Alternative Risk Financing Techniques and Basic Actuarial Loss Projections Jacqueline Friedland, Actuarial Practice Leader KPMG LLP Phone: (416) , CONFERENCE PRESENTS

2 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

3 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)

4 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

5 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 1 Source: The Art of Self-Insurance by David A. North and Catherine D. Bennett (2002 Sedgwick Claims Management Services, Inc.).

6 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

7 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

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

9 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

10 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

11 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

12 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

13 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)

14 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

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

16 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

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

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

19 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

20 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

21 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

22 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

23 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

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