Lesson 6 Risk Financing

Lesson 6 Risk Financing Lesson 6 Intro p1 (ELR) An organization s risks have been identified and analyzed. For those risks that cannot be avoided, risk control techniques have been implemented to either prevent reduce the frequency and/or severity of losses. The next step in the risk management process is Step 4 Financing of Risk. It is during this step that the risk manager determines the source (or sources) of funds to pay for expected losses. Lesson 6 Intro p2 (ELR) Lesson 6 Learning Objectives 1. Explain retention in terms of budgeted losses and tolerance corridor. 2. Understand the criteria for comparison among the various transfer options. 3. Understand the characteristics, advantages, and disadvantages of a guaranteed cost plan. 4. Understand the characteristics, advantages, and disadvantages of a small deductible plan. 5. Understand a dividend plan. 6. Understand how Loss Sensitive Transfer Plans differ from Simple Transfer Options. 7. Discuss the characteristics, advantages and disadvantages of a pooling arrangement. 8. Discuss the six types of captives and their advantages and disadvantages. Elements of Risk Management Course Print 8.10.2012 1

Lesson 6 Topic A Risk-Taking Appetite and Ability Lesson 6 Topic A Risk-Taking Appetite and Ability p1 (ELR) Organizations use internal funds and/or external funds to pay for losses. An organization may choose to retain losses, either in whole or part (internal funding) or transfer the financing of losses using insurance (external funding). For those of you with an insurance background, there is a natural tendency to recommend insurance as the primary source of risk financing. For the risk manager, however, insurance is not the first choice. There are other finance methods that may be more effective and/or economical for the organization. The decision as to which finance method is best is based, in part, on how much the organization is able and willing to retain. Lesson 6 Topic A Risk-Taking Appetite and Ability p2 (ELR) Risk Appetite and Ability Continued It is important to remember that insurance is a method to finance a loss, not transfer risk. It is also important to remember that the only losses financed by the insurance policy are those that are within the coverage provided and within the limit of insurance. Losses outside the scope of coverage or in excess of the limit of insurance are no longer financed externally. Lesson 6 Topic A Risk-Taking Appetite and Ability p3 (ELR) Risk Appetite and Ability Continued Both quantitative and qualitative constraints should be considered by the risk manager when determining and recommending a retention level. It is possible that the organization has the financial ability for a large deductible plan; however, management is risk adverse and not willing to jeopardize the financial well-being of the organization. Risk Taking Appetite and Ability Quantitative Constraints Qualitative Constraints Likewise, an organization could be willing to have a large deductible program, yet is not financially able to do so without jeopardizing the financial security of the organization. Elements of Risk Management Course Print 8.10.2012 2

Lesson 6 Topic A Risk-Taking Appetite and Ability p4 (ELR) Quantitative Constraints The risk manager must consider potential Quantitative Constraints that may impact the retention level to determine if funds are available to pay retained losses. The Income Statement, Balance Sheet and Statement of Cash Flows should be analyzed to determine if funds are available and if the organization s financial position would cover the retained losses or allow for a loan, if necessary. Quantitative Constraints Net Income Net Worth Ability to Borrow Cash Flow Lesson 6 Topic A Risk-Taking Appetite and Ability p5 (ELR) Qualitative Constraints Qualitative Constraints may include both internal and external factors. What is the organization's appetite for risk? Is it conservative with a low appetite for risk? If so, even though the Quantitative Analysis clearly indicated funds are available, management may be unwilling to use those funds to pay for retained losses. In this case, the firm has the Risk Taking Ability, but not the Risk Taking Appetite. Qualitative Constraints Internal Factors External Factors History of Risk-Taking Market Maturity Long-Term Organizational Objectives Competition and Need to Take Business Stages in Organization Life Cycle Risk Financial Stability Public Image Management s Willingness to Assume Risk Stockholder or Stakeholder Attitudes Versus Financial Ability to Assume Risk Lesson 6 Topic A Risk-Taking Appetite and Ability p6 (ELR) Retention-Transfer Diagram A Retention Transfer Diagram illustrates a finance method using both retention and transfer. This diagram is useful when explaining to others how retention and transfer work together to finance losses. Elements of Risk Management Course Print 8.10.2012 3

Lesson 6 Topic A Risk-Taking Appetite and Ability p7 (ELR) Learning Objective: Explain retention in terms of "budgeted losses" and "tolerance corridor". Before explaining the diagram itself, let us first define the terms used in the diagram. Retention Budgeted Losses + Tolerance Corridor Budgeted Losses Planned Retention Based Upon Expected Losses Expected losses are determined (projected) during analysis Tolerance Corridor Marginal Retention Amount Beyond Budgeted Retention That May Also Be Actively Retained May be voluntary Example: The firm selects a retention level of $125,000. May be forced Example: The expected losses are $750,000 but the excess carrier requires $1,000,000 aggregate retention. The extra $250,000 is the (forced) tolerance corridor. Lesson 6 Topic A Risk-Taking Appetite and Ability p8 (ELR) Learning Objective: Explain retention in terms of "budgeted losses" and "tolerance corridor". Example ABC Company s planned retention for expected losses in the upcoming year is $750,000 and plans to budget accordingly. However, the excess insurance company requires a $1,000,000 aggregate retention. Therefore, the retention is now $1,000,000: $750,000 Budgeted Losses and $250,000 Tolerance Corridor. ABC Company will retain the first $250,000 of each loss up to a total for all losses (annual aggregate) of $1,000,000. ABC purchased insurance (finance method: transfer) that covers (1) the amount of each loss above its $250,000 per occurrence retention up to a maximum of $1,000,000 and (2) the amount of all losses in Elements of Risk Management Course Print 8.10.2012 4

excess of its $1,000,000 retention up to a maximum (annual aggregate) of $3,000,000. Note: The amount of any one loss in excess of $1,250,000 and/or total losses above $4M are also retained by ABC Company. Please refer to Lesson 6 Topic A Risk-Taking Appetite and Ability p9 to complete the Knowledge Check at this time. Elements of Risk Management Course Print 8.10.2012 5

Lesson 6 Topic B Characteristics of Transfer Options Lesson 6 Topic B Transfer Options and Criteria for Comparison p1 (ELR) Learning Objective: Understand the criteria for comparison among the various transfer options. The risk manager may have several financing options to consider. Each option has characteristics that should be evaluated and compared by the risk managers when they are determining which is the most appropriate for their organization. Lesson 6 Topic B Transfer Options and Criteria for Comparison p2 (ELR) Learning Objective: Understand the criteria for comparison among the various transfer options. Accounting & Tax Impact When are premiums, loss reserves and loss payments deductible to the organization? Program Flexibility Is there flexibility in the insurance contract language? Will the insurance company provide manuscript coverage not included in the policy if needed? Service Options What services, if any, will be provided by the insurance company versus provided by the organization's internal staff? Are services bundled or unbundled? Degree of Retention How much will be retained (internal financing) versus how much will be paid by an entity outside the organization (external financing)? Premium Certainty Are the rates guaranteed based on estimated exposures (subject to an audit) regardless of the amount or size of losses paid during the policy period? Cash Flow Possibilities When is the premium due? Is it due at policy inception or can it be paid throughout the policy period, allowing the organization to use the money elsewhere. If a Loss Sensitive Plan, when is it anticipated loss payments would be made? Degree of Loss Sensitivity Will the cost of the finance plan be impacted by losses, either per occurrence or on an aggregate basis? For example, a finance option containing a large deductible would be more sensitive to losses than one without a deductible. Elements of Risk Management Course Print 8.10.2012 6

Lesson 6 Topic B Transfer Options and Criteria for Comparison p3 (ELR) Transfer Options During the rest of this section, you will be introduced to various transfer options with a focus on a Guaranteed Cost, Small Deductible Plan, Large Deductible Plan, Pooling Arrangements and Captives. The other options included below will be introduced but not discussed in detail as they are outside the scope of this course. Simple Transfer Loss Sensitive Transfer Alternative Financing Options Guaranteed Cost of Fully Insured Large Deductible Plan Pooling Arrangements Plan Small Deductible Plan Retrospectively Rated Plan Captives Dividend Plan Self Insurance Plan Finite Risk Reinsurance Contracts Elements of Risk Management Course Print 8.10.2012 7

Lesson 6 Topic C Simple Transfer Options p1 (ELR) Lesson 6 Topic C - Simple Transfer Options Learning Objective: Understand the characteristics, advantages, and disadvantages of a guaranteed cost plan. Guaranteed Cost (Fully Insured Plan) The first simple transfer option we will look at is Guaranteed Cost. With a Guaranteed Cost plan, the organization (the insured) pays the premium to the insurance carrier who in turn makes claim payments to the claimant. Insured > Insurance Carrier > Claimants Guaranteed Cost Plans are also called Fully Insured Plans. These plans offer 100% external financing of risk, subject to policy terms and conditions. The organization has complete certainty as to premium level and a very stable cost of risk under this type of plan. Tradeoffs include few or no cash flow advantages and no immediate loss sensitivity. Lesson 6 Topic C Simple Transfer Options p2 (ELR) Learning Objective: Understand the characteristics, advantages, and disadvantages of a guaranteed cost plan. What are the characteristics of a Guaranteed Cost Plan? Accounting & Tax Impact Premiums are deductible when paid unless the organization is on an accrual basis. A tax accountant can provide advice related to deductibility. Program Flexibility This option has limited flexibility in both contract language and rating plan options. Service Options Services are bundled; the insurance company provides claims services. Degree of Retention With this option, there is 100% external financing of risk by the insurance company, subject to the policy terms and conditions, up to the policy limits. Losses not covered by the policy and losses in excess of the policy limits become the organization's responsibility (retention). Premium Certainty Rates are fixed or guaranteed and applied to estimated exposures. Modifiers (scheduled, discretionary and experience) are known in advance. The policy may be subject to audit. This component of Cost of Risk is very stable. Cash Flow Possibilities Cash flow is poor or non-existent. The premium is typically due at the Elements of Risk Management Course Print 8.10.2012 8

beginning of the policy period. Degree of Loss Sensitivity - There is no immediate sensitivity as the rates are guaranteed. The policy may be sensitive to loss frequency and severity at renewal as losses may result in an increase in premium or underwriting action Lesson 6 Topic C Simple Transfer Options p3 (ELR) Learning Objective: Understand the characteristics, advantages, and disadvantages of a guaranteed cost plan. Advantages of a Guaranteed Cost Plan 1. Plans provide high budget predictability or certainty (subject to audit of exposures known to insured) 2. Insured enjoys easy, one stop shopping; all services provided by the insurer 3. The agent/broker or the insurer provides the Certificates of Insurance 4. Coverage is standardized and predictable 5. Poor experience may go unpunished at renewal (deferred to later renewals) Bob owns 10 fast food restaurants. There are several workers' compensation losses each year, and losses are projected to continue as Bob does not necessarily promote safety in the workplace. After all, Bob is not worried about the losses since his insurance pays for them. Bob's insurance may not be negatively impacted at renewal because workers compensation claims normally have long development tails and the ultimate incurred cost will not be known for several years when they close. Lesson 6 Topic C Simple Transfer Options p4 (ELR) Learning Objective: Understand the characteristics, advantages, and disadvantages of a guaranteed cost plan. Disadvantages of a Guaranteed Cost Plan 1. Insurer s expenses and profit are passed along. If Bob's Insurer has been running a combined ratio less than 100% for his class of business, it will find that competitive pressures and capacity will keep premium levels depressed even though his particular account has a 100%-plus loss ratio. Alternately, if the Insurer files rate increases across the board for the state Bob's operations are located, he'll get hit with premium increases regardless of loss ratio. 2. Limited cash flow to deferral of premium over maximum of 12 months (generally) Elements of Risk Management Course Print 8.10.2012 9

Most premium payment plans are accelerated to have complete payment by 3rd quarter of the policy period. While there are no penalties or interest on an audit bill for Workers' Compensation, most other carriers offer payment plans that are front-loaded (25% up front and 9 equal payments) in order to capture the minimum earned. 3. Good experience may go unrewarded at renewal (deferred to later renewal) Chet is concerned about the losses at the 10 restaurants he owns and operates. He recently implemented risk control techniques that are projected to reduce his losses by 50 percent. Since bodily Injury-type claims usually have longer tails than property-type claims, the carrier will be hesitant to immediately apply credits until or unless developed losses are extinguished. 4. Services provided by the insurer may be inappropriate, inadequate, or not needed 5. Coverage and rating is often inflexible with few or no options 6. No short-term incentives to reduce losses are provided, so term cost of risk may be affected Lesson 6 Topic C Simple Transfer Options p5 (ELR) Learning Objective: Understand the characteristics, advantages, and disadvantages of a small deductible plan. Small Deductible Plans Small Deductible Plans, for purposes of this course, are normally plans that have a deductible of $100,000 or less. The amount of risk that the organization retains can be very small to rather large, premiums are fixed and the plans can be somewhat sensitive to losses, depending upon the size of the deductible and loss frequency. Elements of Risk Management Course Print 8.10.2012 10

Lesson 6 Topic C Simple Transfer Options p6 (ELR) Learning Objective: Understand the characteristics, advantages, and disadvantages of a small deductible plan. What are the Characteristics of a Small Deductible Plan? Accounting & Tax Impact Premiums are deductible when paid unless the organization is on an accrual basis. A tax accountant can provide advice related to deductibility. Program Flexibility Premiums are deductible when paid. Losses are deductible as paid. A tax accountant can provide related to deductibility. Service Options Services are bundled; the insurance company provides claims services although there may be a claim consultant involved. Degree of Retention With this option, retention can range from very slight to rather substantial if the firm is frequency prone and there is no aggregate deductible. Losses not covered by the policy and losses in excess of the policy limits become the organization's responsibility (retention). Premium Certainty Rates are fixed or guaranteed and applied to estimated exposures. Modifiers (scheduled, discretionary and experience) are known in advance. The policy may be subject to audit. This component of Cost of Risk is very stable. Cash Flow Possibilities Cash flow can be advantageous. Installments may be available and there is a deductible credit resulting in a premium savings. The "lag time" between the loss and the deductible reimbursement can also provide cash flow opportunities. Degree of Loss Sensitivity This option can be quite sensitive to losses depending on claim frequency and the size of the deductible. Lesson 6 Topic C Simple Transfer Options p7 (ELR) Learning Objective: Understand the characteristics, advantages, and disadvantages of a small deductible plan. Advantages of a Small Deductible Plan 1. These types of plans can be structured to produce reasonable budget certainty for the organization 2. Depending upon the insurer, these plans are usually easy to implement, easy to understand, relatively easy to administer. 3. Insurance policy and certificates are standard; deductibles need NOT be shown on certificate. 4. Direct savings and cash flow savings can be substantial, particularly if frequency is low and Elements of Risk Management Course Print 8.10.2012 11

credits are reasonable. A good rule of thumb is 3:1 delta when negotiating credits - i.e., the reduction in premium should be equal to at least the deductible cost for 3 claims. A 1:1 delta, where the premium deductible is equal to 1 claim deductible is tantamount to exchanging dollars with the Insurer, giving the insured no advantage or incentive. We'll see in the upcoming pages the opportunity for savings under a Small Deductible Plan. 5. These plans can provide a real incentive to reduce frequency of losses resulting in a direct savings in premiums and cash flow savings and any reduction in frequency lessens the likelihood of a severe loss. Lesson 6 Topic C Simple Transfer Options p8 (ELR) Learning Objective: Understand the characteristics, advantages, and disadvantages of a small deductible plan. Disadvantages of Small Deductible Plan 1. Since these plans are based on standardized insurance policies that usually are class-rated or manually-rated, there is often little or no Flexibility with respect to coverage and pricing. 2. The rating schedules frequently do not offer credits that are adequate to justify the additional expenses of paying losses within the deductibles. 3. Services may be inadequate or inappropriate for the particular insured. 4. While these plans create more interest in claims handling, the insured has little or no control over the claims payments since the carrier provides the claims services and will reserve according to their own interests. 5. Firm may be required to offer some form of security, often in the form of escrow, which reduces cash flow advantages. 6. Policy accounts may be held open for long periods of time before final cost is known for those claims with long development depends on plan and insurer. A delivery truck struck another vehicle in 2006 resulting in both Workers' Compensation benefits to the injured driver, as well as a bodily Injury claim from the occupant of the other vehicle. Because of the significant injuries, neither claim closed until 2011 because of the long tail development to close. The carrier was reluctant to release any deductible collateral as long as the claims were open, reducing cashflow advantages in several ways. Elements of Risk Management Course Print 8.10.2012 12

Lesson 6 Topic C Simple Transfer Options p9 (ELR) Learning Objective: Understand the characteristics, advantages, and disadvantages of a small deductible plan. Comparing Simple Transfer Options Let's make a few comparisons between a Guaranteed Cost Plan and Small Deductible Plan. Criteria For Comparison Guaranteed Cost Plan Small Deductible Plan Degree of Retention None Low Cash Flow Advantages (Generally) No Some Loss Sensitivity No Some Lesson 6 Topic C Simple Transfer Options p10 (ELR) Learning Objective: Understand the characteristics, advantages, and disadvantages of a small deductible plan. Example We'll say that $270,000 is the premium for a Guaranteed Cost Workers Compensation policy for a firm. What would that look like as a Small Deductible Plan? For purposes of comparison, we have calculated the premium for a Small Deductible Plan (with a $25,000 per claim deductible and expected losses at $110,000) at $240,946. Note: The calculation of the "cost" for our Small Deductible Plan is beyond the scope of this course, however it includes not only the insurance premium, but also the retention created by the deductible. Lesson 6 Topic C Simple Transfer Options p11 (ELR) Learning Objective: Understand the characteristics, advantages, and disadvantages of a small deductible plan. Sensitivity of Plan Costs to Losses The Guaranteed Cost premium is $270,000. The Small Deductible Plan offers an 11 percent savings IF projected losses are actually realized. Elements of Risk Management Course Print 8.10.2012 13

Small Deductible Plans quickly become the more expensive option if loss frequency or severity is higher than projected. Small Deductible Plans offer additional savings if loss frequency or severity is lower than projected. Please refer to Lesson 6 Topic C Simple Transfer Options p12 (ELR) to complete the Knowledge Check at this time. Lesson 6 Topic C Simple Transfer Options p13 (ELR) Learning Objective: Understand a dividend plan. Dividend Plan A Dividend Plan is also a Simple Transfer Option. It is a Guaranteed Cost Program with a Dividend Option. A Sliding Scale Dividend Option pays according to actual incurred losses. The lower the losses, the higher the dividend and the higher the losses, the lower the dividend. Dividends cannot be guaranteed by the insurance company so there are no promises that dividends WILL be paid. The possibility of a dividend, however, creates an incentive to reduce losses. We will not cover the dividend calculation in this course. Insured <> Insurance Carrier > Claimant The insured pays premium to the insurance carrier but may receive a dividend based on actual incurred losses. Elements of Risk Management Course Print 8.10.2012 14

Lesson 6 Topic D Loss Sensitive Transfer Lesson 6 Topic D Loss Sensitive Transfer Options p1 (ELR) Learning Objective: Understand how Loss Sensitive Transfer Plans differ from Simple Transfer Options. Recall the definition of Loss sensitivity Simple Transfer Options are not loss sensitive to any large degree. Now let s look at a finance option that is truly loss sensitive the Large Deductible Plan. For purposes of this course a large deductible is $100,000 and higher. Two additional Loss Sensitive Transfer options are Retrospectively Rated Plans and Self-Insurance Plans. We will describe these plans, but we will not study them in detail for purposes of this course. Lesson 6 Topic D Loss Sensitive Transfer Options p2 (ELR) Learning Objective: Understand how Loss Sensitive Transfer Plans differ from Simple Transfer Options. Characteristics of a Large Deductible Plan Accounting & Tax Impact Complex accounting and tax impact with regard to premiums, loss reserves and loss payments. A tax accountant can provide advice related to deductibility. Program Flexibility Program flexibility is high Service Options Services may be unbundled; services options are widely available such as loss control, claims service and actuarial assistance in loss projections. Degree of Retention With this option, retention can approach $100,000 and higher and range from very slight to rather substantial if the firm is frequency prone and there is no aggregate deductible. Losses not covered by the policy and losses in excess of the policy limits become the organization's responsibility (retention). Premium Certainty Premium certainty is high with fixed rates, subject to audit. The Cost of Risk varies based on actual retained losses. Cash Flow Possibilities Cash flow possibilities can be high to settle claims - "lag time". depending upon the length of time Degree of Loss Sensitivity This option is quite sensitive to losses depending on claim frequency and the size of the deductible. Elements of Risk Management Course Print 8.10.2012 15

Lesson 6 Topic D Loss Sensitive Transfer Options p3 (ELR) Learning Objective: Understand how Loss Sensitive Transfer Plans differ from Simple Transfer Options. The Attachment Point The attachment point is the level at which the insurance policy covers a loss. Loss projections, loss stratification and loss sensitivity calculations help the insurer to establish the attachment point. Lesson 6 Topic D Loss Sensitive Transfer Options p4 (ELR) Advantages of a Large Deductible Plan 1. Positive cash flow potential. 2. Return on loss control program investments can be realized. Carl's organization spent $10,000 on a driver safety training program for its 50 company drivers. As a result, the frequency of the vehicle losses decreased by 40% over the previous year resulting in a savings of 20% on the vehicle liability insurance premium of $250,000 or $50,000 savings. 3. Coverages may be customized. 4. Services may be customized. 5. Claims services with a large deductible can be unbundled or purchased outside the carrier. Therefore, claims can be better managed and controlled by the insured. 6. Policies and certificates are available from the insurance carrier. 7. Expense components can be negotiated with the insurance carriers. The first year Bob purchased his $150,000 large deductible program, the carrier charged him 16% for the Loss Conversion Factors (LCF), which represents the direct costs incurred to close a claim (adjuster's Elements of Risk Management Course Print 8.10.2012 16

time, legal counsel's time on that claim, etc.) However, if Bob renewed the program, the LCF could be negotiated to reduce every year for 4 years eventually bottoming out at 12%. 8. First step toward self-insurance or captive program Bob is reluctant to totally self-insure his fleet risk because of uncertainty in severity claim cash flow, but is willing to set aside funds sufficient to fund variable and fixed costs up to the $250,000 level. This gives him the experience in adjusting claims, controlling development and reserving practices and applying effective loss control measures. Then, after gaining a sufficient comfort level with loss projections and correlations to exposures, he might be prepared to consider the necessary capital investment for a captive, or rent-a-captive program. The advantages and disadvantages take into consideration the risk of losses subject to the deductible and the financial incentive for the organization to reduce losses. Lesson 6 Topic D Loss Sensitive Transfer Options p5 (ELR) Disadvantages of a Large Deductible Plan 1. Poor loss experience can cancel advantages 2. Accurate attachment point determination is a must. After several years of controlling claims below the $250,000 threshold, Bob had 3 successive claims over a span of 2 months that each exceeded the $250,000 stop loss. Even though he previously had concurrent claims, none of them had hit the reinsurance attachment point and these three claims caused severe cash flow issues. At renewal, Bob talked with his Agent about alternatives available to protect his balance sheet, including an aggregate contract but because of the recent prior claims history, the premiums for aggregate protection were more than he could afford. 3. Insurer may require expensive security or collateral with which the organization may not be willing or able to comply. 4. Aggregate protection may be cost prohibitive or may not be available. The advantages and disadvantages take into consideration the risk of losses subject to the deductible and the financial incentive for the organization to reduce losses. Elements of Risk Management Course Print 8.10.2012 17

Lesson 6 Topic D Loss Sensitive Transfer Options p6 (ELR) Transfer Options and Criteria for Comparison Type of Plan Degree of Retention Cash Flow Advantages Loss Sensitive 1. Guaranteed Cost, full Insurance None Generally No No 2. Dividends None No Yes 3. Small Deductibles Low Some Some 4. Large Deductibles Moderate to High Yes Yes 5. Incurred Loss Retrospectively Rated Plan Varies Some Possible Yes 6. Paid Loss Retrospectively Rated Plan Varies Yes Yes 7. Self-funding (SIR) High Yes Yes 8. Rent-a-Captive and Single- Parent Captives Varies Varies Yes 9. Group Plan Varies Varies Varies Other Factors Characteristics of plans Fixed vs. variable costs Service (claims and loss control) sources and quality Plans flexibility (customization possible) Accounting and tax impact Lesson 6 Topic D Loss Sensitive Transfer Options p7 (ELR) Learning Objective: Understand how Loss Sensitive Transfer Plans differ from Simple Transfer Options. Loss Sensitive Transfer and Collateral You may recall one of the potential disadvantages of the Large Deductible Plan was that the insurer may require collateral. Sources of Collateral Cash or Cash Equivalent Certificate of Deposit (CDs) Bank Trust Agreements Letter of Credit Collateral is property, usually in the form of Accounts Receivable Surety Bond funds or personal property, pledged to secure a debt or loan. Collateral is required to assure that any funds advanced on behalf of the insured are repaid to the carrier. In other words, if the insurance company pays the portion of the loss that is subject to the deductible, the insured has to reimburse the Elements of Risk Management Course Print 8.10.2012 18

insurance company. Collateral guarantees the funds will be available. The higher the level of projected ultimate losses subject to a deductible, the higher the level of required collateral. Elements of Risk Management Course Print 8.10.2012 19

Lesson 6 Topic E Alternative Financing Options Lesson 6 Topic E Alternative Financing Options p1 (ELR) An Alternative Financing Option, such as a pool or captive, may be a better finance option for an organization than a Simple Transfer or Loss Sensitive Option. The popularity of the alternative market is clear by the growth it has experienced over the years. This growth can be attributed to: Hard markets (decreased availability and/or affordability of traditional insurance coverage) Favorable tax rulings Income statement and Earnings Per Share (EPS) pressure Economy Increased perception of risk Lesson 6 Topic E Alternative Financing Options p2 (ELR) Alternative Financing Options continued The alternative market is a continuum of both externally financed and internally financed risk. The options may include a layer of conventional insurance, a retained layer and a buffer layer of financing in between. These next few pages will provide an overview of a pooling arrangement and captives. Buffer Layer Buffer layer financing is a flexible mix of external and internal financing. Alternatives may include retroactive deductibles, sliding deductibles, some finite risk contracts, excess swing plans, corridor deductibles. Elements of Risk Management Course Print 8.10.2012 20

Lesson 6 Topic E Alternative Financing Options p3 (ELR) Learning Objective: Discuss the characteristics, advantages, and disadvantages of a pooling arrangement. Pooling Arrangements Characteristics Pooling is a risk financing arrangement designed to jointly manage the loss exposures of two or more organizations that are unable to legally or feasibly self-insure these exposures. Many states have special legislation allowing pools to organize to provide workers compensation insurance. Pools are state-specific; multi-state pools do not exist. Accounting & Tax Impact Customization is possible Program Flexibility Underwriting, loss control and claims may be controlled by the pool. Service Options Underwriting, loss control and claims may be controlled by the pool. Degree of Retention Generally the same as Guaranteed Cost. Premium Certainty Generally the same as Guaranteed Cost. Cash Flow Possibilities Generally the same as Guaranteed Cost except pool participants financially benefit from the cash flow an insurance company experiences. Degree of Loss Sensitivity Generally the same as Guaranteed Cost. Lesson 6 Topic E Alternative Financing Options p4 (ELR) Advantages of Pools 1. Cost Stability Pool premiums are usually based upon expected member losses and administrative costs and are less impacted by market fluctuations 2. Cost reduction Pool administrative expenses are generally lower than those of commercial insurance companies. There is no profit component and contingencies for unexpected losses can be less. 3. Pools tend to foster an increased focus on loss control and claims management. 4. Rating Plans can be flexible enough to reflect the group s combined loss experience. 5. Coverage forms can be designed to meet member s needs. 6. Pools can increase the SIR, reduce or remove aggregate coverage and convert to an insurance company as group experience matures. Elements of Risk Management Course Print 8.10.2012 21

Lesson 6 Topic E Alternative Financing Options p5 (ELR) Disadvantages of Pools 1. Risk sharing within a smaller universe The smaller size of most pools makes them more susceptible to large swings in loss costs (this can be offset by limiting the pool's retention by purchasing reinsurance). Failure to maintain adequate records - Pool size and the desire to minimize administrative costs may result in less complete underwriting and financial data. Increased underwriting risk because of "political pressure" from influential pool members. 2. Financial problems of individual members are shared 3. Members may lack expertize in insurance company management 4. Failure to uniformly enforce required risk management practices amongst all members. 5. Joint and Severable Liability If the Pool becomes insolvent all of the members will become liable for all of the liabilities of the pool, not just the liabilities that relate to the individual member's losses. Lesson 6 Topic E Alternative Financing Options p6 (ELR) Learning Objective: Discuss the six types of captives and their advantages and disadvantages. Captives A captive insurance company is a closely held insurance company whose insurance business is supplied by and controlled by its owners, and in which the insureds are the beneficiaries (adapted from Captive Insurance Company Reports ). As such, it is a separate legal entity from its organizers subject to insurance regulation by the appropriate legislative body. There are six types of captives: Single parent captive Primarily insures the risks of its owner, typically one large organization. Group captive Owned by multiple, unrelated organizations (policyholders); owners may be either homogeneous or heterogeneous. Association captive Very similar in purpose and structure to a group captive; formed to insure the risks of organizations involved in the same or similar industries and belong to the association who sponsors the captive. Agency captive Owned by insurance agencies formed for the purpose of insuring the risks of the agency's clients or to participate with an insurance company to provide coverage for a difficult risk. Elements of Risk Management Course Print 8.10.2012 22

Rent-a-captive Licensed offshore insurer owned by an outside organization, (e.g., a broker, reinsurer, insurance company, or other business enterprise). These facilities are available to other organizations for a fee. The renting takes the form of the purchase of preferred shares in the rent-a-captive or participation in a profit-sharing arrangement. Risk retention group A special kind of pool limited to liability coverages for owner/insureds formed under the Risk Retention Act of 1986. Technically, these groups are not captives. Lesson 6 Topic E Alternative Financing Options p7 (ELR) Commentary The history of the captive insurance company concept does not date from 1981 or 1986 (the years in which important Risk Retention Acts were passed), but as early as 1782 with the formation of mutual insurance companies, insurance entities owned by their insureds to provide insurance coverage the existing insurance market would not provide. In 1835, Zachariah Allen formed Manufacturers Mutual Fire Insurance Company to provide fire insurance for his and his competitors mills. Eventually this became Factory Mutual and ultimately FM Global. Ocean marine insurers had long formed clubs, the British version of a mutual insurance company, to write protection and indemnity coverage for the marine industry. Other notable captive insurers formed in the first half of the 20th century included Church Mutual Insurance Company (formed by the Episcopal Church in 1929) and Mahoning Insurance Company (formed by Youngstown Sheet & Tube Company in 1935). In spite of these early efforts, captive insurers did not become prevalent until the 1950s, when tax regulations began to provide tax advantages to alternatives to the traditional insurance market. These tax advantages eventually disappeared, but by then, the risk management reasons for captive formation were well established. A more recent example of a captive evolving into a global multiline insurer is ACE, a company started in 1985 to provide directors and officers liability and high excess liability capacity when the traditional insurance market that would not provide coverage, limits, and affordable premiums. The captive insurance marketplace continues to grow and evolve. Elements of Risk Management Course Print 8.10.2012 23

Lesson 6 Topic E Alternative Financing Options p8 (ELR) Learning Objective: Discuss the six types of captives and their advantages and disadvantages. Characteristics of Captives Captives, regardless of the type, have the following characteristics: Control over claims and reserving practices Control over investments made by the captive Potential tax advantages extremely limited to the owner(s)/policyholder(s); however, the captive itself has the advantageous tax rules applicable to all insurance carriers related to the treatment of investment income and recognition of revenues and expenses Recapture of investment income and underwriting profit that would otherwise accrue to the insurance carrier Lesson 6 Topic E Alternative Financing Options p9 (ELR) Learning Objective: Discuss the six types of captives and their advantages and disadvantages. Reasons to Form a Captive Why would an organization choose a captive over traditional insurance? There are five critical factors that have impacted the popularity of captives. Availability problems Certain types of coverage, especially for exposures that insurers perceive as being high-risk, may be difficult to secure and even if coverage is available, breadth or limits offered may be insufficient given the severity of the loss exposure potential. Pricing inequity Insureds may be dissatisfied with pricing of insurance products, e.g., excessive given the risk involved, drastic fluctuation on a year-to-year basis making the planning and budgeting process challenging or exorbitant because insurers pass on what insureds believe to be their excessive overhead structures in the form of high expense loadings. Need for improved existing products - Since most insurance policies are created for mass customization, many organizations find insurers unwilling or unable to satisfy their specialized needs for services and coverage. For example, some organizations may be willing to accept greater retentions, but insurers are unwilling to grant sufficient premium savings. The demand for more sophisticated loss control measures, the change in an emphasis on loss control that focuses on protecting the insured, not the insurance carrier, and greater influence in claims settlements, are not being met by the traditional commercial insurance marketplace. Elements of Risk Management Course Print 8.10.2012 24

Lack of flexibility Coverage breadth or limits offered may be insufficient for the organization's needs; rating plans are excessively regulated or created by a mass marketplace; and innovation is stifled when certain types of insurance coverage is mandated by regulators, lenders, and customers. Lack of value with conventional insurance transactions Insurance is the most expensive form of risk financing when losses are predictable. Services and pricing are based on mass customization without regard to the organization's needs. Expense losses and profit loadings are excessive. Lesson 6 Topic E Alternative Financing Options p10 (ELR) Learning Objective: Discuss the six types of captives and their advantages and disadvantages. Advantages of Captives As with other finance options, there are both advantages and disadvantages to using a Captive to finance losses to an organization. Each must be evaluated individually to determine its impact. 1. Reduction in the long-term cost of risk The reduction in the long-term cost of risk is the most important result of successful captive ownership. Captives provide a financial focus for the identification and management of risk. 2. Reduced operating costs Cost of normal overhead operations can often be potentially reduced by 30% to 40% of a traditional insurance premium. Normal insurer overhead generally includes agent's commissions, insurer services (underwriting, claims, loss control), general overhead (rent, management expense, other usual business expenses), insurer profit, profit contingency loading, and stockholder (or policyholder) dividends. A captive can expect to lower these costs to 10% to 25% of premium. 3. Investment income and operating profit Owners can earn investment income on loss reserves instead of that income accruing to the insurance carrier. Traditional loss-sensitive programs, such as incurred loss retros, provide for potential return premiums, but the formula does not include recognition of investment income. Underwriter profit is generated when the loss reserves exceed the ultimate value of losses at the end of the payout period. 4. Broader coverage Most captives, especially those domiciled off-shore, are subject to fewer limitations in coverage format. True customization of policies is possible, and mass customization is minimized. 5. Equitable rating Rating equity in a captive insurance carrier manifests itself in two forms: Elements of Risk Management Course Print 8.10.2012 25

A captive can develop rates that accurately reflect the expected losses of its insured(s) Traditional insurance arrangements often do not provide adequate credit when an organization assumes a high level of retained potential loss 6. Coverage stability and availability A captive mitigates the extent to which the underwriting cycle can cause radical short-term swings in premium levels and coverage breadth. Captives increase the likelihood that both the availability of coverage as well as premium stability of that coverage will track more closely with the risks inherent in its own exposures rather than those built into the broad insurance marketplace over which the organization has no control. 7. Direct reinsurer access Reinsurers' customers are primary insurance companies allowing them to eliminate or reduce the cost of commissions paid to reinsurance intermediaries, to obtain pricing that is driven by the captive's own exposures and loss record rather than those of the broad marketplace, and to access reinsurance pools that have been established by captive owners. Traditionally, insureds could only approach the reinsurance markets if they owned an insurance company, but this has changed in recent years. 8. Improved services Administering, underwriting, loss control, and claim adjusting services is oriented to its owner's special needs resulting with greater accuracy in rating, improved loss control, and more input into and control over sensitive loss settlements. 9. Fewer regulatory restrictions A number of states do not allow or place onerous restrictions on self-insurance of workers compensation and automobile liability exposures. Additionally, for certain lines of coverage, some states have restrictions in the areas of policy forms, rates, and evidence of financial security. A captive helps overcome many such constraints. 10. Enhanced risk management perspective A number of intangible and meaningful benefits accrue from establishing a captive, such as: Increased visibility and enhanced appreciation of the risk management function within the organization Ability of the firm to select an optimal retention level rather than one imposed on the insured by the marketplace or insurer Facilitation of more equitable cost allocation between divisions of a company and creation of a potential profit center Elements of Risk Management Course Print 8.10.2012 26

Investment income generated by a captive should be attributed to the risk management department rather than being absorbed in the general funds of the owner Lesson 6 Topic E Alternative Financing Options p11 (ELR) Learning Objective: Discuss the six types of captives and their advantages and disadvantages. Disadvantages of Captives As with other finance options, there are both advantages and disadvantages to using a Captive to finance losses to an organization. Each must be evaluated individually to determine its impact. 1. Internal Administrative costs More time of administrative/risk management personnel and senior management is required than having an insured program. 2. Long-term capitalization and commitment Generally requires a substantial initial outlay of capital. Depending on the specifics of the organization, this could range from one-third to one-half of the insured's annual premium for the line of coverage the captive is insuring. In dollar terms, the capital commitment might range from several hundred thousand dollars to several million just for initial capitalization. The organization must commit these funds for at least three to five years. However, the capital contribution is not an expense, but rather an investment. It appears on the balance sheet, not the income statement. In addition, group captive owners may have increased liability for the losses of other members of their group. 3. Dependence upon service providers Captive owners, not the insurance company, hire providers and must ultimately control and approve recommendations, actions, and decisions of adjusters, tax attorneys, safety/loss control personnel, reinsurers, actuaries, accountants, and regulatory authorities, among others. 4. Inadequate loss reserves and potential losses Unlike a traditional insurance arrangement, owners must be prepared for the fact that the captive may suffer losses greater than originally expected. This situation could trigger the need for an additional infusion of capital and/or a sharply increased renewal premium rate. Similarly, owners should be prepared for the possibility of having to increase inadequate reserves Elements of Risk Management Course Print 8.10.2012 27

increasing the importance of timely actuarial reviews. Most captive domiciles require annual loss reserve certification by an actuary. 5. Complex taxation issues There are two sources of tax liability for a captive and their owners: 1) income tax on underwriting and investment income; and 2) Federal Excise Tax (FET) on direct premiums, assumed reinsurance of offshore captives and state-imposed direct procurement taxes. 6. Increased cost or reduced availability of other insurance Use of a captive for a certain line of coverage may cause the premium for other lines (that remain commercially insured) to increase in price when the underwriter uses account basis pricing. By removing one line, usually a predictable, profitable line, an insurer may increase the price of other lines to offset the loss of premium, or may not choose to renew. Lesson 6 Topic E Alternative Financing Options p12 (ELR) Learning Objective: Describe the use of fronting programs by captives. Fronting A Fronting Program may be required of a captive for two reasons: For workers compensation and automobile liability, states require insurers to be licensed and admitted to do business in that state. Since captives and other forms of alternative risk funding structures may not satisfy state capital and surplus requirements, a licensed, admitted fronting carrier must be used. In addition, some types of businesses such as contractors are required to provide evidence of insurance from admitted insurers that hold acceptable claims-paying and financial strength ratings. Most captives do not apply to these rating agencies because of the expense of obtaining the rating. Fronting: Use of an insurer or reinsurer to issue "paper" (i.e., and insurance policy) on behalf of a self- Elements of Risk Management Course Print 8.10.2012 28

insured organization or captive insurer without the issuer's intention of bearing any of the risk. Fronting is typically used for compliance with regulations or conditions in a contract that require an admitted insurance carrier or a minimum financial rating. Lesson 6 Topic E Alternative Financing Options p13 (ELR) Learning Objective: Describe the use of fronting programs by captives. Fronting Program Characteristics 1. Captive owner (insured) pays the premium to the fronting carrier (the primary carrier). In some instances, the captive is a pool or other alternative risk funding structure. 2. Fronting carrier cedes that portion of the premium designated to pay losses, predetermined based upon share of risk, to the captive, who is acting as the reinsurance company. Generally, 100% of the losses are ceded, but sometimes the fronting carrier retains a share of the risk and premium. 3. Fronting carrier issues a policy to the insured and pays insured losses to claimants. Through the reinsurance treaty with the captive, the fronting carrier recovers these claims payments. 4. Fronting carrier may also provide services and use of its license. 5. Fronting fee is charged by the fronting carrier for use of its services, license, balance sheet, and any service assistance. 6. Fronting carrier generally requires security in the form of an irrevocable letter of credit or similar mechanism. 7. In theory, the fronting carrier assumes no risk. However, there is always some degree of financial risk that the captive will become bankrupt or the letter of credit will not be sufficient. The greater the degree of risk perceived by the fronting carrier, the higher the fronting fee. Please refer to the end of Lesson 6 Topic E to complete Self Quiz 6 at this time. Lesson 6 Review p1 (ELR) Summary Risk can be financed using internal and/or external sources. There are several external options from which to choose. The risk manager should be familiar with the characteristics, advantages and Elements of Risk Management Course Print 8.10.2012 29