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Alternative risk transfer roundtable. (Special Advertising Section).


Richard Inserra

Assistant Treasurer and Director Risk Management

Praxair, Inc.

Sheila Small

Assistant Treasurer, Risk Management and Insurance

Verizon Communications

Paul Wagner, Jr.

Director, Risk Management

AGL Resources

Lorna Beebe

Senior Vice President

Zurich Corporate Solutions

Valerie Butt

Senior Vice President

Zurich Corporate Solutions

RM: What is alternative risk transfer?

Small: Anything outside of traditional insurance, traditional being going to the insurance company, where there's a one hundred percent risk transfer or some combination of risk transfer and self-insured retentions.

Wagner: I see ART as developing from the days of basic self-insurance where you took predictable risks and managed that layer of risk within your corporation versus the traditional market. From there, self-insurance has progressed to include the use of captives and other vehicles. The captive gives you the ability to customize your core program to deal direct with many of the markets and put together integrated products that are not readily available through the traditional markets.

Inserra: What used to be considered alternative venues or risk structures have since become mainstream. Captives for instance. Sometimes people consider them alternatives, other times people don't. I remember when the alternative markets were ACE and XL--now they are publicly traded and they're acting like insurance companies. Some people think that the more exotic things are the alternative risk transfer--the integrated programs.

Beebe: There is some confusion around the term "ART." I don't really consider a captive truly ART anymore. ART is anything that is done outside of the traditional models of an insurance program. It can be a captive, it can be integrated insurance, it can be a structured finance program or a catastrophe bond.

Butt: ART blends risk retention and risk transfer at the lowest total cost of risk and results in mutually aligning the financial interests of both the insurer and the insured. That can span a whole spectrum of solutions. In the late eighties, captives changed the risk financing landscape. For this hard market, there are other tools like integrated insurance and structured solutions that will become standard products.

RM: What are some of the myths regarding the alternative market?

Wagner: There is a myth that the alternative market only exists in a hard market. I've had direct experience with two companies where we've entered the alternative market during very soft markets and achieved tremendous cost efficiencies versus the traditional market.

Beebe: Some people believe ART is very narrow in its applicability, such as cat bonds or captives, and reserved for well-capitalized companies. However, it has become much more of an overall strategic enterprise risk management process, blending traditional insurance and reinsurance with some form of self-funding. It will continue to grow in the areas where both insureds and insurers can manage nontraditional types of risk in concert.

Small: Another thing that disputes the myth of only using alternative markets during a hard market is the failures of several of the insurance companies. My company has better financial strength than some of those insurance companies, so why would I want to put in long-tail risk transfer if the companies can't guarantee that they're going to be there to pay your claims down the road?

RM: Can smaller companies use ART?

Butt: If you look at integrated insurance, there is maybe two hundred million dollars in global capacity right now. For a Fortune 500 company that may not make a material difference, but for a Fortune 1000, this amount of capacity can provide a substantial amount of earnings protection.

Smaller companies are also experiencing an exponential increase in insurance rates, but the economy is not letting them pass those off onto their clients or their consumers, whereas a larger company might have that leverage. So in some instances, an integrated program can be even more beneficial for smaller companies.

Wagner: If you look at the traditional market structure versus the ART structure, there are built-in cost efficiencies. The basic ART mechanism would be a captive dealing with a reinsurer. You have the opportunity of reducing some of the frictional costs that are involved, whether you're a large company or a smaller company.

Inserra: In our business, we deal with a number of small distributors. These are companies that are really small by our standards, under seventy-five million dollars, but we see a lot of them banding together into association pools. One even formed a Colorado captive and ran it for ten years because they had trouble getting coverage.

The big guys might be more interested in things like credit derivatives and exotic things like that; small guys wouldn't need that type of thing.

Different approaches to traditional market practices in the insurance industry have been around for years and will continue to be. The current market is driving more of that.

RM: How did you first get involved in ART? What exposures led you to it?

Inserra: Back when I was with Union Carbide, the CFO came to me and said: "I want you to cut 25 percent from your insurance costs." And this was in a soft market. So we put together a blended program that focused on traditional coverages but expanded to some alternatives. It worked very effectively for us for five years until we were acquired. But in doing that, between that program and the earnings from our captive, we had a negative cost of risk for the last three years of my tenure at Union Carbide.

Wagner: In the early nineties, when we already had a good-sized self-insurance program in effect, we decided to venture into the ART market. We looked at the captive for cost efficiencies as step one. By removing ourselves from the traditional market, we saved substantial frictional costs during the first and second years with the captive operation and it provided the stepping stone to advance into an integrated program that saved additional costs and provided additional coverage benefits.

We also looked at a weather product to attach to our captive integrated program. Being a regional retailer, if we had a major snowstorm three or four days prior to Christmas, there was no way we could recover the sales. We put together a program that protected us based on the amount of snowfall that would trigger the coverage. We had also looked at credit disability through our charge cards and a wrap-up construction program.

Small: My experience started very slow in the beginning when I took over the risk management position at Bell Atlantic in 1990. With the legacy of the old Bell system, we carried very high retentions. Most of the people in the corporation would tell you, "What do you mean we have insurance? We're all self-insured, self-administered." That was the mantra of everyone in the Bell system. They had their own claims organization. They were fully self-insured for workers' compensation. They had a two million dollar retention for auto liability, general liability and property. Insurance was really purchased for catastrophe coverage. In the beginning, we went through the traditional markets. Our insurance budget was not that huge because workers' compensation expenses, working liability expenses and auto liability were integrated into the individual departments. It wasn't until more sophisticated products came out there that we ventured into an integrated program. Combining various lines under one umbrella saved a lot of money. I don't know if that was necessarily a revelation on our part to force an integrated program as much as the market was really soft and they were trying to get more of our business under one umbrella program.

Bell Atlantic didn't have a captive. We tried to initiate one but it wasn't in the culture. But when we merged with Nynex, they had a captive. That's when we went crazy with alternative markets. We do very interesting things under ART currently. It started slow and has developed into a huge captive facility.

RM: What support services did you use?

Inserra: We were using a consultant who specializes in that area. They had actuaries help us go to several markets to put the program together. Finding somebody with the expertise is a good thing to do especially if you're getting into a sophisticated program.

Wagner: There's a major increase today in support services that are available for a company that wants to pursue the ART venture versus what was available ten years ago. Today there are many organizations both from a carrier perspective and a broker perspective that would offer financial solutions and services that really did not exist before.

RM: What is the difference in forming an ART program today?

Butt: The difference between the solutions that are being used today versus the ones in the past is that because of accounting scandals like Enron, there is increased scrutiny by shareholders, analysts and other stakeholders. For an ART program to be successful today, there has to be a viable business purpose for any of the risk financing vehicles that you put together. During the past maybe it was just accounting or tax-driven, but that can't be the sole motivation.

Inserra: The biggest hurdle we had from the first program we put together was from the internal cost and accounting standpoint. If you're putting together a program and you're funding a certain amount of risk, that tends to be more expensive then just buying pure insurance. We had to come up with a strategy for managing that, otherwise the cost would have gone up, which was unacceptable. Once we used the captive to fund the difference, it worked out fine.

Wagner: Ten years ago there was a multitude of reinsurers that would support your program. Today that has been cut down significantly. But ten years ago the support services were not as readily available as today.

Beebe: People are taking a more holistic view of risk, whereas programs in the past looked at more traditional lines of cover. Other types of risks--environmental, contingency and credit, to name a few--are what companies want to incorporate into their risk financing program, but premiums for true risk transfer can be prohibitive. Companies usually start with an integrated program and add these hard-to-insure risks to it.

RM: What is an example of an ART program you put together more recently?

Beebe: Clients with interest in ART programs range from Fortune 100 companies to not-for-profits. It's driven by what keeps their management up at night. As an example of a dual trigger program, a not-for-profit relied on its investment portfolio to keep a certain amount of working capital for the operations of a chain of hospitals. They needed protection against two events occurring simultaneously: substantial declines in the equity markets (which happened) and high loss experience in their malpractice and medical lines of insurance. We designed a program that protected them if both losses occurred. They retained a certain amount of their equity losses, but once a threshold of twenty percent was reached, our insurance would provide coverage. We would stop their losses for the enterprise. It was their "sleep insurance."

Butt: The solution that we offered provided true risk transfer for the company. In our discussions with the treasurer, he looked at buying a put on key stock market indices in combination with a traditional insurance aggregate stop. Our program saved them over 30 percent of what they could have achieved separately in the insurance and capital markets.

It's not rocket science. Basically our program allowed the company to cap its exposure in the event of these two types of losses occurring within the same accounting period. For this insured, what they were concerned about was the worst-case scenario. They didn't feel they needed to hedge at the money. They were trying to protect their balance sheet from catastrophic risks.

That's one of the more esoteric-type structures, however, and it may not apply to every company. A more simple structure involved a client whose risk management department consisted of three people, including herself. Being a large manufacturing company with over one billion dollars in sales, she had forty-one different policies that renewed at eight different times during the year. So she was overwhelmed with the administrative burden that was caused by those policies. To solve this issue, she purchased an integrated insurance program that combined all of her lines of coverage into one policy that provided her with an annual per occurrence limit as well as a three-year term limit. We also provided aggregate stop protection.

In implementing this program, she was able to achieve a number of objectives. She achieved a long-term, stable program that she was able to keep on a consistent basis over time. She was able to also have aggregate stop protection that protected her earnings. Most importantly for her, she was able to free up time that she used to spend on a very small portion of her cost of risk, which was the risk premium, and spend that time on other more important things, such as claims control and risk engineering, which she felt was the driver of her cost of risk.

Wagner: We wanted to achieve some cost efficiencies and integrate our basic insurable coverages, so we established a captive and went directly to the reinsurance market. We were able to integrate our insurance risk except for property since we had a sweetheart deal at that point for property. We integrated on a multiyear basis all of our coverages above the retention and working layers. The integration also provided a basket retention aggregate.

Inserra: Most recently we were looking to put something together that would incorporate a wide range of coverages, very much like what Paul described--first level right above our corporate retentions. We were looking at property, boiler and machinery, crime coverage, auto, general liability--we left comp out; we were willing to consider corporate reimbursement on the directors' and officers' side--employer's liability and product recall, all of that into one package to see if we could achieve some synergies. We went quite far down the road, but ultimately management wasn't interested in buying it because they perceived it as a little more expensive than what we were paying at the present time. So we put it on the back burner for the time being.

Small: Traditionally, we had bought intellectual property and errors and omissions coverage, but when we went to do the renewal this year, in addition to being really hit on the financial product side because of the WorldComs, Adelphis and Enrons, limits were very much curtailed. The carriers wanted us to take huge retentions. And they came back with a traditional solution that said: we probably didn't price your last year's program very well, so included in this new program, moving forward, we're going to give you assessments on the prior year's program.

We were coming off a fifteen-month policy renewal for our financial products which had been placed on July 1, 2001. So we really got the impact of 9/11 and all of the scandals going on in the corporate world all at once. This threw me over the top.

I decided to go the alternative route, taking the amount of money that I was going to use for risk transfer premiums and fund the captive for some risk transfer, but at a much lower retention level. The intent was to design a program that handled the working level exposure. For example, the expiring program had a one million dollar retention and the traditional markets wanted to drive that up to ten million dollars. IP and E&O claims tend to have a hefty bill. So not only would the corporation have to pay a lot more for the insurance, but legal would also have to increase their budgets to handle the ongoing legal fees that would no longer be insured.

I opted to take this amount of premiums, keep the retention the way it was and buy small amount of excess insurance. We would carry the predictable legal costs. These type of claims tend to be high-profile, with a high frequency for the telecommunications company. For example, our provisioning of DSL was construed by some not to be the way we advertised it to be, so we faced a class action suit over it.

So I went to management and said: E&O and IP claims are high-profile, the exposure is huge, amounting to millions of dollars. And the claims tend to be long-tail; they get to be in the press, people know about them and they must be disclosed to the analysts and the institutional investor world. And if we have to take a hit on a quarterly earnings report, then so be it, because you really can't buy enough insurance for this. The capacity is not out there. The pricing is outrageous. Interestingly enough, when I approached the treasurer, who is my boss, with this idea, he was very reluctant because he felt risk transfer was one thing, but to take on this exposure and this new philosophy of risk was something that we needed to socialize much higher up in the corporation, which we did. And we got the approval to do it.

When we called the carrier and told them we were not purchasing the insurance product, I was told that the following morning I would receive revised quotes. Ultimately, we purchased a little bit of catastrophic coverage, a kind of reinsurance behind the captive for a reasonable sum, but there were no longer assessments on things going backwards.

Although we are a huge corporation, in the past we tended to be a very conservative corporation on assuming risk. Once we realized that we are larger than many of the insurance companies out there, it really changed our landscape for understanding risk. There was a real change in philosophy. That's what I consider a real ART transaction.

RM: What are some examples of successful ART triggers?

Inserra: Last year, our HR people were talking about some of the renewals coming up and some of our businesses were buying down their medical. I was surprised at how low the stop-losses were. The limit was one million dollars, but they were buying down below that significantly.

I asked if they would give our insurance subsidiary a chance to quote on it, since I could guarantee a better form and at least equal the price. They said sure, and we ended up taking it away from a third party.

It was a risk that within Praxair's risk profile we take each and every day, but here we were, sending corporate dollars out to third parties. The companies that write this stuff gradually recover their losses over time, plus they have their mark-up, so we just brought it in house. The CFO thought it was a great idea.

Wagner: Our integrated products were proof in and of themselves because we knew what the traditional market was pricing and what the integrated program produced. It was easy to show the substantial savings at the start-up when the hard market hit. Two of the integrated programs were multiyear, which made it more difficult to substantiate the savings. But when we went out to the traditional market again, versus the integrated format, the cost efficiency was substantial.

Small: If you read through the insurance periodicals, they say that the majority of companies are not buying terrorism insurance. When we did our risk assessment, enterprisewide, the ability to get terrorism coverage was one of our top ten priorities because we are in all of the major cities. So when TRIA was passed, even though it could cost as much as twenty cents on the dollar, it was still prudent of us to buy some type of protection. But we could not buy entire limits. We concluded that it would be prudent for us to put it in the captive because then we can at least draw upon some of the federal backstop.

RM: What has given the ART market legitimacy and made it a more attractive option?

Small: In our company, the escalating costs of risk became a real big issue. Also, the frequency of insurer insolvency forced us to no longer rely one hundred percent on the traditional insurance markets. The role of the risk manager has also changed significantly over the last few years. We need to aggressively show people that we're just not traditional insurance buyers that go out and buy a program by signing on the bottom line. We can and we need to bring more creativity and more innovation to the risk management function. We need to evaluate what makes sense for us in our industry and for our risks individually. How do you make the best use of your dollar with the intent of protecting the balance sheet of the corporation which is paramount?

Wagner: The ART market will prove its worth beyond any hard market. If you just take a look at the integrated programs of the typical insured risk, once that's established, particularly within a basket added to the integration, you now have a platform where you can start adding your nontraditional insurable risk.

Inserra: I think risk managers are more willing to step out and explore those alternatives, where that wasn't something that was done twenty or thirty years ago. Some risk managers have started branching out and doing these integrated and more sophisticated deals. These are being communicated, and success breeds understanding.
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Comment:Alternative risk transfer roundtable. (Special Advertising Section).
Publication:Risk Management
Article Type:Panel Discussion
Geographic Code:1USA
Date:Aug 1, 2003
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