Structured Risk Finance Offers an Alternative to Annual Renewals

Rising loss costs, higher excess liability rates, and growing coverage restrictions are prompting organizations to consider alternatives to traditional annual insurance programs. During an IRMI webinar, Steve Bird, director of risk management at Zachry Group, and Michael Meisten, senior vice president and chief broking officer at American Global, examined how structured risk finance programs can help organizations manage volatility and use capital more efficiently.

Claims trends vary by industry, coverage line, geography, jurisdiction, and the effectiveness of an organization's safety and loss control practices. However, Mr. Bird said loss cost inflation, social inflation, nuclear verdicts, and difficult legal jurisdictions have contributed to more frequent severe claims.

Those trends can affect an organization for years. Insurers may consider 7 to 10 years of loss history when underwriting a risk, meaning an unusually severe loss or several difficult years can continue influencing insurance costs long after an organization has taken corrective action.

Commercial insurance conditions also vary by coverage. Mr. Bird said increases in some primary casualty lines have moderated, while property and workers compensation rates may be flat or declining for some insureds. Excess liability remains more volatile, however, with some organizations encountering rate increases of 10 percent to more than 20 percent.

Coverage restrictions have also expanded as new risks emerge. These market conditions can create inefficiencies when organizations transfer losses that are predictable and financially manageable while paying insurers to assume them.

Moving Beyond Large Deductibles

Large-deductible and self-insured retention programs are often an organization's first step toward retaining more risk. These arrangements can reduce upfront premium, provide greater involvement in claims, and make annual costs more predictable than guaranteed-cost coverage.

However, traditional programs generally maintain separate deductibles, limits, and annual terms for each coverage line. Organizations must also negotiate renewals every 12 months and may accumulate substantial collateral requirements over time.

A structured risk finance program can combine shared retentions and aggregate limits across multiple coverage lines under a multiyear arrangement. Depending on the organization's exposures, a program might include general liability, auto liability, workers compensation, property, professional liability, or pollution liability.

The webinar used a 3-year arrangement to illustrate the concept. In the example, the insured retained up to $5 million per loss, subject to a $15 million annual aggregate and a $25 million aggregate for the full term. A structured layer above that retention provided additional limits over the same 3-year period. The figures were illustrative, and the speakers emphasized that retentions and limits are negotiable and should reflect the insured's risk profile.

Rather than renegotiating coverage annually, the organization receives defined terms for the multiyear period. This can reduce exposure to short-term insurance market fluctuations and make losses easier to project. While an organization may have difficulty forecasting losses for a single year, its average loss experience may be more predictable over 3, 6, or 9 years, assuming its operations remain relatively stable.

Sharing Underwriting Results

Structured programs may also allow an insured to participate in favorable or unfavorable underwriting results. In another webinar example, an insurer charged a $7 million premium, allocated $6 million to expected losses, and retained $1 million for underwriting expenses, capital costs, overhead, and profit.

If losses ultimately came in below the $6 million estimate, the insured and insurer could share the resulting underwriting profit according to a predetermined formula. If losses exceeded the estimate, the insured could owe an additional premium based on an agreed calculation, subject to a maximum cost.

This approach gives organizations that have invested in safety, loss control, and claims management an opportunity to receive a financial benefit when losses perform better than projected. In exchange, the organization accepts some responsibility for adverse results. Aggregate protection can cap that exposure if losses are significantly higher than expected.

Structured risk finance does not eliminate insurance risk. Instead, it distributes the financial effects over a longer period and establishes in advance how favorable and unfavorable results will be handled.

Evaluating Whether a Program Fits

Developing a structured program begins with establishing the organization's short- and long-term business goals. Its insurance strategy should support those objectives and reflect where the company expects to be in 18, 36, or 60 months.

The process also requires a detailed review of loss experience, safety and loss control procedures, contractual risk transfer, coverage gaps, and sources of claims volatility. Even if an organization ultimately decides against a structured program, Mr. Bird said the review can reveal weaknesses or opportunities for improvement in areas such as driver training, quality control, vendor agreements, and claims practices.

Mr. Meisten suggested organizations begin examining alternatives when premium or other financing costs approach 20 percent of the insurance limit purchased. He described a premium-to-limit ratio of more than 30 percent as inefficient, although the appropriate threshold will depend on the organization.

Risk-bearing capacity and risk appetite must also be considered separately. A company may have the financial capacity to absorb a large loss without being comfortable retaining that amount. Increasing a deductible from $500,000 to $5 million solely because modeling suggests long-term savings would not necessarily align with management's tolerance for volatility.

Addressing Collateral and Claims

A structured program can take 6 to 24 months to evaluate and implement. Organizations may need time to model losses, secure internal approval, assess collateral, negotiate coverage, and identify fronting and excess insurance markets.

Existing collateral obligations do not disappear when an organization changes its risk financing approach. Potential options discussed during the webinar included cash or other assets held in trust and surety bonds used to offset some collateral requirements. These costs must be included in the overall analysis.

Fronted policies can allow an organization to satisfy contractual or regulatory insurance requirements while retaining much of the underlying risk. A fronting insurer issues the policy and certificates of insurance, while the structured arrangement provides a mechanism for funding retained losses. A single-parent captive insurance company may also participate in the retained layer, while group captives typically involve a different structure and longer commitment.

Operational considerations extend beyond financing. Organizations should address day-to-day claims handling, settlement authority, access to specialized services, and the involvement of fronting and excess insurers. Larger retentions can provide an insured with more influence over claims, but those responsibilities and authorities should be established before the program begins.

Structured risk finance is not suitable for every organization or coverage line. The webinar emphasized that its value depends on loss predictability, financial capacity, risk appetite, collateral requirements, operational needs, and a willingness to make a multiyear commitment.

Watch the full webinar HERE for the complete discussion of structured risk finance programs and their operational considerations.