ALTERNATIVE RISK FINANCING: SIZE DOESN’T MATTER
Most medium-sized and smaller companies protect themselves against their property and liability exposures by purchasing Commercial insurance, while large corporations and government agencies prefer to use some type of alternative risk financing for this purpose. However, businesses of any size can employ this tool to enjoy such benefits as improved cash flow and a lower total cost of risk.
Using alternative risk requires internal management discipline and a willingness to commit the appropriate resources. Size isn’t that important. The main criterion is losses. As a rule of thumb, alternative risk financing makes sense if a business has approximately $1,000,000 worth of annual losses in a single line. The claims should have these characteristics: (1) reasonable predictability; (2) moderate volatility; (3) minimal exposure to a catastrophic event; and (4) high frequency and low severity – meaning that a business should have at least several dozen losses a year, most of less than $50,000. For example, a large hotel or bank would probably experience a number of small Workers Compensation claims, but few large claims.
Casualty insurance products (such as Workers Comp, General Liability and Auto Liability) are the best candidates for alternative risk financing. Because Comp and Liability claims tend to be paid over one to five years or more, insurers of these lines generate substantial investment income on their premium reserves until losses are fully paid. By using alternative risk financing, a company can invest its funds elsewhere, rather than paying premiums.
Insurers have developed a number of colorful terms for what amounts to a handful of alternative risk financing techniques. These methods include:
- Excess insurance
- Reinsurance
- Guaranteed cost
- Retrospective rating
- Large deductible
- Self-insurance
- Captive insurance