Risk financing solutions do exist!
The current period of hardening looks different in some important ways, and smaller companies in particular have more options than they have had in the past, says Peter Kranz of Beecher Carlson.
“Company A must then ask itself whether it is worth potential savings of $200,000 per year to accept additional risk up to $600,000 per year.”
Peter Kranz, Beecher Carlson
As we all know, the insurance market has been hardening for upwards of two years. It appears to have started in the real estate sector, with property premiums increasing following several years of wind and wildfire events. General liability followed suit, and since then it has expanded across almost all lines of business and industry sectors.
As with prior periods of premium pricing increases and firming markets, larger organisations have reacted by increasing their retentions—taking on more risk—in exchange for premium dollar relief. However, in some ways the current environment is very different from what we have seen in the past. These differences include, but are not limited to:
- Insurance markets are less likely to respond to pushback on premium increases—in some instances the markets will simply “walk away”. They are not as focused on filling their capacity.
- Insureds’ access to claims data, and ability to analyse said data, has dramatically increased over the past five to 10 years allowing for a greater understanding of what causes claims, how to control claims and which types of claims are most likely to become high value.
- Carriers have less redundancy in their reserves to release to reduce the surplus implications of severe events.
- Capital markets have been growing more hesitant providing capacity behind cat lines due to the frequency of events reducing the return to investors.
This has pushed more of the carrier premium increases down to the middle and small markets, which have increasingly been responsible for a larger share of carrier profit. Historically, the small and middle market companies did not have the same range of options their larger peers had—but that is now changing.
Over the last 10-plus years, we have seen an increase in group captives and risk-pooling structures. Many of these have been associated with captives which are under intense scrutiny by the Internal Revenue Service for, perhaps, being established incorrectly or not for the right reasons. At present, there are products or “structures” being sold, rather than solutions.
The key questions for any insured are:
- Is my risk being financed in the most cost-efficient way?
- What is my worst-case scenario?
Many, though not all, of the group structures in the marketplace charge an increased premium so it “looks” as though the insured is getting a benefit. In fact, on a comparison basis at expected losses, they are paying more—mostly to the high expense load of the structure.
Others take an A fund/B fund approach, where the insured may have to replenish one or both funds several times, with adverse experience before any stop loss or aggregate kicks in. In almost any group structure, the insured is exposed to the loss experience of others. Further, some group structures can be very difficult to exit.
There are certainly good group captive structures out there, but insureds should be careful to ensure the products they buy are the best solutions for them.
Ultimately, the answer to the two questions posed earlier is an equation, and there are potentially more customisable solutions. Before going too far, if an insured is paying a carrier to assume $900,000 of losses at a cost of $1 million then they should continue with that programme! If that is not the case, the following calculation comes into play.
Let’s start by presenting this initial example—company A pays $2 million in guaranteed cost premiums and retains no risk (Table 1).
Table 1: Company A premiums and cost of risk
Retained losses (deductible) 0 Guaranteed cost premiums $2,000,000 Total cost of risk $2,000,000
We will illustrate a few different scenarios based on different loss rates including the following assumptions (Table 2):
- Company A increases retentions from $0 to $250,000 per occurrence: This means company A is now exposed to all losses up to $250,000 Carrier premiums drop from $2 million to $500,000
- Retained losses funded into captive
- Carrier loss rates on premium of 40 percent, 60 percent and 80 percent (expected losses)
- Captive purchases an integrated (aka multiline or basket) aggregate across several lines of business with an attachment point at 175 percent of expected losses
This means the carrier will start paying on the stop loss once actual losses exceed 1.75 times the expected amount of losses
“All this illustrates the necessary risk tolerance/risk appetite discussions companies should be having.”
Table 2: Company A figures based on different scenarios
Carrier loss rate on premium (current) 40% 60% 80% $ Expected retained losses (increased deductible) 800,000 1,200,000 1,600,000 Guaranteed cost premiums 500,000 500,000 500,000 Captive stop loss 250,000 250,000 250,000 Captive operating and reinsurance brokerage costs 250,000 250,000 250,000 Expected total cost of risk 1,800,000 2,200,000 2,600,000 Exposure in excess of expected 600,000 900,000 1,200,000 Potential (cost) benefit versus current structure 200,000 (-200,000) (-200,000) Stop loss attachment point 175% of expected losses
Table 2 demonstrates that at expected loss rates of 60 percent and 80 percent on premium, respectively, the captive structure with a stop loss would cost more than the current guaranteed cost structure. Company A could consider increasing its retentions without using a captive, which would save an additional $500,000 annually. Some of those dollars could be used to try to obtain an aggregate on the $250,000 retention from the carrier placing the coverage excess the $250,000 per occurrence.
At a 40 percent loss rate on premium in the illustration there is potential annual cost savings of $200,000. Company A must then ask itself whether it is worth potential savings of $200,000 per year to accept additional risk up to $600,000 per year.
If the probability is that losses will be as expected four out of five years and will breach the aggregate the fifth year, meaning $600,000 of losses over the expected amount in that fifth year, company A would have a five-year net saving of $200,000 ($200,000 x 4 years = $800,000 minus $600,000 of adverse year losses).
All this illustrates the necessary risk tolerance/risk appetite discussions companies should be having as the future of risk financing will be shifting away from a line-by-line approach towards holistic solutions to how organisations finance risk.
Putting together aggregate structures is not only feasible—it is being done. During the pandemic, the alternative risk transfer markets have tightened up a bit, but we expect that with additional capital and improving economic conditions those markets will ultimately open back up, allowing for more creative solutions for middle and small market companies.