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Alternatives continue to lure buyers from traditional markets.

Alternatives Continue to Lure Buyers From Traditional Markets

Several factors will continue to drive insureds to various forms of self-insurance. Foremost among the factors are increased disenchantment with traditional insurance mechanisms and improved understanding of property/casualty insurance.

Disenchantment with the insurance industry is widespread as an aftermath of the recent hard market cycle. Risk managers, financial officers and corporate counsels are examining alternative ways of funding for predictable losses, securing services and providing catastrophic protection for their organizations. This disenchantment is fading only slowly with the current softening of the market.

It is ironic that a product that was in part created to help an organization stabilize the impact of unforeseen losses on its financial statements has become a major source of cost instability. When architects and engineering firms are paying almost 25 percent of their revenues for professional liability insurance and some U.S. manufacturers find that insurance costs are their third or fourth largest expense, the product is no longer fulfilling one of its primary purposes.

The roller coaster has begun again. The problems with the tort system remain, while premiums fall for no apparent reason to individuals who work outside the insurance industry.

An even more fundamental catalyst for change is the increasing sophistication of the commercial insurance buyer. Each hard market cycle strips away a little more of the mystique that traditionally has surrounded insurance. And smaller and smaller organizations are learning the essentials of loss financing.

Particularly for large organizations, insurance is a product that has been historically oversold by brokers and insurers. Organizations which routinely commit $25 million or $50 million to new product research and development processes have been reluctant to retain all but a small fraction of their ultimate loss exposure. One result of the last hard market is the number of firms that now retain the first $25 million or more of each products loss and have found the experience less disconcerting than expected. Several have indicated that they have redefined their ideas of what constitutes catastrophic loss and will continue to self insure at previously unthought-of levels.

Some of these organizations plan to engage in insurance arbitrage. They will buy various layers of insurance only when they believe that it makes actuarial sense. In adopting this approach, they will, of course, contribute to the price instability that they decry.

Against this backdrop, it is possible to draw some conclusions about future trends in alternative insurance markets.

Self-Insurance

Qualified programs of self-insurance for workers' compensation and automobile liability will continue to grow. Within the limits of their financial ability to pay losses, nonprofit organizations should be self-insured for their predictable losses. Other organizations will increasingly choose self-insurance, in part to distance themselves from admitted insurers and in part because the hard dollar costs of utilizing other types of loss financing programs will make self-insurance an increasingly attractive option.

There will be impediments to this growth and difficulties with it. Increases in self-insurance taxes will diminish the financial savings. Guaranty funds to make good the losses of insolvent self-insurers will generate an exposure to the losses of others that most self-insureds do not want. Availability of reasonably priced surety bonds required for financial security is yet another issue.

Firms too small to self-insure, either because of inadequate finances or potential savings disproportionate to the risk, will nevertheless choose to do so. The self-insureds that fail to achieve their objectives, however, will not affect the many other organizations that will correctly view self-insurance as the least expensive loss financing vehicle open to them. There, thus, will be a continuing process of adverse selection against traditional markets.

Other Loss Financing Plans

One factor favoring traditional insurance markets is that most alternative loss financing techniques depend on traditional insurers for fronting policies or other forms of admitted paper. The demand for these types of policies will continue to grow and thus continue the process of converting risk-bearing premiums to fee-based income.

Another trend that is likely to produce this result is the escalating cost of insurer charges for retros. The data in Tables 1 and 2 illustrate the point for two different insureds. Table 1 shows data for a 1988 primary casualty renewal for workers' compensation, automobile liability and general liability. The programs represent quotations from four different insurers for paid-loss retros. Claims handling and loss prevention charges have been excluded. The insured, a multibillion dollar revenue manufacturer, thus is paying between 10 percent and 20 percent of its estimated ultimate losses of $15 million simply for admitted insurance company paper.

Contrast this insured's situation with that of the insured whose data are listed in Table 2. Program 1 is a deductible program for general liability quoted by one carrier, while the other two programs are cash flow retro quotations with alternative per occurrence loss limits from a different insurer. The hard dollar costs in the deductible program are minimal. (The deductible quote was a renewal quotation from the underwriter which has had the account for several years; it was largely unchanged from the prior year.) This insured would have paid a $600,000 surcharge to purchase a retro. It obviously chose the deductible program.

As smaller insureds learn the techniques of loss financing, they also are increasingly adopting plans which give them control of the underwriting profit or loss and the investment income on their loss reserves. Table 3 shows the data available to some 2,000 store owners. With expected losses of $3.6 million compared to premiums quoted of $7.6 million, these small insureds chose to form a captive insurance company. Another reason for choosing the captive was their belief that administrative service could be provided for much less than a traditional insurer would charge.

Captives and Rent-A-Captives

The growth of captive insurance companies will continue but at a slower pace. Single parent captives formed by U.S. organizations will experience slower growth now that they offer neither a tax deduction for the premiums paid to them nor any tax deferral possibilities; they will be used primarily as cost stabilization vehicles. They also will serve as funding devices for self-insurance programs. The rate of growth in captive formations (by nonprofit organizations) actually may accelerate because of a unique tax benefit available to such companies.

U.S. insurers, in collaboration with risk managers, brokers and consultants, commenced introducing a variety of alternatives to formal self-insurance in the early 1970s. To supplement old standbys like deductibles and incurred loss retro programs, insurers added paid loss retros, compensating balance retros, loan back plans, investment credit retros and more recently, deferred premium payment retros. Most of these programs were designed to emulate the cash flows associated with qualified programs of self-insurance while producing a current year tax deduction for the ultimate loss reserves.

Despite the industry literature to the contrary, tax issues played a prominent role in the adoption of many of these programs. Corporations seeking to minimize the effective cost of their insurance programs recognized this elementary fact. The rapid acceptance of these loss financing innovations was based on insureds' ability to control their loss reserve dollars and the associated investment income while achieving a lower after-tax cost than was possible with qualified self-insurance.

A major change that has taken place in the last few years is that the Internal Revenue Service now understands the time value of money concepts on which these loss financing programs are based. It has moved aggressively to disallow tax deductions for most of these plans and has sought legislation from the Congress, as needed, to sustain its position in the face of adverse court decisions. The 1984 tax act eliminated any possibility of securing a tax deduction for loss reserves, for example, in a qualified program of self-insurance; some ambiguity had previously existed on this point, particularly in the Western United States.

Corroon & Black's outside tax counsel, Sutherland, Asbill & Brennan, has suggested that the IRS may soon attack the tax deductibility of all retrospectively-rated plans, including incurred loss retros, written for large insureds in the special risk markets. If mounted, the thrust of the IRS' attack would be that because larger corporations can predict their ultimate losses with reasonable certainty, there is no transfer of risk in any retro plan.

This brief summary of the tax aspects of primary casualty loss financing plans is important in evaluating the future use of such plans. Many of these plans cease to make economic sense in the absence of associated tax benefits. The "standard" plan, of the future may very well be a paid-loss retro for workers' compensation, deducting only paid losses for tax purposes and large deductibles for automobile, general and product liability.

Most captive growth will come in the group area. Properly structured multi-owner companies retain many of the advantages traditionally attributed to captives.

Because of the need for admitted paper for workers' compensation and automobile liability policies, certificates of insurance for other coverages and reinsurance, the impact of captives on traditional insurance markets will be much the same as outlined above for other types of primary loss funding programs.

If fronting costs and security requirements continue to increase, one likely impact will be the formation of admitted insurance companies by insureds. Several have been formed recently, including one multi-state company which removed $40 million in liability insurance from traditional markets.

Risk Management Services

There are only so many hard dollar costs that can be wrung out of loss financing fronting charges. That process now has been going on for years. As a result, pricing competitions will diminish, in effectiveness in the years ahead.

They are likely to be supplanted by a greater emphasis on the quality of risk management services delivered to insureds by traditional insurers. To compete effectively, insurers will need to be able to document the effectiveness of their claims adjusting and loss prevention staffs. This is something that insurers traditionally have not attempted to do. When challenged to conduct controlled tests that would attest to service effectiveness, insurers' reactions often are ones of bemusement.

As risk managers increase their emphasis on reducing loss costs, insurers will come under increased pressure to demonstrate that they can be effective partners. There will be adjustments required which full-service insurers will find difficult to make.

Excess Loss Programs

Traditional insurers, which have seen much of the excess liability market lost to ACE and X.L. since late 1985, will lose additional profitable premium volume to new specialized facilities providing coverage below $25 million. One small captive insurer with as little as $10 million in annualized primary premiums is researching formation of an excess liability facility to write $4 million in excess of $1 million. Alternative facilities for segments of the industry as staid as contract surety are being investigated.

A large company in a low margin industry has formed a captive insurance company to write $5 million in excess of $5 million primary. The long-term aim is to have the captive initially quota share $20 million in excess of $5 million and ultimately to write the full $20 million layer. This firm is a shareholder in ACE and X.L. and, at the end of this process, will purchase only primary liability and its attendant first excess layer from a traditional underwriter.

Since these programs typically do not require fronting paper and offer only limited opportunities to sell services, traditional insurers lose income in both areas. Another source of lost excess premium volume is the many firms that now self-insure the first $25 million of product liability.

Western Europe and Pacific

Alternative loss financing plans are not nearly as prevalent outside the United States. This fact reflects several factors. Premium levels for most companies are lower, often much lower than for similarly sized firms in the United States. Workers' compensation and/or automobile liability are government provided coverages and product liability losses are less. Property premiums typically are the major non-benefit insurance expenditure, and property does not lend itself readily to alternative techniques.

European and Japanese insurers have traditionally resisted widespread introduction of alternative loss financing programs. Their job has been made easier by interlocking directorships and other business relationships that reduce the pressure for insurers to innovate. Yet the number of tariff-rated coverages offer opportunities for larger insureds to cut their costs.

The product liability directive in the European Economic Community may be the change that will alter the status quo in Europe. Certainly European reinsurers are already expressing concern over the impact this initiative will have on losses. Their belief appears to be, however, that without a contingency fee system for plaintiff attorneys and some of the other failings of the American legal system, there is little possibility of the situation spiraling out of control. In the latter context, it is interesting to note that there already have been suggestions in the British press that a way needs to be found to allow individuals without the economic means access to the legal system.

In the short term, there is likely to be marginal incremental movement into alternative techniques, except for captives. The latter are being formed in greater numbers from Australia to Singapore to Luxembourg. [Tabular Data 1 to 3 Omitted]

James V. Davis is chairman of Advanced Risk Services for Corroon & Black Corporation. This article was adapted from a paper he delivered at the XXIV International Insurance Seminar in London in July.
COPYRIGHT 1989 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1989 Gale, Cengage Learning. All rights reserved.

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Title Annotation:self-insurance
Author:Davis, James V.
Publication:Risk Management
Date:Feb 1, 1989
Words:2227
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