The phrase 'Alternative risk transfer' (ART) is somewhat of a misnomer. Many ART options embrace a significant element of self-insurance and therefore 'risk transfer' misrepresents a large portion of the choice available in the market. However, ART has become the common term for referring to those options and products which fall outside the practice of paying a premium to insurers in exchange for an indemnification of contingent liabilities resulting from losses of insured perils.
ART solutions are not new. However, the hard insurance market has heightened risk managers' interest in learning about their applicability to their organisation's particular risk profile and risk appetite.
What options are available for protecting your company's balance sheet and earnings in the most cost effective manner? Before exploring ART solutions, it is important to consider the issue of self-insurance. Increasing the company's exposure to potential losses, whether by choice or because of lack of capacity, is the first step in moving toward ART solutions.
There are many reasons why self-insurance may be part of the overall risk financing strategy. These include:
The level at which self-insured exposure is set is driven by an entity's ability to withstand potential self-insured losses, its cultural tolerance to potential self-insured losses, the options available, and market conditions. In today's market, self-insurance is often being imposed by insurers increasing the level and structure of deductibles and excluding certain risks. Exposure to self-insured risk is mitigated if the company has a good loss history and sound risk management practices.
Once the risk manager has established what level of self-insurance he has elected (or has been forced) to assume, he should explore ways in which to treat the resulting exposure.
It is important to note that the company is not indemnified by a third party for losses that occur within the levels of self-insurance assumed. For self-insured exposure that is unpredictable, or where there is exposure to large-scale single incidents, the company is at risk of increasing the volatility of its earnings if losses are unexpectedly high in any given year. While it is not the only motivation, ART products are often useful for balance sheet or income smoothing that enables the company to reflect an even level of losses in the company's financial accounts, even though actual losses may fluctuate from year to year.
Self-insured retentions can be dealt with on a stand-alone basis, or be combined with an element of risk transfer. The structure of the solution will affect the ultimate choice of ART options.
Where self-insured retentions are dealt with on a stand-alone basis, there are three basic methods for financing self-retained risk, with permutations on each. They are:
While the expensing basis is not considered an ART solution, it is one of the range of options available when dealing with self-insured retentions. This approach means paying self-insured losses from cash flow as they occur – the simplest form of self-insurance.
The advantage of this approach is that money that would otherwise be paid out in premiums is retained and is available to spend elsewhere. Claims are paid when settled, which can be several years after they are first notified. The main disadvantage is that unpredictable losses make the income and cash flow budgeting process difficult. Any reserves made against claims notified are not usually tax deductible.
The virtual captive can be interesting for companies with a decentralised group structure, or for any entity wanting to create a real cash fund that is used only to pay insurance losses. Contributions ('premiums') are collected and are set aside in a reserve, or contingency, fund for the payment of retained losses. This involves pre-loss financing (as distinct from the expensing basis mentioned above) and can be a suitable method of financing higher levels of retained risk.
The main advantage of a virtual captive is that it provides the opportunity to enhance control of the risk management strategy. By centralising and benchmarking loss experience across the company, poor loss experience can be highlighted, and attention focused on where better risk control measures should be put in place. Premiums paid by each operating company can be adjusted to reflect poor or good loss experience in order to encourage them to improve their loss experience.
A virtual captive can sometimes improve leverage over insurers. As the virtual captive matures and its fund capital grows, it justifies the retention of greater portions of the parent's risk. This in turn diminishes the dependence on commercial insurance and can improve the bargaining position when purchasing commercial insurance. However, this advantage is more relevant in a buyer's market than in the current hard market conditions.
A virtual captive is an internal structure, and thus avoids the formalities and costs associated with the establishment and operation of an insurance subsidiary. A key drawback is that the fund created to pay losses is often raided for other purposes. Also, there is no benefit of income smoothing at the consolidated group level, although individual operating companies will replace losses with insurance premium and thus benefit from known expense level. Premiums paid to the virtual captive and any claims reserves made by it are not generally tax deductible.
A captive insurance company is an entity formed primarily to insure or reinsure the risks of its sponsor. Captives are most frequently owned by a single legal entity, although there are a number of captives owned by consortia and associations, which mutualise or pool the risks of each participant.
Captive insurance companies are usually formed in domiciles that recognise the unique characteristics and objectives of captives and regulate them accordingly. The number of captive formations continues to grow, with the rate accelerating in hard markets.
Captives are either wholly-owned, rent-a-captives or protected/segregated cell companies. A captive can make good financial sense if its premium income will be sizeable enough to justify the additional expense of setting it up and if its business is expected to be profitable.
Captives are a popular method of maximising the benefits of self-insurance. They can provide both financial and insurance benefits. However, they do have some disadvantages.
Captives and other forms of self-insurance have been around for a long time and now barely justify the tag 'alternative'. There are, in addition, numerous other and newer forms of ART products. All forms of ART and, in particular, captive-type self- insurance structures are attracting greater interest as a result of the prevailing market conditions.
Amy Dadarria is managing director, Ark Consulting (London) Ltd, the London-based consulting arm of the Heritage Group, Tel: 020 7621 3701, E-mail: firstname.lastname@example.org
Financial Captive insurance companies offer the potential to:
Insurance In addition to enhancing the focus on risk management and the leverage over insurers, as is the case with a virtual captive, an insurance subsidiary offers the potential to:
In addition to captives, there is a wide range of ART products that can be tailored to specific needs. They include the following.