STRIMA

September 18, 2002Branson, Missouri

Alternative Risk Financing

Steven P. Kahn, CPCU, ARM

Managing Director

ARM Tech, an Aon Company

Presented by:

Jenny P. Emery

Senior Vice President

Towers Perrin Reinsurance

A Definition

Alternative risk financing refers to loss funding mechanisms other than commercial insurance.

Exhibit 1

Key Point

Closely evaluate:• Real risk financing needs

• “Hazard” risks and other risks

• All costs of the mechanism

• Financial, political and legal support you will need

Exhibit 2

Loss Portfolio Transfer

In return for a premium payment, an insurance company assumes responsibility for incurred but unpaid claims.

Exhibit 3

Advantages of LPT

1. Establishes a defined level of certainty for future loss payments (up to the policy limits).

2. Insurer is responsible for:• Loss development• IBNR

3. Removes what is often an unfunded liability.

4. May place claims administration responsibility with another organization.

Exhibit 4

Key LPT Issues1. Limits:

• Size of each claim insurer will pay• Aggregate amount insurer will pay

2. Scope of coverage within which claims fall.3. Allocated loss adjustment expenses:

• Insurer pays all ALAE• Insurer pays pro rata share of ALAE• Insurer pays no ALAE

4. Data needs:• Actuarial study:

— Loss projection— Payout pattern

• Claims audit• Discount factor you want to use

5. Data credibility.

Exhibit 5

Finite Risk Insurance

A program in which the insured pays a premium to the insurer based on the losses the insured can expect to pay.

The insurer will pay losses within set limits and credits interest earnings to the insured.

Exhibit 6

Typical Features of Finite Risk Insurance

• Multi-year policy• Insurer has interest rate risk but seeks to

limit this• Insurer has timing risk• Insurer profit is based on fees and use of

funds• Insured has a credit risk• Insured may receive a premium return if

losses are less than expected• Can apply to uninsurable risk

Exhibit 7

Catastrophe Bonds

1. State issues bonds2. If the specified type of loss occurs:

a. Interest is forgivenb. Interest and principal are forgiven

3. Specified losses:a. Earthquake b. Windc. Flood

All exceeding certain size and damage4. A few specifics:

a. Principal put in trustb. Period interest paymentsc. Principal repaid at maturity

Exhibit 8

What is a “Pool”

A group of entities that:– Jointly retain losses to a selected level– Arranges services needed to support the

program

Exhibit 9

Alternative Forms

1. Trust

2. Risk retention group

3. Group/association captive

4. Joint powers authority

5. Licensed insurer

Exhibit 10

Typical Pool Structure

Exhibit 11

Individual Members

Excess Insurance

Pool Retention(Loss Fund)

Loss Payments

Premiums

Services:•Legal defense•Claims administration•Other

Advantages of Pools

1. Reduce cost2. Stabilize cost3. Customized rating plan4. Directed loss control5. High-quality claims service6. High-quality administration7. Broad coverage8. Build long-term equity

Exhibit 12

Potential Disadvantages of Pools

1. Less flexibility

2. Management time

3. Underfunding

4. Industry-specific loss problems

Exhibit 13

Key Issues1. Rating plan that:

• Provides savings to all• Does not result in adverse selection

2. Use of agents

3. Building surplus vs. keeping rates low

4. Sufficient administrative support:• Staffing• Other expenditures

5. “Political” issues

Exhibit 14

Challenges You Have Tackled

• Managing and reducing risk created by state operations

• Optimizing use of commercial insurance

• Measuring and managing risk financing costs for budgetary stability

• Deriving real value from service providers

Exhibit 15

Ideas for Challenges You Should Tackle Next

1. The risk you pay for….indirectly

2. The unreasonable penalties the excess market wants you to pay

3. The de-stabilizing risks that the insurance industry isn’t very good at

Exhibit 16

Sources of Indirect Risk

• “Cost Plus” contracts:– One-time (e.g., construction)– On-going (e.g., outsourced services)

• State-funded services that require minimum insurance:– Social service agencies

Exhibit 17

Example Success Story: Public Sector Transportation

Before

• Six contracted bus companies spending $15 million/year on auto liability

• Poor services; no incentive to manage risk

• Cost passed-through to DOT

After

• DOT-sponsored insurance program:– Large SIR’s

– High limits

– Quality coverage and service

– Incentives to improve risk management

• All-in program cost: $11.5 million/year

Annual Savings: 23%

Exhibit 18

Unreasonable Penaltiesin the Excess Market

• Sources of trouble:– Years of underpricing– Emerging exposures (asbestos, mold)– 9/11– Investment losses

• Impact on buyer of excess:– Expanded definition of “working layer excess”– “Exorbitant” cost for truly remote protection

Exhibit 19

“If the risk is really so remote that I shouldn’t charge much for it, then it’s not worth writing it. I have to charge with the expectation that a loss will occur.”

— U.S. Reinsurance Executive

Example Success Story:NLC Mutual Reinsurance

Before

• Numerous state-municipal league-sponsored pools buying excess

• Typical costs 10% to 25% of premium dollar

• Little negotiating power

After

• NLC Mutual negotiating Reinsurance Treaty on behalf of many pools

• More capacity; better pricing

• Dividends returned to member

Result: 18.86% of PremiumReturned to Members over past 8

yearsExhibit 20

The De-stabilizing Risks

• Terrorism

• Newly emerging (e.g., mold)

• Industry-specific risks

Exhibit 21

Example Success Story:A Work in Progress - Terrorism Pool

250 million xs 50-million250 million xs 50-million

40-million xs 10-million40-million xs 10-million

Companies set their own retentions and buy insurance

The first pool layer is “pre-funded”

The second pool layer is “post-funded”

Offshore Industry CaptiveOffshore Industry Captive

The premiums from the first layer are ceded by the pool to a captive owned by the members

Exhibit 22

A Word About Alternative Risk Vehicles

The Public Sector Bias• They are gimmicks to avoid taxes

– And not relevant to the public sector

• They create lots of “frictional cost”

• They require lots of new structure, which may not be politically palatable

The Truth• They are structured facilities that

can enhance long-term success of self-insurance or risk-retention programs

• The “value” of the added costs can be easily offset by:– Better terms/costs for

reinsurance– Allowing for participation by

multiple entities

• New tools (e.g., segregated cell captives) have greatly simplified formation and management

Exhibit 23

STRIMA

Alternative Risk Financing

Steven P. Kahn, CPCU, ARM

Managing Director

ARM Tech, an Aon Company

Jenny P. Emery

Senior Vice President

Towers Perrin Reinsurance