Peter Eyre explains how risk managers can include their profitable employee benefits risks within a captive insurer, and dispels some of the myths surrounding the issue
With an estimated average global premium of $60bn1) per year and average loss ratios of 56%2), it is no wonder that risk managers are taking an interest in the employee benefits risks that corporations are passing to insurers. For risk managers who are not familiar with employee benefits risks, determining whether to embark on a global buying programme (multinational pooling) and then whether to include such risks via their captive, may seem like a minefield. But, once the myths are dispelled, the terminology is understood and the hard facts are taken on board, it should be possible to capture your profitable employee benefits risks.
Research shows that international employers usually spend around $800 per year per employee on insured risks. So a company of 5,000 employees may have an annual bill of $4m.
Throughout the world, the use of employee benefits is an incentive to employment, but it differs dramatically in its application in individual countries. For example, group life insurance is a common benefit in the UK and US. However, a US employer will usually insure up to $50,000 basic life per employee, whereas in the UK the figure may be 4 times annual salary, or even 10 times if the liability for the spouse's death-in-service pension is included.
Group medical cover is the most common global form of employee benefit, other than salary. Risk exposure relates to the cost of treatment and may be limited to an annual amount or a lifetime sum, perhaps as much as $1m. Co-insurance (the employee contribution) and spiralling costs make this a problematic contract to pool, although some contracts outside the US still have attractive loss ratios and can be included in a global programme.
Group life is the second most common form of insured benefit, but is the most frequent type of risk to be included in a global pooling programme. It is a lump sum death benefit, usually expressed as a multiple of salary and frequently wholly paid for by the employer. In addition, if the company runs a pension scheme based on final salary, it may have an annual pension liability for each employee on death before retirement, the cost of which can have a capitalised value varying between 4 and 10 times salary, which is sometimes insured.
Group disability is direct income replacement during illness, usually with a deferred period of 3 to 6 months. Employer sponsored, the insurer usually contracts with the company and pays the employer around 66% of the salary, as well as the employee's share of pension contributions. The exposure is the insured salary, potentially up to retirement.
Group accident death and disability (AD&D) is usually expressed as a lump sum and provided as a rider to the life insurance in some countries.
Historic loss ratios
Figure 1 shows the average loss ratio of 89 pools1) sampled from contract data in 27 countries. The medical loss ratio includes the US, which suggests that this can still be a profitable contract outside that country. Local fronting charges, reinsurance, taxes and commissions can absorb another 20% to 35%, leaving a potential average profit on the number one pooled contract type, group life, of between 13% and 28%.
Looking at group life loss ratios (death claims) by country from the same survey (Figure 2), you might be forgiven for thinking that the UK is a more dangerous place to live in than elsewhere. In fact, the figures reflect the more competitive market for buying insurance. Mortality is broadly similar throughout, but the cost of insurance is lower in the UK and France compared to Germany and Japan.
So why do most pools only deliver on average a dividend profit of around 6%? There is an old adage: rubbish in – rubbish out, which applies to around one third of in-force pools. In building up the global account balance, employee benefits networks combine the local contract experience, both loss making and profitable, to make a local balance first. After this, the network combines the results, positive or negative, with other countries, now at an international level. Lack of care over the ingoing local contracts and the neglect of pools once they are established can lead to a deteriorating result.
Worse still, many pools have no structured arrangement to manage the losses once they begin to mount up. Building up a successful pooling programme depends firstly on selecting good underlying risks on the way in and then in judiciously employing the available risk management tools to avoid extreme or repetitive losses. Stop loss, limited loss carry forward, excess loss and catastrophe reinsurance are all available from the employee benefits networks, albeit in a variety of forms and at differing costs.
Getting started on an international benefits programme will involve dealing with departments who may be more familiar with the terminology of benefits. It is useful to have some prepared responses if you find you are not making progress. Here are some of the more easily refuted objections.
Myth 1 – Employee benefits risks are all linked to pensions and can't be touched.
This is a common rebuff to enquiries about pooling risks in a global programme. It arises because, in some countries, the legislation which covers pensions includes the conditions under which the death or disability benefits can be paid. However, provided local conditions are met in the local policy, and the cost of the benefit is fully met by the employer, most countries could participate in a broader global pooling programme
Myth 2 – US risks cannot be included
Many insured employee benefits in the US are partly or wholly funded by the employee, and are usually excluded from pooling. However, there is no restriction on basic life cover or disability contracts which are fully paid for by the employer.
Myth 3 – The HR department has already put all the available risks into a multinational pool
An actively managed pooling programme usually manages to capture around 40% of its insured risks. Test the actual pool size against the rule of thumb of $800 per employee, times the number of employees the group has globally.
Myth 4 – We already have experience rated local contracts written competitively in every country
The loss ratios should be enough to dispel this myth.
The winners and losers
Once you decide to go ahead, the best measure of success is the total premium you successfully transfer into the pool. There is no real minimum where you will not obtain some benefit. The networks are prepared to deal with as few as 100 employees, provided they are in two countries or more. Roughly 2,200 pools exist, with an average size of around $1.5m. About 10% of these are using their captive, starting at around $3m of pooled premium.
There are four key stages in the development of a full captive programme.
Stage 1 – Up to $3m premiums: 'vanilla' pooling. For most companies, the pool itself will be an adequate method of buying and managing employee benefits risks, without involving the captive.
Stage 2 – From $3m pooled premium: the passive employee benefits captive. There may be some tax benefit in the captive receiving the dividends from the pool. To do this, the captive needs to become the contracting party to the pool and may need to take a modest net line reinsurance from the network.
Stage 3 – From $5m premiums: the active employee benefits captive. The pool is contracted to the captive, which then takes a cession from the stop loss or excess loss premiums, and is actively involved in the risk.
Stage 4 – From $10m premiums: the mature employee benefits captive. Local network insurers cede the premium to the captive, which settles claims with the insurer on a quarterly basis.
As with any global buying programme, winning the hearts and minds of the management is critical. The rewards are generally worth the investment. As the financial director of one company recently told me: "We tend to think in terms of product sales. If we get $1m back in dividends from this programme, we would need to sell $40m of products to get the same result. That's how important it is".
1) Watson Wyatt pool study 2002 2) Measured against gross written premium
Peter Eyre is senior international consultant at Watson Wyatt, Tel: 01737 274076, E-mail: email@example.com
Chairman of AIRMIC special interest group on captives, David Hertzell of Davies Arnold Cooper, advocates proceeding – but with caution
Traditionally, employee benefits have been insured either directly or on a pool basis with the conventional insurance market. Throughout the developed world the cost of employee benefits have risen, and against this background it is no surprise that risk managers are taking a greater interest. Can the cost be contained and some of the transferred profit retained by greater use of captive insurance?
The recent study undertaken by Mercer Human Resource Consulting and Marsh found that, while only 3% of captive owners used their captives to reinsure pooling agreements for non US employee benefits, nearly 30% expected to do so in the next two years. From the corporate perspective, pooling employee benefit covers, whether or not a captive is involved, achieves a greater economy of scale and reflects increasing globalisation. Using a captive in an offshore location can allow the parent corporation to provide parity of benefits to an international workforce. Transient employees can benefit from a consistent package, regardless of local legislation.
The most common employee benefits are death in service, personal accident, disability insurance, medical expense and sickness benefits. Some of these are long tail, and statistically the risk represented by an insured population tends to be better than that of the general population. Such risks can therefore benefit the captive too, by increasing its capitalisation and diversifying its exposure away from traditional short tail property risks.
Despite these advantages the risk manager needs to proceed with caution. Employee benefits risks can be quite complex and the data is based upon trends which may not continue into the future. Smaller organisations may feel concerned at the moral obligation of dealing with employee claims through a subsidiary, and there will certainly be potential for conflict in the parent/captive/reinsurer relationship. Larger organisations may have some concern at their aggregate exposures following September 11, particularly in a market where reinsurance for such risks is not easy to place. Funding employee benefits in your captive can be a good idea but take advice first.