The ART of Self-Insurance
THE RHA REVIEW
Volume 8, No. 2, First Quarter 2002
By Donald W. Bendure, MBA, CPCU, RPLU, RF, ACI
If the forecast for insureds in 2002 is true to expectations, then, in the words of Mae West, "Fasten your seat belts, boys. It's going to be a bumpy ride."
Insurance rates are going up. Way up. In a survey by the Commercial Insurance Market Index of 2001 renewals, more than 50 percent of all medium and large commercial accounts saw premium increases in excess of 30 percent. The excess layers of insurance are increasing premiums at a significantly higher rate than the lower layers. This leaves less money to cover the lower layers of exposure (or the more predictable burning layers, as they are sometimes called) in order to be comfortable that the larger catastrophe exposures are adequately insured.
Insurance capacity is going down. Way down. Enter the random acts of violence and fraud none of us expected: the World Trade Center and Enron. The insurance industry is capitalized at roughly $300 billion. Present estimates are that the WTC has removed approximately $100 billion from that capital. Enron will most assuredly blow through $350 million in Directors' and Officers' liability limits, adversely affecting the D&O markets. "Enron," now a verb, will affect most stock market accounts that have remotely confusing or difficult financial statements. Andersen will most assuredly blow through its Accountants' Errors and Omissions limits, adversely affecting the limits available for E&O coverage in general. The grandfather of all highly protected risks, Industrial Risk Insurers, has lost the taste for insuring high limits on property, limiting its usual 100 million and higher capacity to a maximum of 10 (that's 10) million. As it was in the 1986 insurance crisis, even Congress is getting into the act, and now we even have our very own House Financial Services Committee for the venue. One of the top 10 largest insurance companies in the country announced in January that its losses for just the fourth quarter of 2001 would exceed $1.6 billion, attributable to the WTC, Enron and other events.
What's an insured to do?
By the end of this year, many insureds will seriously consider self-insuring some of their exposures to loss. For those who have the ability to consider alternative ways of handling risk, self-insurance is coming back into the spotlight. Done well, self-insurance can be a very cost-effective, efficient and gratifying method of handling risk. Done improperly, self-insurance can be a nightmare of misunderstandings and litigation. Most, if not all, however, need guidance in this pursuit.
Self-insurance is sometimes referred to as "alternative risk transfer," or ART. In the truest sense, it is not risk transfer at all but a program of self-funding. There are many varied and sometimes elegant techniques of keeping one's own exposure, most having to do with cash-flow funding or tax consequences. Providing layers of excess insurance over self-insurance layers requires careful crafting but is most important if the insured is to realize a beneficial program.
Several questions need to be addressed by the prospective self-insured. Taking into consideration market conditions, some important questions that should be asked are:
- How much risk is the self-insured willing or able to take? There are many approaches to this question, some involving financial limits, but mainly the risk appetite for the self-insured comes into play here. Exploring these limits provides the main opportunity for development of a successful program.
- How predictable are the expected losses within the self-insured limits proposed? If the amounts of losses are highly predictable, then the self-insured can better budget for them and reduce costs by eliminating the elements of insurance premiums that would not serve to pay those costs.
- What are the benefits to be derived from self-insurance? The self-insured can create stability of coverage for hard-to-place exposures by being willing to accept the risk in the lower layers. This acceptance instills confidence in the insurance market for the excess layers. Also, special needs for claims handling can be satisfied while at the same time providing for the risk financing of the self-insured layers. Loss prevention and mitigation become very important for the self-insured and can translate into significant savings for the overall program.
If this author's hunch is correct, nowhere will the self-insurance spike be felt more acutely than in the Directors' and Officers' liability insurance for large companies. Many reports indicate that self-insured retention requirements for D&O are doubling and tripling, and most carriers now require co-insurance with the excess carrier. This keeps the self-insured involved completely through the excess insurance limits and beyond. You could call this the "Buzz Lightyear" approach to self-insurance. Under these conditions, loss prevention and mitigation become all the more important to the self-insured. By the end of 2000, carriers offered $50 to $100 million in D&O limits in excess of nominal self-insured retentions. By the end of 2001, the typical limit offered was $10 million, with a very few offering a maximum of $25 million. Moving coverage to a different carrier is complicated by the usual exclusion requirement for pending and prior litigation. Clearly, self-insurance will become more common in the lower layers of this coverage, which has become "Enronized."
Medical malpractice capacity and coverage are areas of insurance that have quietly melted down while other calamities have captured the headlines. These areas are ripe for self-insurance. Many captives which have lain dormant for many years because of the soft market are now being dusted off and put back to use. Feasibility studies are always a requirement for these ventures, and much care must be taken in order to structure the coverage and excess layers that are normally supported by reinsurance. Some states have attempted to respond to the lack of capacity by enabling companies to form risk-retention groups and joint underwriting associations. Washington, D.C., Montana and South Carolina are the newest entrants into the self-insurance market through the captive insurance laws passed there recently.
Activity abounds in the feasibility study area for many traditional classifications of exposures, such as trucking, recently hit hard by insurer premium increases. Many self-insurance programs rely on lines of coverage that have high frequency and low severity to balance the portfolio of self-insurance and the predictability of the layer. Workers' Compensation, General Liability and other lines less severe in nature can be used to provide this predictability. Many of these combinations of coverage can be compared and contrasted in the feasibility study prepared as the basis for the self-insurance layer.
Remember, a thorough feasibility study is an opportunity for an insured to understand its risk profile better. Such a study could easily point out alternatives that the insured had not considered that will keep Buzz Lightyear firmly planted on the ground. Until then, keep your seat belts on. It's going to be a bumpy ride.