Analysis of Risk Transfer Products

In a shifting marketplace, it is important to know the different types of risk financing
products and how they may or may not fit your particular situation. The selection of the
appropriate risk financing product will be a decision based on the level risk tolerance of
the insured, Balance Sheet of the insured, Loss Experience of the Insured, the
marketplaces willingness to offer such products and risk management knowledge. Also,
a detailed analysis of the cost/benefit of each approach is warranted. In this article we
will explore guaranteed cost, retrospective rated plans, deductible plans, captive
programs and self-insurance programs.

Guaranteed Cost

This plan is most often used by businesses for their workers’ compensation. The insurer
sets the rates at the beginning of the policy term, based on worker classification and
prior loss experience. The rates remain the same throughout the policy period regardless
of the losses experienced during that term of coverage. The insurer pays all losses and
associated expenses. In a Guaranteed Cost policy, the only variable affecting premium
that should change between policy inception and audit is payroll.

Generally accounts with annual premiums under $100,000 fit best in this program. The
loss experience during the policy term will impact their premium in future years, but not
in the current year. Accounts that have inconsistent loss experience from year to year
will also benefit from the Guaranteed Cost plan.

Advantages of this program include fixed cost, all inclusive coverage and no risk
involved to the policy holder. Because the insurer assumes all of the risk a disadvantage
may include higher policy year costs, no savings during low loss years and premiums
are subject to market fluctuations. For most accounts, though, avoiding the risk of
paying additional premium in a bad year out-weighs the disadvantages.
Retrospective Rated Plans (Retros) Retrospective means “looking back on” and that is exactly how this plan works. The
ultimate premium is calculated after the policy expires, based on the loss experience of
the policy year. This plan is one in a group of plans also referred to as “loss sensitive
plans”. When considering a retro option, it is vital to be able to reasonably predict

In a retro plan, the insurer issues the policy using an estimated rate per classification.
Approximately six months after the policy expires the first calculation is made to determine if the account will owe additional premium or receive a return premium based on the loss experience of that policy term. Additional calculations will be made at 12-
month intervals, usually for a period of three to five years. The final premium is subject
to a predetermined minimum and maximum total premium.

A retro provides a simple manner of making premium cost loss sensitive. Expenses
remain the responsibility of the insurance company. For those employers that effectively
control their losses, the premium is lower than on a guaranteed cost plan.
Conversely there are also disadvantages to this type of plan. If the loss experience
exceeds expectations the ultimate cost is greater than the guaranteed cost plan. In
addition, rather than closing out the premium cost after one year the final premium is
not determined for several years. This can be quite costly as serious losses develop over
a period of years.

Deductible Plans

Deductible plans, a true form of self-insurance, allows an employer to reimburse an
insurer for workers’ compensation liability losses, up to a stated deductible amount, in
return for a lower premium. These plans are used for accounts that would generate
premium well into six figures under a guaranteed cost plan.
As with the retro plan, it is crucial to be able to realistically predict losses. However, an
account that has had problems in the past that have been corrected may benefit greatly
from this plan.

The insurer issues a policy of workers’ compensation similar to that of a guarantee cost
plan. The insured is responsible for first portion of any loss up to the agreed deductible
figure, including claim handling expenses. The policy will also contain an aggregate
deductible, which limits the insured’s maximum exposure during the policy term. These
plans require collateral, usually in the form of a letter of credit. The up front costs in this
plan may be greatly reduced, 25-40% of the normal premium, and the possibility for a
lower overall cost is substantially greater than a retro plan.

Of course, there are also disadvantages with this type of plan. Poor loss experience can
generate costs that far exceed a guarantee cost plan. Some claims can take a long time to
close and the client may find they are making payments over a multiple of years.
Further, the required collateral can reduce the firm’s credit lines and will multiply with
each policy year the insured remains on the deductible plan.

Captive Programs

A captive program involves much more than purchasing insurance — the insured also
becomes an insurer. A captive is an insurance company that is formed to provide
insurance to its group or association of owners. A captive solution may be effective for
a single parent company, members of a common industry, or a group of unrelated
parties who want to share risk.

In this type of program, the insured becomes a member or owner of a reinsurance
company. Along with other insured’s, premiums are paid forming a pool to pay losses.
An insurance carrier, otherwise called the fronting carrier, issues the policy, although
the insurance company assumes very little of the risk. The premiums paid by the
members are forwarded to the insurance company who, in turn, sends the funds, after
expenses, to the captive group. The captive is then responsible for paying losses.
The up front cost for this program is typically somewhere between the deductible plan
and retro plan pricing. The premiums are used to pay expenses to the fronting carrier,
taxes, loss control, claim expenses and reinsurance costs. The captive normally
purchases aggregate reinsurance to protect its members. Collateral is required for the
difference between the premium collected and the maximum liability of the insured. The
maximum liability to the insured is usually equal to one year of estimated losses. The
insured will also be required to share in some part of the severe losses of other

Advantages of entering a captive plan can be substantially lower up front premium,
especially in a difficult or hard market, stability of coverage and pricing and more
control over claims. The account can also realize a profit down the road in underwriting
profits and investment income. Participation in a captive program should be a long-term
financial decision as its biggest advantage is to even out the cyclical nature of the
insurance marketplace.

Disadvantages include possible significant penalties, long-term capital investment,
responsibility for other member losses and loss of access to credit lines or collateral.

Self Insurance

The lowest fixed cost program is self-insurance. With that benefit also comes the
greatest level of risk. In addition, regulatory and administrative responsibilities can be

State approval is required for each state where an account wishes to self-insure. In
California, the approval process takes on average six to twelve months. Among other
requirements, the account must have at least $5 million shareholder equity, average net profits of at least $500,000 and certified, audited financial statements. Collateral equal to 135% of estimated losses must be posted, subject to a minimum of $220,000.
Although excess insurance may be purchased, self-insurers are required to retain a
minimum of $120,000 per occurrence and $1,000,000 aggregate annually.

There are significant advantages to self-insurance programs over the above discussed
options including the lowest fixed costs, maximum use of cash, control over claim, and
no need to remarket insurance coverage year to year.

Comparing this to the other plan options disadvantages are; governmental regulations,
controls and monitoring are time consuming, it carries the highest degree of risk,
requires a substantial long term commitment, is difficult to accomplish in multi-state
employment situations and ties up collateral to the greatest extent. There are also
limitations to tax deductions versus the other programs discussed as well as short-term
adverse accounting implications.