Allocating Risks Among Market Participants: Lessons from the Insurance Industry

1. Allocating Risks Among Market Participants:Lessons from the Insurance Industry Presentation to: Rethinking Credit and Collection for Gas and Electric Deregulation Conference Roger Colton Fisher, Sheehan & Colton Belmont, MA January 1998

2. The Insurance Industry Models • Three types of "public pools" exist: • Customers failing to select competitive provider • Payment-troubled, disconnected • High cost / bad risk

3. Risk Allocation Pool Inappropriate • Reasons why customers failing to select a competitive provider should not be part of a risk allocation pool. • Different policy considerations exist: • Not how to allocate high risk or high cost • How to "jump start" the competitive market • How to overcome market barriers to "choice"

4. Models of Public Pools • Three models to allocate risks in high risk/high cost public pools: • Assigned risk plan • Joint underwriting association • Reinsurance facility

5. The Assigned Risk Plan Model • Develops a standard set of rates and policy terms for assigned risk business. • Companies are assigned unwanted policyholders on a random basis, generally in proportion to the amount of total insurance that the companies do in the state. • The company to whom a consumer is assigned takes full responsibility for either the profit or the loss resulting from its "assigned risks." • The company provides all of the services normally coincident with the insurance policy, including accepting premium payments, paying claims, and performing the other ordinary business functions of providing insurance.

6. Joint Underwriting Association Model • A limited number of companies --frequently known as "servicing carriers"-- agree to handle all of the involuntary business. • The servicing carriers perform all of the functions of the insurance carrier • The servicing carriers are compensated for providing these services. • Although policies are issued in the names of the servicing carriers, the risk is borne by the association. • The association's underwriting losses are made up from surcharges imposed upon public pool participants as well as by "residual market equalization charges" imposed on all insureds in either the voluntary or residual market.

7. Reinsurance Facilities Model:Overview • Through a reinsurance facility, the risks imposed by public market participants are "reinsured" through a public pool facility. • A reinsurance contract is precisely what it indicates: a contract through which an insurer procures a third person to insure against loss or liability by reason of the original insurance. • The reinsurance facility involves a paper transaction between the facility and the insurance company that is often transparent to the consumer. • The insured will generally pay the same rate as found in the voluntary market. • The profits or losses from facility operation are shared proportionately among all facility participants.

8. Reinsurance Facilities Model:Eligibility for Coverage • Objective measure: Carriers can cede "unacceptable risks" to the reinsurance facility. An "unacceptable risk" is one that statistics prove will be unprofitable. • Subjective measure: Insurance carriers have an absolute right to cede a risk to the state reinsurance facility. The only criterion for eligibility is that the company does not wish to retain the risk without regard to any objective criteria. • Market driven: Consumers who are otherwise unable to obtain coverage in the private market will be served by the pool.

9. Reinsurance Facilities Model:Allocation of Costs • Apportionment can be based on market penetration. In this scheme, losses/profits are apportioned irrespective of the number of risks ceded to the facility. • Apportionment can be based on facility utilization. In this scheme, losses/profits are apportioned based on the degree to which a company uses the facility relative to total facility use. • Apportionment can be based on a weighted average. Use of a weighted average might, for example, be based on 80% facility use and 20% market share. • In some instances, liability capped at 1% of net worth, to protect small companies.

10. Reinsurance Facilities Model:Distribution of Gains • Any gain after loss payouts is distributed to persons served by the facility. • Only way for carrier to make a profit on the customer is to retain the customer in the private market.

11. Assessing the Relative Merits: Defining Five Criteria • Whether new entrants are encouraged; • Whether suppliers and/or incumbents retain management flexibility; • Whether supply and cost responsibility are shared by all market participants; • Whether the structure and/or process addresses all three target groups; • Whether the structure/process succeeds in promoting universal service.

12. Assessing the Relative Merits: Applying the Criteria (#1 of 2) • Residual market mechanisms in the insurance industries are not designed to encourage new market participants. If incorrectly designed, however, these mechanisms may interfere with the entry of new companies. • Different residual market mechanisms grant different levels of management flexibility to industry participants. Reinsurance facilities grant maximum flexibility to industry participants. Assigned risk pools and joint underwriting associations provide for little, if any, flexibility. • All residual market mechanisms in the insurance industries provide for a sharing of costs between companies. Cost allocation can be based on unweighted facility use, unweighted market share, or a weighted combination of the two.

13. Assessing the Relative Merits: Applying the Criteria (#2 of 2) • Neither the assigned risk pool nor the joint underwriting association directly address universal service for the poor. Consumers who have lost insurance service because of the failure to pay premiums are specifically excluded from participation in the residual markets. This operates against the interests of low-income consumers since these mechanisms often offer service at significantly higher prices. • Assigned risk plans and joint underwriting associations fail to promote universal service. They have been found to result in lesser service being provided at significantly increased rates. In addition, excessive cession of "clean risks" to these pools impedes universal service.

14. Advantages of Using Insurance Models • There is an established mechanism for sharing the costs of the residual market. A variety of cost-sharing methods have been explored, modified, and abandoned. Various cost-sharing methods have been found to be both effective and fair. • The cost sharing mechanisms are competitively neutral. Neither consumers nor market participants can choose to avoid the costs of serving the residual market through a selection of carriers or through a selection of services. • The reinsurance facility approach maximizes consumer choice. Residual market participants are not assigned to an unwilling carrier. • The reinsurance facility approach also maximizes management flexibility. Management is left to decide whether to serve the residual market, how to serve that market, and how to manage the risks of serving that market.

15. Disadvantages of Using Insurance Models(page 1 of 2) • Rather than allowing for management flexibility and innovation, the assigned risk pool seems to adopt the worst aspects of the electric utility industry's cost recovery philosophy. There is no incentive for, and no reward for, managing the risks in the residual market and lowering the cost of serving the residual market. • Unless provided through a reinsurance facility, under which residual market customers are provided the same service at the same rates as other customers, the residual insurance pools do not promote the affordability of insurance service. As a result, the "availability" of insurance may be illusory given its unaffordability.

16. Disadvantages of Using Insurance Models(page 2 of 2) • Unless cost allocations are based on facility use (including some type of weighted approach), limits are placed upon the cession of risks, or specific incentives are provided to consumers through the voluntary market, there is a strong tendency for residual insurance markets to become over-populated. • Without specific incentives created to move residual market participants into the voluntary market, consumers remain in the residual market. • Given a facility-based cost allocation method, and an assumption that new market entrants tend to under-price service thereby attracting a disproportionate share of residual risks, such a cost allocation serves to discourage new entrants.

17. For more information: roger@fsconline.com