Alternative Risk Financing: Not Just For Fortune 500 Companies

ALTERNATIVE RISK FINANCING: NOT JUST FOR FORTUNE 500 COMPANIES

by Greg Ryan and James Bukowski

Grow revenues and earnings by offering alternative risk financing to selected clients.

Large corporations and government agencies generally use some type of alternative risk financing for their property and liability loss exposures. Medium-sized and smaller companies usually buy Commercial insurance for this purpose. However, alternative risk financing is not just for Fortune 500 companies. Many other firms can enjoy some of its benefits, such as improved cash flow and a lower total cost of risk.

This article offers s a basic overview of risk financing concepts for medium-sized firms (generally, those with fewer than 1,000 employees). After surveying the principal types of risk financing alternatives, we’ll outline the decision-making process and components for implementing such a program.

The article will use these definitions:

Risk financing: The use of insurance and other techniques to pay for loss obligations.

Alternative risk financing: The self-assumption of risk, combined with insurance, to finance a company’s property and liability losses; a formal program for managing and paying for an organization’s losses, usually for a defined period.

COMPANY SIZE

The first question owners and managers of medium-sized firms ask is “How large must my business be to use alternative risk financing?”

Size isn’t very important. The main criterion is losses. As a rule of thumb, alternative risk financing requires approximately $500,000 in annual incurred losses in one line of insurance — for example, Auto, General Liability, or Workers Compensation. Losses in this line should be reasonably predictable, and the firm should be reasonably able to accept risk. Internal management discipline and a willingness to commit the appropriate resources are also required.

The losses should have these characteristics:

• Reasonably predictable
• Not extremely volatile
• Not exposed to a catastrophic loss
• High frequency and low severity

“High frequency and low severity” means that the number of losses should be at least several dozen per year, of which most are less than $50,000. As a case in point, a large hotel would probably experience many small Workers Compensation claims but relatively few, if any, large claims. A bank can also expect to have numerous low severity Comp claims. Alternative risk financing usually involves loss severity — the exposure to large losses — by purchasing excess insurance or reinsurance.

INSURANCE LINES

The other question asked most often is “What lines of insurance are best for alternative risk financing?”

Casualty lines — Workers Compensation, General Liability (including Products), and Auto Liability — are the best candidates for alternative risk financing. Workers Comp and Liability claims tend to be paid over long time frames, one to five years or more. Insurers of these lines generate substantial investment income on their reserves until losses are fully paid. Mid-size companies using alternative risk financing can earn the investment income on reserves that was formerly earned by an insurance company.

ALTERNATIVE RISK FINANCING OPTIONS

Insurers have developed many colorful titles for what amounts to a handful of alternative risk financing techniques. Methods range from guaranteed cost (for risk-averse firms) to self-insurance and captive insurance (for firms seeking the ultimate in control over the risk management and financing process). These techniques include:

• Guaranteed cost
• Retrospective rating
• Large deductible
• Self-insurance
• Captive insurance

This chart summarizes the main features of these alternatives:

Analysis of Key Risk Financing Alternatives

Rating Scale 1-5: 1 = least favorable; 5 = most favorable

Guaranteed cost insurance. Guaranteed cost remains an attractive option, particularly in a highly competitive insurance market. “Guaranteed cost” means that the insured pays a one-time premium based either on a rate (for example, per payroll or property values) or a flat amount. The insurer assumes the loss obligations covered under the policy. In some circumstances, guaranteed cost can be the best of all worlds. A specially tailored program can use an insured’s expected losses to calculate premium. The premium is then discounted to recognize the time value of money. Insurer calculations include a risk charge for large losses and the possibility that losses might exceed projections.

Many buyers like the fact that guaranteed cost programs pose no upside risk (i.e., no additional premium or cost for the risk transferred). The only risk of guaranteed cost insurance is that the insurer might become insolvent or otherwise unable to pay losses covered by the policy. However, for a mid-size company, guaranteed cost insurance might not always be a bargain because underwriters can assess substantial risk charges due to the greater volatility of the loss base. Guaranteed cost programs also have few cash flow benefits for a buyer, other than installment payment plans.

There are a number of variations on guaranteed cost arrangements. Many of these use a loss-sensitive formula to calculate the final premium. Examples include both incurred and paid loss-rated and dividend programs.

Incurred loss retrospective rating plans. Retrospective rating plans (“retros”) have been filed in most states for Workers Compensation and other lines. Usually these are loss-sensitive plans in which the insured pays a standard premium that’s adjusted after policy expiration based on loss experience. In recent years, many of these plans have allowed policyholders to pay a premium based on expected losses and expenses during the coverage period.

Incurred loss retro plans tend to carry heavy expense loads and provide limited cash flow benefits. The adjusted premium is based on incurred losses — paid and reserve amounts. Most plans offer little flexibility. If a portion of premium is deferred, collateral might be required to mitigate the statutory impact of deferral on an insurer’s financials.

Large-deductible plans. As the name suggests, a large-deductible plan means that an organization assumes a substantial per-accident or per-occurrence deductible. This can often range from $50,000 to $250,000. Large-deductible plans are currently popular. They use the insurer’s claims-paying guarantee to ensure that obligations to third parties and employees are met. The policyholder is responsible for paying all losses below the deductible threshold. If the insured is unable to do so, the insurance company is on the hook for the full amount of losses.

Large-deductible plans have largely supplanted the utility and popularity of paid loss retrospective rating plans. One of the reasons is that an insured pays lower premium taxes under a large-deductible plan than under a paid loss retro plan. Workers Compensation is the line most often financed through a large-deductible plan.

Another reason for the popularity of large-deductible plans is that they allow the insured to hold cash until there are actual loss payments — only program expenses need be paid at up front. Because the insurer is ultimately responsible for unpaid losses, collateral is required to eliminate credit risk, and insurers tend to be less flexible in program design and services.

Self-insurance. Self-insurance, often the least expensive risk financing arrangement, involves the retention of loss obligations and payment of these obligations as they become due. Self-insurance is distinguished from non-insurance in that self-insurance makes a formal accrual of liabilities. Workers Compensation, Auto, and General Liability are usually self-insured.

Due to the states’ responsibilities for protecting injured workers, Comp self-insurance is highly regulated. Employers who want to retain Workers Compensation exposures are required to demonstrate the financial ability to pay losses. This qualification process must be maintained, as states continually monitor an employer’s status. State regulators require security deposits of qualified self-insureds to ensure that they can meet all loss obligations. Some states require Stop Loss insurance on self-insured Workers Compensation plans. Automobile Liability is also subject to a fair amount of regulation due to the states’ financial responsibility laws.

Meeting the qualification process, complying with state regulations, and maintaining Workers Compensation collateral requirements (cash deposits or letters of credit) can be demanding from an administrative standpoint. Nonetheless, self-insurance is usually the low-cost option for alternative risk financing arrangements.

Captive Insurance. Captive insurance offers a formalized method to pre-fund risks through an insurance subsidiary (“captive”) that’s usually owned by a parent company or a related party. Most captive insurers are established in a favorable domicile that minimizes regulation of these special-purpose insurers. Most captives are a form of self-insurance.

Captives insure risks in two distinct ways: Direct and fronted. A direct writing captive issues policies and directly covers the risks of policyholders. It might also purchase reinsurance and contract with vendors for underwriting and claims services.

A fronted captive operates as a reinsurer and employs the services of a licensed, recognized fronting insurer. The fronting company performs most administrative functions, such as issuing policies to the captive owner(s), providing required certificates of insurance, and adjusting claims covered under the policy. Captive programs for Workers Compensation always use a fronting insurer because of the requirement to have an admitted insurer.

Captives provide owner-policyholders a high degree of control over the insurance and risk management process. Captive risk financing carries somewhat higher non-loss costs and imposes greater administrative concerns than self-insurance and large-deductible plans.

CHOOSING RISK FINANCING

Here are the steps that a medium-sized company should follow in the financial evaluation of risk management alternatives:

1. Work with a consultant or your broker to identify and analyze suitable alternatives.
2. Project losses and costs, and compare the net present value of each of the risk financing alternatives to the cost of purchasing insurance.
3. Simulate the variability of results. Be certain that you examine worst-case scenarios as well as expected loss situations.
4. Incorporate a retention analysis into your evaluation process. Make it specific to the firm’s exposures, loss experience, and financial imperatives. The retention analysis should establish optimal per accident/occurrence levels of economic exposure to loss.
5. Integrate market-based pricing of insurance or reinsurance into your analysis so that the retention selection takes advantage of market conditions.

PROGRAM COMPONENTS

The use of alternative risk financing — whether a large-deductible program, self-insurance, or captive insurance — requires careful coordination of program components. The required services can be purchased independently from vendors or bundled by an insurer that provides excess or stop-loss insurance.

Risk financing program components include:

• Claims administration
• Loss control
• Policyholder services
• Certificates administration
• Actuarial services
• Excess or stop-loss insurance/reinsurance
• Security or collateral requirements
• Program management and oversight

Administrative demands on an organization increase when the firm purchases unbundled services independent of the insurance arrangement. On the other hand, buying such services often gives greater control and cost savings. Loss control should receive close attention: Self-insurance triggers filings and administrative paperwork. Deductible and self-insured plans will require a focus on cash management.

Security requirements are generally met by providing bonds or letters of credit. In some cases, the proper form of security offsets the impact of a policyholder’s losses or other liabilities on an insurer’s surplus.

Although owners and top management will be delighted with premium savings, they might be unaware that they need to be closely concerned with the process. The company’s controller or human resources manager should involve the consultant or broker in educating management.

CONCLUSION

Medium-sized companies might well find alternative risk financing more cost-effective than conventional insurance. They should base their decision to use such methods on an analysis of costs and losses, including insurance market pricing. Companies willing to commit the necessary resources will probably enjoy improved cash flow and cost savings. The extent of improvement and the degree of control over the risk management process will vary, depending on the firm’s internal management practices and organizational suitability.

Reproduced with permission from riskVue, a free monthly online magazine for risk and insurance professionals.