Could it be that the frequent threat of a hard market cycle that was the bane (for the buyer) and nirvana (for the insurance industry) over 10 years ago is returning after a long sabbatical? It appears that the property/casualty market is beginning to increase the pricing of a number of insurance contracts and insurance company loss ratios can no longer be justified or offset by market investments.

Certainly the rates in a number of states for workers' compensation, medical malpractice, selected professional liability and other high risk areas of insurance are increasing. Added to the premium increases in group healthcare programmes and medical services that are already causing employers to lament, the 21st century corporation is preparing for an increase in the line item on the expense sheet that captures the costs of property/casualty and employee benefit insurance premiums. Historically, a hardening in these markets has caused a rush by medium and large employers to alternative risk transfer (ART) programmes such as self-insurance, group insurance, risk retention groups, and captive insurance.

ART programmes, also called alternative risk funding mechanisms, became one of the fastest growing segments of the insurance industry in the 1980s with an estimated $60 billion in premium and premium equivalent being used to finance losses in programmes other than traditional, commercial insurance policies. Originally used primarily by large corporations, ART programmes became a choice of mid-sized to large companies who were willing to assume large portions of their insurance risks alone or with others.

ART history and appreciation

ART products remained relatively popular, and even grew moderately in some risk areas, despite a soft insurance market in the 1990s, because of their ability to provide customised risk financing solutions that were consistent with the corporation's response to and comfort with risk. They proved excellent vehicles within which an employer could provide its own or sub-contracted comprehensive and tailored risk management services. This emphasis on the management of the frequency and severity of corporate exposures and resulting claims was largely motivated by the employer's assumption of significant risk that is the basis of most ART programmes.

Such programmes were also utilised to avoid the historic cycles of the insurance industry, providing the corporation with level pricing and consistent coverage. ART lovers were able to gain control of their coverage since it enables policy language to be tailored to the specific needs of the insured, even during difficult market cycles in which commercial carriers reduce their costs by excluding or limiting volatile coverages that produce frequent and/or severe claim experience. ART programmes, structured properly, stabilize the cost of risk since the real cost of the programme is dependent primarily on the corporation's own losses, administrative expenses and excess insurance. On the administrative side, the self-funded must manage their own claims and ART thus avoids the rather hefty frictional costs associated with insurance company overheads and residual market loads. These programmes also allow the employer to retain any profits from premium investments as well as reserve surpluses rather than allowing an insurance company to benefit from positive loss experience.

Risk and claims management also motivates the ARTistic corporation to require a more dedicated approach to the identification, evaluation, analysis and mitigation of operational exposures inherent to their specific industry and culture. They are also able to determine how claims will be handled and, which claims should be contested or settled and to select their own legal representation. The ART client is able to gain control over claims costs through an aggressive risk control programme that is often beyond the scope of services of an insurance carrier.

Types of ART available

ART is by definition a creative approach to funding the predicted losses in a given risk area. While most programmes include a substantial retention level by the corporation, there is normally only a partial transfer of risk that includes elements of a traditional insurance programme through the use of reinsurance. As in a traditional insurance programme, the risk above an established and carefully evaluated level is transferred to an insurer through excess insurance, although unlike traditional insurance the retained risk is often not managed by the insurer.

Thus, ART programmes include a variety of mechanisms such as:

  • Large deductibles programmes

  • Self-insured retention programmes

    (SIR)

  • Individual and group self-insurance

  • Captive insurance companies

  • Risk retention and purchasing groups

  • Finite risk and integrated insurance programmes

    Selecting the right ART

    The type of insurance necessary, the alternative programmes permitted, the type of risk in question, the amount of potential risk at stake, and the retention level affordable by the corporation are the primary determinants in selecting the appropriate ART programme. For example, both individual and group self-insurance (SIGs) and risk retention groups are limited to specific lines of insurance by state-specific and NAIC enabling legislation. As a result, alternatives to traditional workers' compensation insurance do not include risk retention groups, which are relegated to liability risks, but do include SIGs. Self-insurance, captives and finite risk and integrated insurance arrangements can be used for many lines of insurance and this alternative programme may encompass several areas of risk. Although some of these ARTistic approaches can be used for multiple lines of coverage, most provide optimum benefits for a limited number of coverage areas.

    Considerations before selecting modern or traditional ART

    Most corporations initially consider ART as an option when traditional insurance has become prohibitively expensive, severely limiting or completely unavailable. ART programmes continue to be used during hard and soft markets as a means of ensuring availability and affordability of coverage. However, if ART appears to be an appropriate option for a corporation, the following issues must be addressed to guarantee the success of an alternative to a commercially purchased programme that places all or most of the underwriting risk on an insurance company.

  • Corporate programme expectations

  • Corporate commitment to resource and management

  • Evaluation of claims history and future trends

  • Ability to reduce exposures, losses and claims costs

  • Adequate identification of exposures: type, location and cause

  • Reasonable corporate retention levels

  • Ability to manage claims effectively

  • Long term commitment to programme

    For an ART arrangement to be successful it cannot simply be purchased and hung on the wall to be admired, since the corporation must have a realistic understanding of the programme's costs, benefits, and limitations. Although ART can be an effective mechanism to reduce the cost of risk over the course of time, the start-up and capitalization expenses can be significant. In addition the ARTistic corporation cannot reduce the cost of losses without hands-on participation in loss prevention and claim management measures.

    Avoiding bad ART

    There is no doubt that an ART programme demands more attention and time from corporate risk management staff than commercial insurance. People must be properly designated and trained to identify, report and manage claims. Loss control and safety programmes must be implemented and may have to be administered by an outside vendor such as a third party administration (TPA) if the corporation has no internal risk management department or function.

    For ART to be a viable option, the corporation must be financially stable, profitable and willing to allocate the funds necessary to finance the ART programme. Revenues, net worth and access to credit (bonds, letters of credit, and other required securitisation methods) must be able to support the ART programme and its losses whether or not the loss experience is favourable. Examining the corporate business objectives and goals, both short-term and long, the last three to five year loss ratios and trends, the current premiums, the corporate aversion to risk and affordable retention levels will determine if ART is an appropriate option for the corporation.

    As an example, a unionised corporation may discover that a self-insured, self-administered workers' compensation programme that includes managed care services such as case management, a preferred provider network, utilisation management and early return-to-work programmes is rejected by its labour force and union. They may feel it is restrictive despite the fact that such medical management will significantly reduce the corporate claim costs.

    Likewise, an employer looking to merge or acquire another corporation may not want the joint and several liability inherent to a workers' compensation self-insurance group that might hinder negotiations with that potential partner.

    An ARTful conclusion

    ART programmes are not for every corporation, even those that are fearful of the pending hard market. However, a properly selected and structured alternative risk transfer vehicle can elicit significant savings if designed properly and the underlying risks managed effectively. Proper evaluation of the corporate mindset, financial capabilities and internal commitment are also keys to selecting a programme that will be a long term success. If the predictions and indications are correct, the year 2000 will see both a hardening insurance market and an increased interest in fine ART - and we may see some really new, innovative and truly modern ART.

  • William Granahan is a senior consultant and risk management consulting practice manager at Milliman & Robertson, in Worcester, MA.

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