CONFERENCE PRESENTS Alternative Risk Financing Techniques and Basic

CONFERENCE PRESENTS Alternative Risk Financing Techniques and Basic Actuarial Loss Projections Jacqueline Friedland, Actuarial Practice Leader KPMG LLP Phone: (416) 777 -8320, Email: jfriedland@kpmg. ca

Organization of Presentation • Introduction of alternative risk financing techniques (also referred to as alternative risk transfer or ART) • Discussion about self-insurance • Detailed description of four alternatives • Loss projection techniques and actuarial analyses • Key steps 2

Introduction of Alternative Risk Financing Techniques • Commonly used alternative risk financing techniques – Funded deductible program – Self-insurance fund – Captive insurer – Reciprocal insurance exchange • Major decision: whether or not to self-finance (i. e. , self-insure) 3

To self-insure or not to self-insure? • What is self-insurance? • Considerations in deciding whether or not to self-insure – – – Availability and pricing Cost effectiveness Tailor-made solutions Enhanced risk management Control • Characteristics conducive to self-insurance • Critical success factors for self-insurance • Disadvantages of self-insurance • Importance of reinsurance and/or excess insurance 4

Major decision: Is self-financing appropriate? • Decision is simply a financing or operational decision • Key decision: Is organization prepared to retain and finance potential losses instead of transferring risk? • “Through the years, the term “self-insurance” has been used loosely to describe a wide variety of risk financing arrangements through which organizations pay all or a significant portion of the costs of selected classes of their own losses. ” 1 Source: The Art of Self-Insurance by David A. North and Catherine D. Bennett (2002 Sedgwick Claims Management Services, Inc. ). 1 5

Examples of Self-Insurance • Small business purchasing automobile physical damage with a $500 deductible • Large oil and gas company purchasing property catastrophe coverage with a $1 million deductible • Associations that pool their risks and pay for members’ losses 6

Assume Prefunding – Regardless of Selected ART • Assume prefunding for expected losses and operating expenses for all four ART techniques • Prefunding at beginning of each policy year • Can take form of insurance premiums or contributions depending on nature of techniques • Many of the drivers for self-insurance relate to assumption of prefunding 7

The Drivers for Self-Insurance • Availability and pricing • Cost effectiveness • Tailor-made solutions • Enhanced risk management • Control 8

Availability and Pricing • Major motivating factor is dissatisfaction with existing insurance coverage or costs • Related to insurance market cycle • Market cycle affects price, cover, limits, etc. • Restrictions often first noticed in long tail coverages or high-risk exposures and industries • Primary reason for self-insurance: take control over one’s insurance destiny • Situations in which commercial market ignores an organization’s favourable loss experience 9

Cost Effectiveness • Reduce long-term costs • Reduce insurance company expenses • Retain investment earnings • Retain underwriting profits • Greater degree of control in litigation and claims settlement strategies • Improvement and management of cash flow 10

Tailor-Made Solutions • Often related to lack of availability of required coverages • Address unique exposures • Tailor-made solutions include: insurance product, underwriting standards, policy terms and conditions • Help facilitate change • Increase underwriting and retention funding flexibility • Improved loss control efficiency • Promote greater awareness 11

Enhanced Risk Management • Ability to improve and enhance risk management operations • Elevation of status of risk manager, and of importance of loss prevention and cost containment programs • Incentives for more proactive risk control and claims management techniques 12

Control • • Often cited as independent benefit Increased control over: ─ ─ ─ ─ • Costs Investment income Availability of coverage and limits Structure of insurance program Underwriting standards Risk management programs Claims and litigation management Assists in control of volatility (e. g. , avoid premium swings due to market cycle) 13

Characteristics Conducive to Self-Insurance • Require an estimate of expected losses and expenses • Ideal candidate: high frequency-low severity • Long-tail lines of insurance also conducive due to retention of investment income • Comments on general liability (GL) – – – Long-tail line of insurance Not typically high frequency-low severity Litigation is frequent, thus greater uncertainty Nevertheless, many self-insure GL Reasons for self-insuring GL: high costs and unavailability of acceptable coverage, terms and conditions, limits Excess insurance critical 14

Critical Success Factors for Self-Insurance • Long-term commitment • Need clearly defined specifics of coverage • Ancillary risk management services 15

Key Considerations and Disadvantages of Self-Insurance • • • Increased administrative responsibilities Variability in losses Pricing of other lines of insurance Capitalization requirements Excess coverage Competitiveness of commercial market 16

Funded Deductible • • What is a funded deductible program? • Deductible levels established based on negotiation • Key determinants of deductible amounts: Choice between pre-determined deductible amounts ─ ─ • Frequency of losses Average value of claims Ability to estimate expected losses Cost of risk transfer above deductible May have aggregate limit 17

Funded Deductible (Continued) • • • Risk transfer premium Contributions for deductible layer Total premiums Separate account accruing investment income Good first step 18

Self-Insurance Fund • Annual contributions for expected losses and expenses • Actuaries frequently involved • Critical requirements for successful operation, well-defined: ─ Coverage ─ Policy documents ─ Limits of coverage • Annual assessments not tax deductible • No capital and surplus requirements • Provision for potential of unanticipated large losses in early years • Excess insurance is important 19

Captive Insurance Company • What is a captive? • Types of captives ─ ─ ─ Single owner/parent captive ─ Group captive ─ Industry captive ─ Association-owned captive ─ Agency captive Segregated portfolio company ─ Protected cell company ─ Incorporated cell company ─ Rent-a-captive ─ Sponsored captive British Columbia captives • Captives and fronting insurance companies • Regulation and operational considerations 20

Reciprocal Insurance Exchange • An insurance market of reciprocal agreements of indemnity or insurance among persons known as subscribers • Attorney-in-fact • Subscribers liable for their share of losses and expenses • Not-for-profit, tax-free status • Actuary used for pricing and reserving • Direct access to reinsurance market • Operating costs • Capital and surplus requirements • Regulatory and financial reporting requirements 21

Loss Projection Techniques and Actuarial Analyses • • • Types of data required Diagnostic analyses Multiple projection methods ─ ─ ─ • Development Expected claims Bornhuetter-Ferguson Severity-frequency Stochastic analyses Actuarial analyses • • Annual contributions Cash flow projections Surplus requirements Financial statement 22

Key Steps • The self-funding continuum • Long term commitment is critical to success of any self-funded program • Most important decision – not which ART techniques, but is the move towards self-funding appropriate • Need to identify stakeholders • Identify and collect data and information • Conduct actuarial analyses/feasibility study • Ascertain the appetite for risk of key parties • Select and develop program • Implement • Monitor 23

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