A call for cautious creativity: navigating the alternative market requires special skills, such as technical underwriting. Insurers must also consider the quality of the alternative-market entity. (Underwriting Insight: Property/Casualty).

If 2001 makes insurance history as the year of the wake-up call, 2002 must surely be the year of renewed industry creativity.

With "aggregation of risk" as the watchwords, the tightening insurance market is increasingly driving small and midsize companies into the alternative market arena. And that is creating new challenges for everyone.

The alternative market originated in the 1980s in reaction to a hardened market and availability problems. In the end, though, the solution created to deal with a transitory situation proved its worth by lasting--and even proliferating--during the prolonged soft market that has just ended.

A 1997 report by Conning & Co. fixed the percent of commercial business in the alternative market--defined as individual risk and group self-insurance--at 34%. In contrast, a recent report by A.M. Best Co. predicts that by next year, alternative markets will protect 50% of the market. Most alternative business traditionally has involved larger companies, but the greatest growth today comes from small and midsize companies. Wise, well-capitalized insurers and reinsurers together with forward-looking agents, brokers and other service providers are poised to take advantage of this new opportunity.

Since small and midsize entities lack the critical mass to retain large, self-insured deductibles, they usually join forces to participate in one of three categories of entities: group-owned captive insurance companies; workers' compensation self-insurance groups; and interlocal risk pools for public entities.

Captives can be owned by brokers, agents, carriers, pre-existing trade or other associations. In most cases, group captives reinsure policies issued by licensed insurers. Workers' comp self-insured groups are similar to group-owned captives, except that they operate under state-specific workers' comp regulations. They are usually formed by a trade association or some other homogeneous group of employers to insure only the workers' comp cover, and they issue their own policies and purchase commercial excess insurance to back them up. Interlocal risk pools are owned by units of local government in a single state and typically operate as tax-exempt, not-for-profit entities under state enabling legislation. They issue their own policies and purchase commercial excess insurance or reinsurance.

The insurers' role in the alternative market requires special skills, such as technical underwriting. They look at the data on a risk's exposures and loss experience, compare it with past experience of similar companies, then make acceptance and pricing decisions. The alternative market brings a new dimension to underwriting. Here, a successful carrier must consider the quality of the alternative-market entity itself.

The underwriter must consider how the entity is organized to manage claims and provide loss control. What is the stability of the policyholder base? How careful is the manager about risk selection? What is the financial condition and stability of the entity itself? Distinguishing the entities that are well run and effective from those that are not is one of the major determinants in the success an insurer will have with this type of market.

It's very important to determine how well the interests of the entity align with those of the carrier. If, for example, an entity is run by people whose compensation is based solely on commission rather than performance, their impetus is to produce volumes of business rather than carefully select it, and loss results are likely to reflect that.

Capitalization is another area that insurers must evaluate. Entities may lack sufficient surplus to support the risk they want to assume. A carrier must recognize the potential reinsurance accounting implications and credit risk posed by alternative-market structures. For example, the carrier ceding premiums and risk to a captive could be dealing with an unauthorized, alien, thinly capitalized reinsurer. In these cases, the carrier typically will require the captive to fully collateralize the ceded premium and assumed risk using a letter of credit from an approved bank or other form of security.

Carriers that fail to coilateralize ceded premiums and liabilities may not be able to take credit for the ceded reinsurance, which results in a hit to their surplus and possibly the inability to access funds from the captive when claims are paid.

All things considered, the alternative market is receiving renewed attention as an opportunity for the industry and its clients to share risks and rewards. We anticipate a surge in growth, primarily from the middle and even small commercial markets. It simply requires vigilance and creativity.

Judith A. Blades, a Best's Review columnist, is senior executive vice president, property/casualty at the Hartford Financial Services Group, Hartford, Conn. She can be reached at [e-mail].