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Alternative Risk Financing:
Not Just For Fortune 500 Companies

By Greg Ryan and James Bukowski

Large corporations and government agencies commonly use some type of alternative risk financing to finance their property and liability loss exposures. Medium-size and smaller companies¹ generally purchase commercial insurance for the same purpose. Alternative risk financing, however, is not just for Fortune 500 companies. Many other firms can enjoy some of the benefits of alternative risk financing, such as improved cash flow and a lower total cost-of-risk.

This article provides a basic overview of risk financing concepts for medium-size firms.² Specifically, it (1) surveys the principal types of risk financing alternatives, and (2) outlines the decision process and program components for implementing an alternative risk financing program.

A few definitions are needed. Risk financing is the use of insurance and other techniques to pay for loss obligations. Alternative risk financing is the self-assumption of risk, combined with insurance, to finance an organization’s property and liability losses. It is a formal program for managing and paying for an organization’s losses, usually for a defined period.³

How Large A Company?

The first question often asked by owners and managers of medium-sized firms is “How large must my business be in order to use alternative risk financing?”

Organizational size is not very important. The main criterion is losses. As a rule of thumb, alternative risk financing requires approximately $500,000 in annual incurred losses in one line of insurance; e.g., automobile or general liability or workers compensation. Losses in the selected line should be reasonably predictable. The organization should be reasonably able to accept risk. Internal management discipline and a willingness to commit the appropriate resources are also required.

The losses should have the following characteristics:

(1) Reasonably predictable

(2) Not extremely volatile

(3) Not exposed to a catastrophic loss

(4) High frequency and low severity

“High frequency” and “low severity” means the number of losses should be at least several dozen per year, with the great majority of losses less than $50,000. As a case in point, a large hotel may expect to experience many small workers compensation claims, but relatively few, if any, large claims. A bank can also expect to have many workers compensation claims of low severity. Alternative risk financing usually handles loss severity—the exposure to large losses—by purchasing excess insurance or reinsurance.

What Lines Of Insurance?

The other question most often asked is “What lines of insurance are best for alternative risk financing?”

The “casualty” lines of insurance—workers compensation, general liability (including products) and automobile liability—are best candidates for alternative risk financing. Workers compensation and liability claims tend to be paid over long time frames, one to five years or more. Insurers of these lines generate substantial investment income on their reserves until losses are fully paid. Mid-sizes organizations using alternative risk financing can earn investment income on reserves that was formerly earned by an insurance company.

What Types Of Alternative Risk Financing?

Insurers have developed many colorful titles for what amounts to a handful of alternative risk financing techniques. Methods range from guaranteed cost (for risk-averse firms) to self insurance and captive insurance (for firms seeking the ultimate in control over the risk management and financing process). The techniques include:

• Guaranteed Cost
• Retrospective Rating
• Large Deductible
• Self-Insurance
• Captive Insurance

The chart below summarizes the salient issues of these alternatives.

1. Guaranteed Cost Insurance

Guaranteed cost remains an attractive option, particularly in a highly competitive insurance market. Guaranteed cost means the insured pays a one-time premium, based either on a rate (e.g. per payroll or property values) or a flat amount. The insurer assumes the loss obligations covered under the policy. Guaranteed cost, in some circumstances, can be the best of all worlds. A specially-tailored program can use an insured’s expected losses as the basis to calculate premium the premium. The premium is then discounted to recognize the time value of money. Insurers include their calculations a risk charge for large losses and the possibility that losses may exceed projections.

Many buyers like the fact that guaranteed cost programs pose no upside risk (i.e. no additional premium or cost for the risk transferred).⁴ For a mid-size company, however, guaranteed cost insurance may not always be a bargain. Underwriters of mid-size companies can assess substantial risk charges in recognition of the greater volatility of the loss base. This will add to the cost of guaranteed cost insurance. Guaranteed cost programs also have few cash flow benefits for a buyer, other than installment payment plans.

There are a number of variations on guaranteed cost arrangements. Many tend to use a loss sensitive formula to calculate the final premium. Examples include both incurred and paid loss-rated and dividend programs.

2. Incurred Loss Retrospective Rating Plans

Retrospective rating plans (called “retros”) have been filed in most states for workers’ compensation and other lines of insurance. They historically have been loss sensitive plans in which the insured pays a standard premium that is adjusted after policy expiration based on actual loss experience. In recent years, many of these plans have allowed policyholders to pay a premium based on expected losses and expenses during the coverage period.

Incurred loss retro plans tend to carry heavy expense loads and provide limited cash flow benefits. The adjusted premium is based on incurred losses, i.e. paid and reserve amounts. Most plans do not usually offer much flexibility. If a portion of premium is deferred, collateral may be required to mitigate the statutory impact of deferral on an insurer’s financials.

3. Large Deductible Plans

As the name suggests, a large deductible plan means an organization assumes a substantial per accident or per occurrence deductible. This can often range from $50,000 to $250,000. Large deductible plans are currently very popular. They use the insurer’s claims paying guarantee to ensure that obligations to third parties and employees are met. The policyholder is responsible for paying all losses beneath the deductible threshold. If the insured is unable to do so, the insurance company is obligated to pay the full amount of losses.

Large deductible plans have largely supplanted the utility and popularity of paid loss retrospective rating plans. One of the reasons is that an insured pays less premium taxes under a large deductible plan than under a paid loss retro plan. Workers’ compensation is the line most often financed through a large deductible plan.

Another reason large deductible plans are popular is that they allow the insured to hold cash until actual loss payments. Only program expenses need be paid at the inception of the coverage period. Because the insurer is ultimately responsible for unpaid losses, collateral is required to eliminate credit risk, and insurers tend to be less flexible in program design and services.

4. Self-Insurance

Self-insurance is often the least expensive risk financing arrangement. It is the retention of loss obligations and payment of those obligations as they become due. Self-insurance is distinguished from non-insurance in that self-insurance makes a formalized accrual of liabilities. Workers’ compensation, general and automobile liability are commonly self-insured.

Due to states’ responsibilities to see that injured workers are protected, workers’ compensation self-insurance is highly regulated. States require that employers desiring to retain workers’ compensation exposures demonstrate the financial ability to pay losses. This qualification process must be sustained as states continually monitor an employer’s status. State regulators require security deposits of qualified self-insureds to ensure that they can meet all loss obligations. Some states require stop loss insurance on self-insured workers’ compensation plans. Automobile liability is also subject to a fair amount of regulation due to states’ financial responsibility laws.

Meeting the qualification process, complying with state regulations and maintaining workers’ compensation collateral requirements (cash deposits or letters of credit) can be demanding from an administrative standpoint. Nonetheless, self-insurance is usually the low cost option for alternative risk financing arrangements.

5. Captive Insurance

Captive insurance is a formalized method to pre-fund risks through an insurance subsidiary called a “captive.” Captives are typically owned by a parent company or a related party. Captive insurers are usually established in a favorable domicile. These domiciles minimize regulation of these special purpose insurers, understanding that most captives are a form of self-insurance.

Captives insure risks in two distinct ways: direct and fronted. A direct writing captive issues policies and directly covers the risks of policyholders. It may also purchase reinsurance and contract with vendors for underwriting and claims services.

A fronted captive operates as a reinsurer and employs the services of a licensed, recognized fronting insurer. The fronting company performs most administrative functions, such as issuing policies to the captive owner(s), providing required certificates of insurance and adjusting claims covered under the policy. Captive programs for workers’ compensation always use a fronting insurer because of the requirement to have an admitted insurer.

Captives provide a high degree of control for captive owner-policyholders over the insurance and risk management process. Captive risk financing carries somewhat higher non-loss costs and imposes greater administrative concerns than self-insurance and large deductible plans.

What Is The Risk Financing Decision Process?

Shown below are the steps in the financial evaluation process that medium-sized companies should follow in reviewing alternatives:

• Work with a consultant or your broker to identify and analyze suitable alternatives.
• Project losses and costs and compare the net present value of each of the risk financing alternatives and insurance purchasing.
• Simulate the variability of results. Be certain that you examine adverse “worst case” as well as “expected” loss scenarios.
• Incorporate a retention analysis into your evaluation process. Make it specific to the firm’s exposures, loss experience and financial imperatives. The retention analysis should establish optimal per accident/occurrence levels of economic exposure to loss.
• Integrate market-based pricing of insurance or reinsurance into your analysis, so that the retention selection takes advantage of market conditions.

What Are The Program Components?

The use of alternative risk financing, in the form of a high deductible program, self-insurance or captive insurance, requires careful coordination of program components. The required services can be purchased independently from vendors or bundled by the insurer that provides excess or stop loss insurance.

Risk financing program components include:

1. Claims administration

2. Loss control

3. Policyholder services

4. Certificates administration

5. Actuarial services

6. Excess or stop loss insurance/reinsurance

7. Security or collateral requirements⁵

8. Program management and oversight

Administrative demands on an organization are accentuated when it purchases unbundled services independent of the insurance arrangement. Purchasing such services, on the other hand, often gives greater control and cost savings. Loss control should receive more attention. Self-insurance triggers filings and administrative paperwork. Deductible and self-insured plans will necessitate attention to cash management.

Make no mistake, there will be a need to educate management. Owners and top level management will be delighted with premium savings, but unaware of an attendant increase in management involvement. A controller or human resources manager will be well advised to involve the consultant or broker in educating management.

Conclusion

Medium-sized firms may find alternative risk financing more efficient than conventional insurance. The decision on whether to use such methods should be based on analysis of costs and losses, including insurance market pricing. Firms willing to commit the necessary resources should benefit in the form of improved cash flows and realizable cost savings. The extent of improvement and the degree of control over the risk management process will vary depending on the firm’s internal management practices and organizational suitability. 

Notes
¹ Medium-sized companies frequently have the controller or human resources managers act as risk manager.
² A medium-sized firm is generally one with less than 1,000 employees.
³ Non-insurance is not considered alternative risk financing because it does not include a formal plan for funding losses.
⁴ The only risk of guaranteed cost insurance is that the insurer may become insolvent or otherwise unable to pay losses covered by the policy.
⁵ Security requirements are generally met by supplying bonds or letters of credit. In some instances, security in the proper form serves to offset the impact to an insurer’s surplus of a policyholder’s losses or other liabilities.

ABOUT THE AUTHORS

Gregory Ryan is Senior Vice President of Becker & Carlson in Woodland Hills, California. His background includes a number of years of experience in large commercial accounts for international brokerage firms, and 12 years’ experience as a captive insurance and risk management consultant.

James Bukowski is a Senior Consultant for Warren, McVeigh & Griffin, Inc. He is responsible for risk management studies and consulting to private and public entities. Mr. Bukowski is also a senior editor and frequent contributor to The Risk Management Letter.

riskVue | The webzine for risk management professionals
January 2000