Why is this Topic Important to Financial Professionals? A basic understanding of reinsurance will help the financial professional better understand how alternative risk transfer structures can benefit clients.  Exposure to the concepts allows fundamental understanding that enables advanced planning.

Reinsurance as defined by Black’s Law Dictionary means, “[i]nsurance of all or part of one insurer’s risk by a second insurer, who accepts the risk in exchange for a percentage of the original premium.”[1] Or in other words, “[r]einsurance is a transaction in which one insurance company indemnifies, for a premium, another insurance company against all or part of the loss that it may sustain under its policy or policies of insurance.”[2]

What are some common examples of reinsurance structures?

• Excess lines coverage, in that the risk from the first layer of coverage (let’s say up to $100,000) could be held by one insurer while the excess for a claim of over the threshold could be covered by another insurer, in essence, the first insurer has reinsured the risk of over $100,000 to another party.
• Fronting-“[a]rrangements by which an insurer, for a specified fee or premium, issues its policies to cover certain risks underwritten or otherwise managed by another insurer or reinsurer.  The insurer then transfers all, or substantially all, of the liabilities thereunder to such insurers by means of reinsurance.”[3]

How does reinsurance relate to small business and alternative risk transfer prerogatives?

Non-traditional risks can commonly be reinsured.  If for example, a business were to form or operate a captive insurance company, the company may still employ a way to “lay-off” some of the risk and liability the insurance company just undertook.  The secondary insurance market, or another name for buying and selling reinsurance, is priced differently than the traditional insurance market.  Some claim that one benefit of alternative risk transfer plans is access to this reinsurance market.

Reinsurance is all about managing the risk appetite of the business though a comprehensive insurance management plan.  “Reinsurance, particularly excess of loss reinsurance,” is generally, “characterized by low claims frequency and high loss severity.”[4] Some benefits reinsurance as it relates to risk management are: [5]

• Limiting Liability – amount of risk retention can be determined and set
• Asset Stabilization- risk of loss transferred to another
• Catastrophe Protection-allows for coverage of large risks though risk sharing
• Increased Capacity / Cash- assigns obligations that may not be funded

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[1] Black’s Law Dictionary (8th ed. 2004), reinsurance.

[2] Reinsurance Association of America.  “Fundamentals Of Property and Casualty Reinsurance” Introduction To Property And Casualty Reinsurance. http://www.reinsurance.org/i4a/pages/index.cfm?pageid=3310.  Last Accessed 8/26/2010.

[3] Reinsurance Association of America.  “Glossary of Terms” http://www.reinsurance.org/i4a/pages/index.cfm?pageid=3309.  Last Accessed 8/26/2010.

[4] Reinsurance association of America “Fundamentals Of Property and Casualty Reinsurance”.  Pg. 10.

[5] “Fundamentals Of Property and Casualty Reinsurance” Purposes Of Reinsurance.  http://www.reinsurance.org/i4a/pages/index.cfm?pageid=3310.  Last Accessed 8/26/2010.

Why is this Topic Important to Financial Professionals? Provides a basis for creative ideas to share with clients to create an overall more efficient insurance management plan.  Offers examples of common alternative risk transfer techniques that are cost effective and generally easy to implement.  After all, the client is always interested in saving money.

One common use of alternative risk transfer is the use of deductibles in connection with decreasing overall business insurance expense.  The insured would simply consider raising the deductible amount which would in turn lower premium amount if the claims rate on the coverage is better than the insurance rate dedicates.[1] Generally, the likelihood of an event occurring is weighed against the nature and severity of loss to determine the retention a company chooses to endure.

A basic example is presented below:

Assume that that an insured has X number of workers compensation claims, where a developed loss picture is X, but no individual claim exceeds $200,000.  If the cost of the deductible is greater than $200,000 then the insured may consider raising a deductible – in other words, where the accidents may be commonplace but the cost is not significant.  The author of the above example notes, “the example depends on the risk, classifications, rates, and the developed standard premium, as well as the insured’s ability to engineer and contain losses.”[2]

Alternative example

Another slight variation of the above example, where the business retains the first layer of coverage, is whereby the business retains subsequent layers of risk, essentially creating a stop-gap or stop-loss arrangement.  This example assumes the client is “an asbestos removal contractor,” and the client has to “prove to a school district that [he has] $20 million of liability insurance limits.” Assume the client has “successfully negotiated a premium that reflects a $25,000 [premium] on the primary $5 million (per occurrence and aggregate) insured layer, but purchasing $14 million of annual aggregate limits in excess of the $5 million primary is prohibitively expensive.” [3]

A broker may suggest creating a layer of self-insurance by retaining some of the risk.  Assume, $5-20 million coverage layer will cost $150,000 annually, but insuring $5-15 million will only cost $80,000.  After determining the likelihood of a claim by the school district of over $15 million, the client discovers the risk is very unlikely to occur and wants to retain the risk in favor of reserving cash flow.

Alternatively, the client may want to consider retaining the $5-6 million dollar level risk as well, which would lower the overall premium, but expose the client to a greater likelihood of paying claims.  The client can negotiate with an “excess lines” insurer to insure from $5-20 million and act as a stop-loss or stop-gap with the insurance company as part of the insurance contract.

The contractor has successfully secured the insurance policy, with substantially less of a premium, to meet the school board’s requirements; however, the client has retained some risk involved with any actual asbestos claim costs.  Naturally, for purposes of securing the school board’s contract, the contractor’s balance sheet must be able to justify the retention of the risk.

Author: Benjamin S. Terner

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[1] “Considering Alternative Risk Transfer”. Peter M. Polstein. International Risk Management Institute, Inc. http://www.irmi.com/expert/articles/2003/polstein02.aspx. February 2003.   Last Accessed 8/31/2010.

[2] Id.

[3] “The Corridor Self-Insured Retention.”  Donald J. Riggin.  http://www.irmi.com/expert/articles/2010/riggin05-risk-finance-captives.aspx.  May 2010.  Last Accessed 8/31/2010.

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For additional information on captives see, Advisorfyi.com–States Competing for Captives Insurance Business, Alternative Risk Transfer Revisited, Captive Market Continues to Grow, LLC Series and Cell Companies, Group Captive Insurance Companies and Year End Tax Considerations, and A Dollar Saved…Captive Insurance Company Costs

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Why is this Topic Important to Financial Professionals? This blogticle presents discussion on one area of the insurance world that is a hot topic. More and more businesses are seeking alternative risk insurance structures to cover a variety of risks. Those wealth managers who can assist clients in alternative risk transfer decision making provide additional resources and services over and above other competition.

What is Alternative Risk Transfer, or ART?

Alternative risk transfer, or ART is defined by International Association of Insurance Supervisors, to mean, “[a]ny form of risk transfer that include at least an element of insurance risk, opposed to pure financial risk, other than a pure insurance contract.” [1]

Alternative risk transfer has a long history. “The oldest known trace” of such insurance can be found in a maritime policy issued in Genoa in 1370. “That policy covered the shipment of goods from Genoa to Sluys and the most dangerous portion of the shipment trip, from Cadiz to Sluys, was reinsured.” [2]

Some distinguishing characteristics, as compared to traditional insurance or pure insurance contract, may include but are not limited to:[3]

• Non-traditional risk funding;
• Underwriting income retention;
• Unique and individual underwriting, i.e., lines of coverage can varry depending on types of risk a may be exposed to;
• Access to coverage for risks the conventional insurance market may consider uninsurable or too costly to insure through traditional methods; or
• Potential to reinsure certain risks

Why would a business consider ART?

Generally, there are uninsurable risks or risks that are prohibitively expensive or otherwise unavailable to insure through the traditional insurance market that a business may be exposed to by operating in its environment. These risks pose various threats to the operation of the business, and just as traditional risks such as fire, theft and flood loss are covered though risk diversification, a business may want to consider the possibility of other detrimental events that could significantly negatively impact its business, and take affirmative action to limit the possibility of losses.

The alternative risk transfer market can be divided into two general categories: “(1) alternative carriers and (2) alternative products.” [4] Examples of the former include:

• Self-insurance arrangements
• Captive insurance companies, which could include, wholly owned insurance subsidiaries, group captive insurance arrangements or some combination or multiple structures.
• Risk retention groups, which are generally formed to, as the name states, retain risk within a group of similar businesses or similar risks.

The latter general category may include[5]:

• multiline products
• specialty products written through an insurer such as Lloyds of London
• some derivatives and finite risk products

Generally, the “[i]nsurance industry has realized that though conventional risk transfer solutions are almost always [favored] (when available at viable pricing levels), it becomes essential to investigate the value of non-conventional solutions and to focus on the benefits that can be derived from these solutions.” [6]

In sum, there are situations where alternative risk transfer may be preferable to more traditional alternatives. Wealth managers that can identify potential cost savings for clients through alternative risk transfer present a competitive advantage.

Next week’s blogticle will discuss some particular risks that may be considered for ART.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] International Association of Insurance Supervisors (IAIS).  “Glossary”.   http://www.iaisweb.org/index.cfm?pageID=47##.  Last Accessed 8/24/2010.

[2] See generally Vladimir Njegomir and  Rado Maksimović. Risk Transfer Solutions for the Insurance Industry. Economic Annals, Volume LIV, No. 180, January – March 2009 citing, Herrmannsdorfer, F. (1926), Bedeutung und Technik der Rückversicherung, Verlag von Piloty & Loehle, München,p. 332.

[3] IAIS. Glossary.

[4] “Alternative Risk Transfer”.  Deepak Godbole.  General Insurance Corporation of India Bimaquest – Vol. IV Issue I1, 37, 41 July 2004. http://www.niapune.com/pdfs/Bimaquest/Volume-4_Issue%202/godbole.pdf.  Last accessed 8/24/2010.

[5] Id.

[6] Id. at 39.