including products recall), Pollution Liability, Errors and Omissions Liability, Workers' Compensation, and high-deductible Property. Various types of entities that could use Financial insurance include medium-size and large self-insured corporations, self-insured public entities or pools, captive insurers, and risk-retention groups. Insurance companies have used variation of this technique for many years (Financial reinsurance).

In the purest form, Financial insurance premiums are calculated by adding the current value of loss payouts to expenses and insurer profits to establish the insurer's aggregate liability. This would be a pure timing risk transfer. In many Financial insurance transactions, however, underwriting risks also are transferred to the insurer. For example, the insurer's aggregate loss limit could be greater than the actuarially forecasted ultimate cost of the claims. If claims development is unexpectedly high, the insurer will pay the difference. Of course, this underwriting risk transfer entails an additional premium.

Financial insurance policies contain an experience account provision, or commutation clause, which allows the insured to cancel the contract and receive a significant return (often 80% to 90% or more) of the unused premium plus interest earnings.

Financial insurance can be prospective or retrospective. In either case, the premium is usually paid in a single lump sum based on the current value of future known or expected losses.

• Although the ultimate cost may be somewhat predictable based on past experience), Prospective Financial insurance involves unknown ultimate losses, so there is almost always an aggregate liability limit in excess of expected loss levels. The aggregate limit could be annual, for a set number of years, or both. The insured intends to fund its own losses over a period of time and to use Financial insurance to avoid severe fluctuations in costs. If future losses rise, additional premiums are paid to the financial reinsurer to the extent that losses exceed funding, with appropriate risk and profit charges.

• Retrospective Financial insurance applies to known losses for which ultimate costs (and timing risk) are subject to fluctuation. By paying a single premium to the financial insurer, the insured removes the risk of adverse claims development, at least up to the aggregate limit, which may be set high enough to cover most of the worst possible disaster (e.g., to the 90% confidence level or higher). Retrospective Financial insurance often is useful when the organization is motivated to buy coverage mostly for financial reasons. Examples could include the desire of a self-insured to obtain a tax deduction for amounts reserved for claims liability, the need to remove financial uncertainty during an acquisition, or a need to stabilize annual earnings.
• Loss Portfolio insurance is a type of Retrospective Financial insurance frequently used by insurers withdrawing from a line of business. The concept also is useful for self-insured organizations that wish to eliminate risk for a book of claims related to an activity no longer pursued. An example would be a manufacturer that has discontinued a product that has been provoking liability claims. This approach is mostly a timing risk transfer in that an insurer accepts the liabilities in exchange for a premium equal to the current value of the organization's loss reserves plus a risk charge for the difference between the total reserve and the agreed-upon aggregate limit. The risk charge need not be large if the purpose of the transfer is primarily to remove the liability from the transferring organization's balance sheet.

Some of the claimed benefits of Financial insurance include:

• Protection of earnings against unexpected fluctuations in loss payments or insurance premium increases not related to the organization's own experience. For nonprofit agencies, this feature protects budget integrity.
• Possible reduced risk-funding costs. The commutation feature allows the insured to participate in underwriting profit that would otherwise go to the insurer.
• Improved debt rating. Removal of a contingent liability from the financial statements may improve the organization's debt rating in the eyes of rating agencies.
• Possible accelerated tax deductions. Loss reserves set up by the corporation are not deductible. Deductions cannot occur until the losses are actually paid. Insurance premiums are deductible when paid. Companies should be aware, however, that deductibility of Financial insurance premiums is considered a gray area by many tax experts. Some tax specialists claim that a pure timing risk transfer might not be considered insurance by the IRS. Any organization considering the use of Financial insurance for tax reasons should consult appropriate tax counsel.
• Possible tax-free accumulation of investment and underwriting income. If located in the appropriate domicile, such as Bermuda, investment and underwriting income credited to an account whose size reflects its loss experience may accumulate tax-free until realized and repatriated by the insured. Consult a tax counsel or on this issue.
• Evidence of insurance coverage where required for vendors, distributors, public agencies, etc. for otherwise uninsurable or prohibitively costly exposures. The Financial insurer can issue evidence of insurance.
• Balance sheet improvement through the elimination of a substantial liability (i.e., release of equity in loss reserves). An organization's balance sheet will be improved if liabilities can be removed at their current values.
• Protection of liability reserves from appropriation. This benefit is of value in public entities where cash-strapped officials may be tempted to use reserve funds for balancing a budget, or in private companies where disgruntled shareholders could demand maximum current earnings per share even at the risk of understating liabilities.

In developing Financial insurance premiums, underwriters usually include the following components:

• Expected losses at net present value
• Timing risk premium for possible early settlement of losses
• Underwriting risk premium for the potential loss between expected and the aggregate limit
• Insurer margin for expense and profit. (This amount may be 10% to 20% of the total premium.)
• Insurer underwriting profit (The insurer shares in profit generated by less-than-expected loss payouts and investment earnings if the commutation clause is exercised by the insured. This insurer percentage may be from 10% to 20% of the experience account balance.)

This article has surveyed some of the many potential uses for financial insurance. Industry leaders predict that this flexible tool will become widely used in the near future. However, tax considerations and ultimate cost of this technique must be carefully scrutinized before an organization decides to use it. Like many sophisticated risk-financing techniques of the past several decades, Financial insurance may become a fad that some organizations rush into without analyzing what it will and won't do.

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