Alternative Risk Financing Techniques and Basic Actuarial Loss Projections

1. CONFERENCE PRESENTS Alternative Risk Financing Techniques and Basic Actuarial Loss Projections Jacqueline Friedland, Actuarial Practice LeaderKPMG LLPPhone: (416) 777-8320, Email: jfriedland@kpmg.ca

2. Organization of Presentation • Introduction of alternative risk financing techniques (also referred to as alternative risk transfer or ART) • Discussion about self-insurance • Detailed description of four alternatives • Loss projection techniques and actuarial analyses • Key steps 2

3. Introduction of Alternative Risk Financing Techniques • Commonly used alternative risk financing techniques • Funded deductible program • Self-insurance fund • Captive insurer • Reciprocal insurance exchange • Major decision: whether or not to self-finance (i.e., self-insure) 3

4. To self-insure or not to self-insure? • What is self-insurance? • Considerations in deciding whether or not to self-insure • Availability and pricing • Cost effectiveness • Tailor-made solutions • Enhanced risk management • Control • Characteristics conducive to self-insurance • Critical success factors for self-insurance • Disadvantages of self-insurance • Importance of reinsurance and/or excess insurance 4

5. Major decision: Is self-financing appropriate? • Decision is simply a financing or operational decision • Key decision: Is organization prepared to retain and finance potential losses instead of transferring risk? • “Through the years, the term “self-insurance” has been used loosely to describe a wide variety of risk financing arrangements through which organizations pay all or a significant portion of the costs of selected classes of their own losses.”1 1 Source: The Art of Self-Insurance by David A. North and Catherine D. Bennett (2002 Sedgwick Claims Management Services, Inc.). 5

6. Examples of Self-Insurance • Small business purchasing automobile physical damage with a $500 deductible • Large oil and gas company purchasing property catastrophe coverage with a $1 million deductible • Associations that pool their risks and pay for members’ losses 6

7. Assume Prefunding – Regardless of Selected ART • Assume prefunding for expected losses and operating expenses for all four ART techniques • Prefunding at beginning of each policy year • Can take form of insurance premiums or contributions depending on nature of techniques • Many of the drivers for self-insurance relate to assumption of prefunding 7

8. The Drivers for Self-Insurance • Availability and pricing • Cost effectiveness • Tailor-made solutions • Enhanced risk management • Control 8

9. Availability and Pricing • Major motivating factor is dissatisfaction with existing insurance coverage or costs • Related to insurance market cycle • Market cycle affects price, cover, limits, etc. • Restrictions often first noticed in long tail coverages or high-risk exposures and industries • Primary reason for self-insurance: take control over one’s insurance destiny • Situations in which commercial market ignores an organization’s favourable loss experience 9

10. Cost Effectiveness • Reduce long-term costs • Reduce insurance company expenses • Retain investment earnings • Retain underwriting profits • Greater degree of control in litigation and claims settlement strategies • Improvement and management of cash flow 10

11. Tailor-Made Solutions • Often related to lack of availability of required coverages • Address unique exposures • Tailor-made solutions include: insurance product, underwriting standards, policy terms and conditions • Help facilitate change • Increase underwriting and retention funding flexibility • Improved loss control efficiency • Promote greater awareness 11

12. Enhanced Risk Management • Ability to improve and enhance risk management operations • Elevation of status of risk manager, and of importance of loss prevention and cost containment programs • Incentives for more proactive risk control and claims management techniques 12

13. Control • Often cited as independent benefit • Increased control over: • Costs • Investment income • Availability of coverage and limits • Structure of insurance program • Underwriting standards • Risk management programs • Claims and litigation management • Assists in control of volatility (e.g., avoid premium swings due to market cycle) 13

14. Characteristics Conducive to Self-Insurance • Require an estimate of expected losses and expenses • Ideal candidate: high frequency-low severity • Long-tail lines of insurance also conducive due to retention of investment income • Comments on general liability (GL) • Long-tail line of insurance • Not typically high frequency-low severity • Litigation is frequent, thus greater uncertainty • Nevertheless, many self-insure GL • Reasons for self-insuring GL: high costs and unavailability of acceptable coverage, terms and conditions, limits • Excess insurance critical 14

15. Critical Success Factors for Self-Insurance • Long-term commitment • Need clearly defined specifics of coverage • Ancillary risk management services 15

16. Key Considerations and Disadvantages of Self-Insurance • Increased administrative responsibilities • Variability in losses • Pricing of other lines of insurance • Capitalization requirements • Excess coverage • Competitiveness of commercial market 16

17. Funded Deductible • What is a funded deductible program? • Choice between pre-determined deductible amounts • Deductible levels established based on negotiation • Key determinants of deductible amounts: • Frequency of losses • Average value of claims • Ability to estimate expected losses • Cost of risk transfer above deductible • May have aggregate limit 17

18. Funded Deductible (Continued) • Risk transfer premium • Contributions for deductible layer • Total premiums • Separate account accruing investment income • Good first step 18

19. Self-Insurance Fund • Annual contributions for expected losses and expenses • Actuaries frequently involved • Critical requirements for successful operation, well-defined: • Coverage • Policy documents • Limits of coverage • Annual assessments not tax deductible • No capital and surplus requirements • Provision for potential of unanticipated large losses in early years • Excess insurance is important 19

20. Captive Insurance Company • What is a captive? • Types of captives • Single owner/parent captive • Group captive • Industry captive • Association-owned captive • Agency captive • Segregated portfolio company • Protected cell company • Incorporated cell company • Rent-a-captive • Sponsored captive • British Columbia captives • Captives and fronting insurance companies • Regulation and operational considerations 20

21. Reciprocal Insurance Exchange • An insurance market of reciprocal agreements of indemnity or insurance among persons known as subscribers • Attorney-in-fact • Subscribers liable for their share of losses and expenses • Not-for-profit, tax-free status • Actuary used for pricing and reserving • Direct access to reinsurance market • Operating costs • Capital and surplus requirements • Regulatory and financial reporting requirements 21

22. Loss Projection Techniques and Actuarial Analyses • Types of data required • Diagnostic analyses • Multiple projection methods • Development • Expected claims • Bornhuetter-Ferguson • Severity-frequency • Stochastic analyses • Actuarial analyses • Annual contributions • Cash flow projections • Surplus requirements • Financial statement 22

23. Key Steps • The self-funding continuum • Long term commitment is critical to success of any self-funded program • Most important decision – not which ART techniques, but is the move towards self-funding appropriate • Need to identify stakeholders • Identify and collect data and information • Conduct actuarial analyses/feasibility study • Ascertain the appetite for risk of key parties • Select and develop program • Implement • Monitor 23

24. THANK YOU FOR ATTENDING THE CONFERENCE ENJOY THE REST OF YOUR CONFERENCE! 24