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Pooling and insurance - one and the same?

Important points to consider when determining whether to participate in an intergovernmental insurance pool or to purchase commercial insurance.

There is an old saying often referred to when addressing similar objects and concepts: "If it walks like a duck, talks like a duck and looks like a duck, then it must be a duck." Further investigation, however, often reveals that it is not really a duck but a close cousin. Although it may resemble a duck in many ways, this cousin will have some subtle but real differences truly distinguishing it from a duck.

In the same light, joining a public entity risk financing pool may look similar to purchasing commercial insurance. There are, however, many subtle and not-so-subtle differences. These differences establish the public entity risk financing pool as a completely separate financial instrument from its cousin, the commercial insurance company. Most pools provide the member entity with a coverage document, true transfer of risk, for a premium paid under the terms and conditions agreed to in a binding contract. At first glance, this looks like commercial insurance, but as one looks further at the financing instruments, the differences appear.

All public entity risk financing pools are not identical, just as all commercial insurance programs are not exactly the same. The many trends and similarities among pools, however, allow their comparison and contrast with commercial insurance.

When investigating whether to use a pool or commercial insurance, there are four basic areas to be evaluated:

* the professionalism of the organization's management,

* the binding contractual arrangement,

* the financial security of the operation and

* the ultimate cost of risk.

Contractual Relationship

Public entities considering joining a public entity risk financing pool must realize these pools require the entity to take an ownership interest in the program. Most pools, through their joint powers agreement or enrollment documents, bind the entity into the program through the assessable provisions of these documents. Under an assessable agreement, the pool can charge a member entity an additional premium for excess costs to the pool during a covered period of time. Because pools usually discover their ultimate loss experience and charge the assessment years after the policy period, they may charge this assessment even if the member has left the program.

On the flip side, pools often give their members a dividend or reimbursement for lower ultimate costs during the policy period, but members who have withdrawn before the pool declares the dividend may not receive the reimbursement. This system of assessments and dividends tends to bind entities into longer relationships than they might have with most commercial insurance programs. Therefore, entities with internal procedures requiring them to bid out the insurance program annually may incur higher financial risk transfer costs.

One of the benefits of this long-term relationship, however, is the ease of operation for the public entity. Procedures established when an entity enrolls in the program often remain the same for many years. Claims and financial reports also tend to remain constant over long periods of time; thus, entities do not have to spend time and resources constantly learning and implementing new programs. This long-term relationship also results in fewer coverage disputes, and usually the pools internally settle those that do occur.

In contrast, most commercial insurance programs do not offer an ownership interest in the program. They write policies to totally transfer financial risks with no retained ownership. Most commercial insurance policies that public entities purchase are not assessable and will not pay the policy holder a dividend or reimbursement.

Many pool documents and policies are manuscript in form, allowing the pool to tailor the policies specifically to members' needs. As the pool usually writes these coverage documents and policies in a basket approach (many different lines of coverage under one program), members don't have to be concerned with gaps in coverage. The pool limits its policy to what the reinsurers, excess markets, facultative markets or the pool itself are willing to insure.

Due to the pool's nature, however, individual members often must accept a bundled package program, including several lines of coverage with little room for modifications to meet specific needs. The pool may require members to purchase coverages or limits they don't necessarily need or want. Loss control, claims services and legal services are three of the major bundled services required by most pools. Commercial insurance programs, especially programs with large self-insured retentions or deductibles, are often more flexible in unbundling services and offering special endorsements to the policy than the public entity risk financing pool.

For the most part, commercial insurance companies write their policies on the Insurance Service Organization forms. Thus, court interpretations of coverages tend to be more consistent than with manuscript forms provided by some pools.

Financial Security

When comparing a pool's financial resources with those of most commercial insurance carriers, one will usually find financial strength with highly rated commercial insurance companies. These companies must meet a higher accountability standard than most pools. They spread their risk among many different types of businesses. Therefore, if a catastrophic event occurs that affects public entities, the insurance companies could spread their losses over many types of business. Pools, however, are limited to public entities and cannot diversify their underwriting risk to the same extent as commercial insurers.

Commercial insurance carriers, partly due to current regulations, typically carry higher surplus ratios than pools. Many public entity pools are building up surplus in their organizations as they are becoming more regulated and sophisticated in their operations.

Commercial insurance companies can draw upon only those financial resources that they are able to generate. If a commercial insurance carrier cannot meet its financial obligations, it can file for protection under current bankruptcy laws like any other privately owned corporation. Pools can, if provided in the joint powers agreement or enrollment document, assess their individual members to make up any financial shortfall.

The insurance business runs in a continuous cycle of hard and soft markets. The commercial insurance carrier can pick and choose the exposures to underwrite during periods of hard markets. With the limitation of one specialized group of businesses, pools must continue to underwrite the risk financing needs of the public entities during the complete market cycle. Knowing its risk financing program will be available regardless of the market cycle may be a comfort to the individual public entity. However, terms, conditions and price of the pool's product during a hard market may change due to the availability and price of the pool's reinsurance or excess insurance.

Management Expertise

When comparing pools' management expertise with the management staff of most highly rated insurance companies, the nod usually will go toward the insurance companies in their understanding of the "business of insurance." Most of the individuals directing the top insurance companies have worked in the insurance business for many years, and their decisions are backed by years of experience. Pools often use insurance consultants to advise or administer the pool. Trustees most often come from a history of public service and learn the business of risk financing from purchasing the product and not the actual production of the product.

Pools may lack the risk financing background of their insurance company counterparts, but they better understand the risks involved in operating a public entity. This underwriting knowledge is important in evaluating and pricing the risk. With a special knowledge of the book of business, pool trustees can develop and administer specialized loss prevention, loss control and claims service programs. This is especially true of pools that have these services in-house rather than with a third-party administrator. An in-house claims service that deals solely with governmental immunity, a single risk financing program and an understanding of the business of government gives pools a real advantage in adjusting their clients' claims.

A pool's administrative cost tends to be less than that of a commercial insurance company. Unlike publicly held insurance companies, pools don't have to generate a profit. Salaries and overhead costs also tend to be less for pools than for commercial insurance companies.

Cost of Risk

If, after careful analysis of the submitted proposals, government officials find that they meet or exceed bid specifications, the deciding factor is often the cost of the program. With public entity budgets getting tighter and tighter, risk transfer costs are becoming more important than ever in the selection process. Before making a decision, it is important to review the entire risk financing program offered--the total "cost of risk" must be computed. Cost of risk is the sum of all insurance premiums, retained losses, allocated loss adjustment expense and administrative expenses. The cost of risk calculation will give the big picture and allow comparison of apples and apples.

To procure the best program for an entity, it is necessary to carefully review and analyze the pool and commercial insurance in the areas of contractual arrangement, financial security of operation, professionalism of management and the cost of risk. It is not enough to follow blindly what other entities have done; the risk financing program for one government may not serve the needs of another. As these risk financing programs continue to change, officials must continue to evaluate their entities' options to ensure that they are using the best possible method of financial risk transfer.

DANIEL J. CULLEN, ARM, is risk manager, City of Ann Arbor, Michigan. This article was initially published in the Nov./Dec. 1992 issue of Public Risk and is reprinted with permission of the Public Risk Management Association.
COPYRIGHT 1993 Government Finance Officers Association
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:intergovernmental insurance pool
Author:Cullen, Daniel J.
Publication:Government Finance Review
Date:Feb 1, 1993
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