Printer Friendly

Using financial insurance for predictable losses.

Despite the confusion surrounding financial insurance, risk financing technique, which is best applied when the traditional insurance market fails in its primary economic mission: to economically stabilize risk. Unfortunately, many companies that stand to benefit from financial insurance avoid it because they are unaware of its applications.

Generally, financial insurance is used to define an insurance contract where a single premium is paid, largely derived from the net present value of future known or expected losses. They may be retrospective in nature as in loss portfolio insurance or prospective as with prospective aggregate covers. Typically, these arrangements are used when future losses are relatively predictable. In contrast to traditional insurance in which the expected level of losses is relatively unknown and the investment income is a relatively small part of the premium calculations, financial insurance products allow policyholders to stabilize and control the operating impact of their exposures to such problems as environmental pollution liability, directors' and officers' liability and products liability. In addition, as the following case study illustrates, it helps manage the impact of higher-than-expected losses in more predictable lines of business such as self-insured workers' compensation programs.

In this particular case study corporation XYZ self-insures its workers' compensation exposures and has protection in excess of $250,000 for any one loss. 1988-1990 cumulative net self-insured paid losses are $2 million; there are outstanding and incurred but not reported (IBNR) reserves of $4 million; and a "gap" of an additional $3 million between incurred losses and the cumulative attachment of the various aggregate protections. The corporation's objective is to buy insurance covering the exposure between paid losses and the attachment of the aggregate protections. This coverage is set out in a retrospective loss portfolio insurance contract.

How does the corporation benefit from the contract? In return for paying a single insurance premium, the company removes uncertainty over ultimate loss costs. As the insurer pays losses annually (or semiannually) in arrears, as original, and without any periodic imitation on loss amount (subject to the overall indemnity limit), the company is insulated against problems of asset and liability matching.

The premium paid is a deductible business expense, while self insurers can only take losses to expense once they are paid. The commutation feature incorporated into the contract allows the company to share in any ultimate transaction profits. The contract calls for establishing an "experience account" to which the premium, less the insurer's margin of 10 percent to 15 percent, is committed. The experience account grows through periodic interest rate credits at, perhaps, the Treasury bill rate. Losses are paid from the account; if exhausted, the insurer continues to pay losses up to the contract limit.

The company has the sole option of canceling the contract at the end of any calendar year, subject to the existence of a positive fund balance. After commutation, the insured receives 90 percent of the positive fund balance as a commutation payment.

The contract limit is $7 million, and a premium of $3.75 million is payable in full at the inception of the contract. This premium consists of $2.5 million, which is the estimated net payment value of outstanding IBNR losses, which will take five years to settle; $500,000 premium for risk of early settlement of outstanding/IBNR losses; and $750,000 risk premium for coverage between outstanding/IBNR losses and the overall contract limit ($3 million). The reinsurer's margin is 15 percent, which reflects the reinsurer's internal expense, risk premium and a margin of profit.

Increasing Demand

As turmoil in the insurance industry continues, the demand for financial insurance is expected to increase dramatically. For a manufacturer unable to secure traditional insurance against product liability losses, the choices have been few: self insure, establish a single-parent captive, join a group captive or risk retention group or purchase some form of high-cost retrospective rating or self-insured retention program. While the first three approaches offer no tax deductibility of reserves and over time accumulate loss exposures, which increase the possibility of large catastrophes clustering in one fiscal year, many corporations have had no choice but to take one of these approaches.

Retrospectively rated programs, or self-insured retention programs, are useful alternatives. But for the manufacturer with a difficult product liability risk or the employer with high workers' compensation costs, the choice is not all that attractive. Although financial insurance was developed to solve both these problems, its practical applications are not well understood by clients. As a result, risk managers and chief financial officers do not use what could be a valuable weapon in stabilizing and boosting their bottom line.

Growth in Financial Insurance

Financial insurance is expected to grow dramatically in the 1990s. Given the problems of properly insuring or self-insuring substantial long-term North American casualty risks and heightened concern on the part of CFOs with the large self-insured retentions they have taken over the last 15 years, financial insurance will be in greater demand.

What is the draw to financial insurance? After all, there is no large risk transfer component to the transaction, and most of the premium is based on net present valuing the expected stream of losses. Why would a company buy financial insurance primarily to fund a future stream of payments? Normally, a company would like to defer those expenses as long as possible, particularly if the investment return on those funds used internally is higher than the return granted by the financial insurer.

Many experts see the 1990s as a period of difficult growth for U.S. corporations. Given today's economic climate, corporations must project their bottom line as much as possible, reducing the possibilities that results would be adversely affected by an unusual combination of self-insured losses. This is the primary reason why CFOs have been paying more attention to the buildup in self-insured exposures over the last several years. Indeed, corporations have carried substantial retentions, whether through self insurance or captives, since the products liability crisis of the 1970s. It is not unusual to find even midsize corporations carrying total retentions of tens of millions of dollars over that time.

Consider that these total retentions over time equal about $50 million. They were accumulated by the corporation accepting a $5 million aggregate retention for each of 10 years. While it is unlikely, it is possible that claims from a number of different years might all cluster in one fiscal year, resulting in total self-insured losses of approximately $30 million. While management may be perfectly willing to accept a $5 million loss in any given year, the prospect of paying out a $30 million loss in any single year will not be applauded by either management or stockholders.

Financial insurance is a good way for the corporation to protect itself against the financial impact of $30 million coming within one year. Consider also that the corporation cannot take a tax deduction for reserves established to cover these losses, even if the company wanted to accumulate funds to protect against total payouts coming due in any one year. Financial insurance, in many cases, can accelerate a tax deduction.

How It Works

Financial insurance almost always includes an a re ate limit of liability, an assumption of underwriting risk by the insurer and an "experience account" provision, which allows the policyholder to share in any ultimate profit of the transaction. These policies feature an aggregate limit of liability so that the insurer caps his or her risk at an absolute amount. Financial insurance almost always includes a transfer of underwriting risk. This means that the insurer bears a risk of technical loss in addition to those resulting from adverse timing of loss payments.

Many financial insurance and reinsurance transactions are underwritten where the insurance exposure is restricted to timing, thus the insurance premium was a calculation of the present value of expected loss payouts, plus expenses and a profit allowance. The Internal Revenue Service may argue that this is not insurance, since there is no transfer of risk other than the timing of the losses. Including an underwriting risk in which the insurer made a profit or loss according to levels of loss activity, rather than just the timing of the loss, is in part an attempt to counter the IRS' position.

Profit commissions to the policyholder are often included so that a policyholder is rewarded for profitable business. If the insurer makes a profit on the insurance policy, some portion of it can be returned to the policyholder as a profit commission. This also encourages a partnership relationship between the insured and the insurer.

While financial insurers and reinsurers are domiciled in many different countries, most participants are found in the United States or Bermuda. The latter domicile offers substantial advantages to financial insurers and reinsurers, including regulatory flexibility and a tax-free environment. Local statutory regulations allow discounting of loss reserves, which is not permissible in the United States. It also allows the tax-free accumulation of investment and underwriting income, which allows the financial insurer to price the product more competitively than those domiciled in a taxable jurisdiction. Portfolio and Aggregate Insurance

There are two principal types of financial insurance programs: loss portfolio insurance and prospective aggregate insurance. Loss portfolio insurance is a form of aggregate excess of loss coverage, which provides a predetermined and limited amount of coverage applicable to the incurred, but unpaid liabilities of a specified portfolio of business. It is used when the insured has retained or self-insured certain types of losses and wishes to retroactively cover those losses which have been incurred, but have gone unpaid.

Typically, the insurer will assume liability for all losses paid subsequent to the inception date, but loss portfolio insurance can also be written as an excess layer above an aggregate retention. The risk transferred in most loss portfolio insurance includes the timing of loss payments in which the insurer settles losses without restriction as to time or the amount up to the aggregate limit of liability on the policy, as well as a layer of traditionally priced excess of loss protection above expected loss levels. The insurer prices the contract based on its actuarial estimate of future loss payment distributions, plus a risk premium for the band of excess protection. If losses are settled faster than anticipated, the insurer will suffer a technical loss.

A variation on this theme is so-called funded loss portfolio insurance, whereby the insured is provided with an aggregate limit of liability subject to a series of annual maximum recoveries. This schedule of cumulative loss payments is contractually predetermined and is based on the anticipated liability stream of the portfolio to be insured.

This coverage is less expensive than a timing risk transaction because the insured does not assume an underwriting risk. It is typically utilized when the underlying portfolio of losses is so volatile that credible predictions of future loss settlement patterns cannot be made. This type of transaction is also appropriate when evidence of insurance coverage is required in difficult classes of business or when tax deductibility is not an important issue.

Prospective aggregate financial insurance relies on the same discounting principles as loss portfolio financial insurance. The major difference is that coverage is provided for future exposures where losses have not yet been incurred by the insured. Policy liability limits are established above the expected ultimate loss range and both the insured and the insurer expect that a large part of the limit of liability will be paid out. The insurer makes an actuarial prediction of the payout characteristics of the future losses, extrapolating from the historical loss data of the insured. By its nature, it is more difficult to perform this evaluation for prospective aggregate insurance than it is for loss portfolio insurance since the insurer has no hard loss data from which to work and there is no guarantee that the loss development characteristics of the past will be consistent with future experience.

Insureds can utilize this type of financial insurance when it is difficult or impossible to purchase traditional liability insurance or when the company has the ability to retain loss but wants to protect against timing variations in loss payments. Note that because both parties expect a significant part of the limit of liability to be utilized, the policy acknowledges that the insured intends to fund its own losses over a period of time and is using this mechanism to avoid severe fluctuations in costs that arise because it is unknown when the claims will actually occur.

As with loss portfolio covers, insurance companies provide a limit of liability in excess of expected loss levels by including a layer of traditionally priced aggregate insurance coverage. This increases the risk potential to the insurance companies and makes the proposal more attractive to the insured as a more substantial risk transfer has taken place, Richard S. Betterley is president of Betterley Risk Consultants inc. in Worcester, MA. Graham C. Pewter is president Of LCF Edmond de Rothschild Insurance Services Ltd. of Bermuda.
COPYRIGHT 1991 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Author:Betterley, Richard S.; Pewter, Graham C.
Publication:Risk Management
Date:Sep 1, 1991
Previous Article:The Campus Security Act: a recipe for litigation.
Next Article:Dynamic forces driving group captive formation.

Related Articles
The alternative market: shopping on a two-way street.
Risks in developing nations pose an uphill battle.
New trends in financial reinsurance.
A Practical Guide to Finite Risk Insurance and Reinsurance, 1994.
Factors to consider when forming a captive.
Taming balance sheet volatility.

Terms of use | Copyright © 2016 Farlex, Inc. | Feedback | For webmasters