Alternative Risk Financing Techniques and Basic Actuarial Loss Projections

Jacqueline Friedland, Actuarial Practice LeaderKPMG LLP

Phone: (416) 777-8320, Email: jfriedland@kpmg.ca

CONFERENCE

PRESENTS

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Organization of Presentation

• Introduction of alternative risk financing techniques (also referred to as alternative risk transfer or ART)

• Discussion about self-insurance

• Detailed description of four alternatives

• Loss projection techniques and actuarial analyses

• Key steps

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Introduction of Alternative Risk Financing Techniques

• Commonly used alternative risk financing techniques– Funded deductible program– Self-insurance fund– Captive insurer – Reciprocal insurance exchange

• Major decision: whether or not to self-finance (i.e., self-insure)

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To self-insure or not to self-insure?

• What is self-insurance?

• Considerations in deciding whether or not to self-insure– Availability and pricing– Cost effectiveness– Tailor-made solutions– Enhanced risk management– Control

• Characteristics conducive to self-insurance

• Critical success factors for self-insurance

• Disadvantages of self-insurance

• Importance of reinsurance and/or excess insurance

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Major decision: Is self-financing appropriate?

• Decision is simply a financing or operational decision

• Key decision: Is organization prepared to retain and finance potential losses instead of transferring risk?

• “Through the years, the term “self-insurance” has been used loosely to describe a wide variety of risk financing arrangements through which organizations pay all or a significant portion of the costs of selected classes of their own losses.”1

1 Source: The Art of Self-Insurance by David A. North and Catherine D. Bennett (2002 Sedgwick Claims Management Services, Inc.).

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Examples of Self-Insurance

• Small business purchasing automobile physical damage with a $500 deductible

• Large oil and gas company purchasing property catastrophe coverage with a $1 million deductible

• Associations that pool their risks and pay for members’ losses

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Assume Prefunding – Regardless of Selected ART

• Assume prefunding for expected losses and operating expenses for all four ART techniques

• Prefunding at beginning of each policy year

• Can take form of insurance premiums or contributions depending on nature of techniques

• Many of the drivers for self-insurance relate to assumption of prefunding

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The Drivers for Self-Insurance

• Availability and pricing

• Cost effectiveness

• Tailor-made solutions

• Enhanced risk management

• Control

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Availability and Pricing

• Major motivating factor is dissatisfaction with existing insurance coverage or costs

• Related to insurance market cycle

• Market cycle affects price, cover, limits, etc.

• Restrictions often first noticed in long tail coverages or high-risk exposures and industries

• Primary reason for self-insurance: take control over one’s insurance destiny

• Situations in which commercial market ignores an organization’s favourable loss experience

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Cost Effectiveness

• Reduce long-term costs

• Reduce insurance company expenses

• Retain investment earnings

• Retain underwriting profits

• Greater degree of control in litigation and claims settlement strategies

• Improvement and management of cash flow

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Tailor-Made Solutions

• Often related to lack of availability of required coverages

• Address unique exposures

• Tailor-made solutions include: insurance product, underwriting standards, policy terms and conditions

• Help facilitate change

• Increase underwriting and retention funding flexibility

• Improved loss control efficiency

• Promote greater awareness

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Enhanced Risk Management

• Ability to improve and enhance risk management operations

• Elevation of status of risk manager, and of importance of loss prevention and cost containment programs

• Incentives for more proactive risk control and claims management techniques

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Control

• Often cited as independent benefit

• Increased control over:─ Costs─ Investment income─ Availability of coverage and limits─ Structure of insurance program─ Underwriting standards─ Risk management programs─ Claims and litigation management

• Assists in control of volatility (e.g., avoid premium swings due to market cycle)

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Characteristics Conducive to Self-Insurance

• Require an estimate of expected losses and expenses

• Ideal candidate: high frequency-low severity

• Long-tail lines of insurance also conducive due to retention of investment income

• Comments on general liability (GL)– Long-tail line of insurance– Not typically high frequency-low severity– Litigation is frequent, thus greater uncertainty – Nevertheless, many self-insure GL– Reasons for self-insuring GL: high costs and unavailability of acceptable

coverage, terms and conditions, limits– Excess insurance critical

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Critical Success Factors for Self-Insurance

• Long-term commitment

• Need clearly defined specifics of coverage

• Ancillary risk management services

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Key Considerations and Disadvantages of Self-Insurance

• Increased administrative responsibilities

• Variability in losses

• Pricing of other lines of insurance

• Capitalization requirements

• Excess coverage

• Competitiveness of commercial market

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Funded Deductible

• What is a funded deductible program?

• Choice between pre-determined deductible amounts

• Deductible levels established based on negotiation

• Key determinants of deductible amounts:─ Frequency of losses─ Average value of claims─ Ability to estimate expected losses ─ Cost of risk transfer above deductible

• May have aggregate limit

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Funded Deductible (Continued)

• Risk transfer premium

• Contributions for deductible layer

• Total premiums

• Separate account accruing investment income

• Good first step

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Self-Insurance Fund

• Annual contributions for expected losses and expenses

• Actuaries frequently involved

• Critical requirements for successful operation, well-defined:─ Coverage ─ Policy documents ─ Limits of coverage

• Annual assessments not tax deductible

• No capital and surplus requirements

• Provision for potential of unanticipated large losses in early years

• Excess insurance is important

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Captive Insurance Company

• What is a captive?

• Types of captives─ Single owner/parent captive

─ Group captive─ Industry captive─ Association-owned captive─ Agency captive

─ Segregated portfolio company ─ Protected cell company ─ Incorporated cell company ─ Rent-a-captive─ Sponsored captive

─ British Columbia captives

• Captives and fronting insurance companies

• Regulation and operational considerations

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Reciprocal Insurance Exchange

• An insurance market of reciprocal agreements of indemnity or insurance among persons known as subscribers

• Attorney-in-fact

• Subscribers liable for their share of losses and expenses

• Not-for-profit, tax-free status

• Actuary used for pricing and reserving

• Direct access to reinsurance market

• Operating costs

• Capital and surplus requirements

• Regulatory and financial reporting requirements

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Loss Projection Techniques and Actuarial Analyses

• Types of data required

• Diagnostic analyses

• Multiple projection methods─ Development ─ Expected claims ─ Bornhuetter-Ferguson─ Severity-frequency ─ Stochastic analyses

• Actuarial analyses• Annual contributions• Cash flow projections• Surplus requirements• Financial statement

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Key Steps

• The self-funding continuum

• Long term commitment is critical to success of any self-funded program

• Most important decision – not which ART techniques, but is the move towards self-funding appropriate

• Need to identify stakeholders

• Identify and collect data and information

• Conduct actuarial analyses/feasibility study

• Ascertain the appetite for risk of key parties

• Select and develop program

• Implement

• Monitor

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