ENTERPRISE RISK MANAGEMENT
The hard market could provide
a real boost to finite risk products
By Michael J. Moody, MBA, ARM
Significant growth of finite risk products is expected since they can provide comprehensive "sleep" protection, so that the insured can better manage volatility.
The current hard market was well on its way before September 11, with industry results already on a serious downward spin. But the upwards of $40 billion in losses from the World Trade Center sent hardening premiums even higher. In its first Market Index report following September 11, the Council of Insurance Agents and Brokers (CIAB) found that increases of between 30% and 50% were commonplace. Some respondents to the Third Quarter Commercial Market Index reported renewal increases of 100% or more, CIAB said. Hardest hit lines included property, business interruption, workers compensation and umbrella liability.
However, the first year of the new millennium wasn't finished raising havoc in the financial markets. Insurers and reinsurers were still finalizing their projected losses from the WTC attack when one of the "darlings" of the market--Enron--collapsed and declared bankruptcy on December 4. Many insurance companies will suffer both underwriting and investment losses from this sudden fall from grace.
And then The St. Paul Companies had to spread its own brand of holiday cheer by announcing that it was exiting the medical malpractice market. This market was still reeling from the collapse of the seventh largest writer--Phico. However, the largest writer is withdrawing from the market, leaving doctors, hospitals and other health care professionals wondering where they can turn. At the very least, they will be facing huge rate increases, if they can get coverage at all. It also undoubtedly means that current estimates of an unhealthy 14% to 16% for health care inflation for 2002 may need to be revised upwards.
Taken in total, these events certainly don't serve as a pleasant precursor to 2002. The insurance industry will be spending quite some time digging out of its financial woes, and many other markets may face the dislocations that the medical malpractice market definitely will face. Movements to alternative risk approaches will be forced on many businesses in the United States and some worldwide. And while observers have been quick to point out that a mitigating factor has been an increase in the flow of capital to the insurance industry, there certainly hasn't been enough to make up for the $40+ billion hit from the WTC or to stand behind the rapidly rising premiums that will push premium-to-surplus ratios toward realms that invite regulatory scrutiny. It could take an infusion of more than $100 billion before there is any "real" increase in capitalization.
Make no mistake, additional capacity will be found. However, it will be the insurance-purchasing public that will be providing the majority of it through increased retentions or deductibles, self-insurance, or other alternative risk financing methods. Those who choose to use the traditional insurance industry will be paying dearly for the "new" capacity in the form of higher premiums.
Certainly this hard market will make more converts to the alternative risk market. And as frequently happens, these alternative approaches have the broadest appeal to those accounts that have better loss experience. This leaves the higher loss experience accounts in the traditional insurance market, thus turning it into nothing more than a glorified assigned risk pool. The effects of this on the insurance industry will be profound and long lasting.
"New" alternative risk option
Many of the current crops of alternative risk transfer (ART) products have been born out of the convergence of insurance and financial markets. However, one of the ART methods that holds some promise for the upcoming hard market has been used by the insurance industry for decades. As a group, these are known as finite risk products (FRP). Originally, FRP began as financial reinsurance deals that allowed insurance companies who were unable to obtain traditional reinsurance during past hard markets to have a method of capping their losses. These original transactions were structured on a post-funded basis, and many regulators soon realized that there was limited risk transfer involved. As a result, many regulatory bodies refused to consider these as reinsurance transactions until more risks were actually transferred.
Once these transactions started to incorporate more risks into them, they started to be referred to as finite risk products. Even today, a hallmark of FRP is that they have less risk transfer than traditional reinsurance transactions. Other characteristics that differentiate FRP from traditional reinsurance would include multi-year timeframes, the explicit recognition of investment income in the transaction and, in most cases, a provision for some type of profit-sharing. While the majority of these transactions has been between insured and reinsured, these types of products would be well suited for uses with single-parent captives. Reinsurers also are developing methods of providing FRP to commercial accounts that want to protect their balance sheet while assuming a portion of a loss. Significant growth of FRPs is expected since they can provide comprehensive "sleep" protection, so that the insured can better manage volatility. The fact that the coverage can be designed over multiple years and is typically priced less than traditional reinsurance should increase the usefulness within the commercial market.
Much of the interest over the past few years has centered on the use of finite risk products to complete mergers and acquisitions. FRPs can provide a method of transferring the risk for a specific exposure (e.g., pollution liability, environmental impairment, or even a self-insured workers compensation program) for a set premium. In this way, both parties can come to the table quantifying the cost to eliminate any future liabilities associated with the exposure. A number of high-profile mergers were able to take place due in large part to the availability of FRPs.
Loss portfolio transfer
One of the most frequently used FRPs is the loss portfolio transfer. This is a form of FRP in which the direct insured transfers open claims to a reinsurer. The coverage is specifically designed to retroactively cover losses of an insured's claims that already have been incurred but not yet settled. Typically, the coverage will also be extended to any incurred but not reported (IBNR) claims during the policy period. Loss portfolio transfers have been very effectively used to clean up balance sheets of buyers that have significant amounts of reserves. When properly designed, loss portfolio transfers can provide a variety of benefits to their owners.
One example of the various benefits that are available involves a self-insured pool of public entities. The coverage provided by the pool was limited to general liability. At the time of the transaction, the pool had been in existence about 12 years, having been started in the hard market of the mid-1980s. Over the years, the pool had performed very well and, as a result, had proven to be a cost-effective alternative for its members by providing broad coverage at competitive prices.
Despite its success, the pool continued to maintain an active reserve of open claims, which included provisions for IBNR reserves of about $12 million. Each year, the board of trustees would consider returning a portion of the reserve funds; however, they did not like the possibility of having to go back to the membership for additional contributions, should the pool experience adverse loss development.
This issue became critical in the mid-1990s when some of the members were able to obtain more competitive general liability quotes from soft market underwriters, and were considering leaving the pool.
The board was looking for a method of capping its liability for the open-ended IBNR claims--and do it at a cost that would allow them to return a meaningful amount to the membership. Board members considered several options; however, they decided on the loss portfolio transfer. They secured a LPT program that assumed the liability for all open claims from the first 10 years of operation. Additionally, any IBNR claims were also included as part of the loss portfolio transfer. A premium was agreed to and the reinsurer took over active management of the claims that remained open from the first 10 years. After the transaction was completed, the board was able to eliminate over $9.5 million of reserve liabilities from its balance sheet. Additionally, they were able to eliminate the liabilities at a premium that left over $3.1 million to return to the membership.
At its first meeting following the transaction, the board made an announcement that they would be distributing refunds from the $3.1 million. As luck would have it, this announcement came out about 30 days in advance of the common renewal date for all members. The announcement went on to state that refunds would be distributed only to active members, 45 days after the renewals.
In summary, the pool had performed exactly as it had been designed to do. The original members believed that by providing aggressive loss prevention measures coupled with specialized claims management, the pool could control its own destiny. That is exactly what happened; but without the loss portfolio transfer, they would not have been able to reward the members for their excellent experience until all claims had been settled. Despite the soft market, the pool retained 100% of its membership that year.
Status of enterprise risk management
Where do all these events and actions leave enterprise risk management (ERM)? The ERM concept is essentially based on a common framework for handling risk throughout the organization. By design, this must effect change across the entire organization. A core concept of ERM is to anticipate risks corporate-wide and plan for them. Risks that were once considered remote or even dismissed as improbable will now have to be taken seriously. Losses that result from faulty risk management will be magnified and in most cases will have a significant impact on overall shareholder value.
Getting management's attention
A recent survey--"Risk Management: An Enterprise-wide Perspective"--by the Financial Executives International (FEI) and Anderson Consulting Group has shed some light on how the financial community views ERM. The survey involved more than 400 companies. More than 60% of the respondents were at the level of CFO or higher.
Among the key findings was what the executives considered to be the most significant risks their companies faced. The following risks were noted by over 90% of the respondents:
* Budget and planning risk
* Human resource risk
* Technological innovation risk
* Access/security risk
* Customer satisfaction risk
* Competitive pricing risk.
One note of concern for corporate risk managers was another key finding of the survey. This finding showed "that 65% of the senior executives surveyed indicated that they lacked high confidence that their company's risk management practices identified and managed all potentially significant business risks." Implementation of an ERM program should go a long way to alleviate senior financial executives' concerns about this matter.
All of the recent activity has not escaped the attention of the boards of directors of many publicly owned corporations. As noted in the January 2002 issue of Corporate Board Member magazine, boards now realize that they have the ultimate responsibility for risk management. "Along with top executives, directors must evaluate all the risks to which a company is exposed and the systems that are in place to cover them." The article goes on to say that "risk management objectives and policies must be a key factor in the company's overall business strategies."
This sounds like a clear mandate for the development and implementation of an ERM program. It would appear that the time is right, and champions within the ranks of top management can be found to support the ERM concept. The article concludes, "It won't be long before security analysts, fund managers, and investors recognize the added value in companies that can discern risks and find efficient, creative ways to avoid or mitigate them. ... Those are the companies that will survive these tumultuous times." *