Assessing the alternatives in risk financing

While risk financing is commonly understood as the money spent in losses – funded either from self-insurance in terms of internal savings, or from the purchase of insurance – there are many alternative strategies that meet the fiscal demands of risk.

These include “single parent captives, group captives, either homogeneous industry groups or across heterogeneous industries, risk-retention groups, [and] the use of alternative financial instruments such as hedges and options”, according to Allied World’s global chief underwriting officer Mike Hoffman.

Douglas Ure, practice leader Asia, Marsh Risk Consultancy, agrees that many organisations are looking at alternatives to risk financing, adding that “this may mean retaining more risk by raising deductibles, particularly for high frequency and fairly certain losses”.

“Retaining risk on balance sheet or establishing an insurance captive are also fairly common approaches to risk financing,” he says.

Vic Pannuzzo, regional managing director, global risk consulting, Aon Risk Solutions, says when assessing alternatives to risk financing, firms should take a more strategic approach with the objective of reducing the total cost of risk over time. To achieve this, a company should consider four options, he advises.

“Firstly, increased levels of self-insurance, so that they may be able to further improve coverage and limits, enhance loss control, and gain more cash flow advantages,” Pannuzzo says.

“Secondly, annual aggregate deductible structure. [This is] a deductible-type programme under which the insured agrees to reimburse its insurer for its own losses during the policy year up to the agreed upon annual aggregate amount. Once the insured has paid losses up to that amount, the insurer pays the remainder of losses for the annual period without seeking reimbursement from the insured.

“Thirdly, protected cell company (PCC) structures. A PCC’s captive insurance insures the risks of its members and returns underwriting profit and investment income. PCCs allow participants to shield their capital and surplus from other participants in separate, protected cells.”

Pannuzzo adds the fourth alternative is structure reinsurance arrangements.

‘Fiercely competitive’

Philip Ondaatje, managing director, strategic risk solutions, JLT (pictured), says that insurance markets throughout Asia have been fiercely competitive over the past two decades and that this competition “has considerably contained the cost of risk transfer and thus limited interest in alternative risk financing methods”.

Ondaatje says at present it is a buyers’ marketplace for traditional risk transfer and thus clients are not perceiving it as a “challenge” to manage.

“Given the wash of capital in the global insurance marketplace at present, we believe that it would take a major macroeconomic event, such as US interest rate rise, to drive this however,” says Ondaatje.

Nevertheless, Hoffman points out that many of Allied World’s Asia-based clients with global footprints are “using the full suite of risk financing approaches”. “It is difficult to generalise,” he says.

Pannuzzo points out that the key challenges facing clients in risk financing include taking a long-term view of the returns that could come from a more engineered or structured approach to risk financing; lack of risk management resources; conservative approach to risk retention; expectation of immediate returns; and centralisation of insurance purchase and programs.

“We advise all clients that the market has always been cyclical in nature, traditionally in opposite cycles to equity markets, and that they need to be prepared for a potential removal of capital from the marketplace which would drive the total cost of risk upward,” Pannuzzo says.

An analytical approach

So what does the future hold for risk financing? Richard Green, head of financial risk products for Asia, Marsh, says that risk financing innovation is likely to come from a more analytical approach to the challenge, which will allow businesses to make more informed decisions about the risks they choose to retain, transfer or mitigate.

“Beyond a more analytical approach to risk financing, we also see insurers develop new policy structures where risks are shared rather than simply transferred,” he says. “Under such structures, the insured has a much greater financial stake in the performance of their own insurance contracts.

“We may even start to see risk financing programs where clients simply ‘borrow’ capital from insurers at a time of crisis and then repay the insurer over a pre-defined number of years, and in that scenario the risk is genuinely financed rather than transferred.”

Pannuzzo says that as risk management standards improve across Asia, he expects many large multinationals to centralise their procurement and risk management functions and look to consolidate their risk financing strategies with increased levels of self-insurance.

“We also expect more capital market products will take a hold, such as ILS, Cat Bonds and Swaps, although we see this in the insurance industry space not direct insureds,” he adds.

Hoffman says that, after it was discussed as a theoretical possibility for a long time, the convergence of capital markets and insurance was now real.

“The impact is meaningful in the reinsurance world, and you will see that evolution continue and work its way into insurance as opposed to being a purely reinsurance phenomenon,” he says.

“In fact, we already are seeing some of the alternative capital entities deploying capacity directly into the property insurance market instead of operating purely as reinsurers, which largely has been the case up until now. This is a major change in the market that will likely continue to unfold over the coming years.”

Ondaatje points out that the future of risk financing is centred on economics: “Insurance is very much a commoditised spend for many in Asia and there is enough capital available to drive this spend to the lowest denominator,” he says.

“Until there is a significant shift in pricing, I believe the use of alternative risk transfer will remain limited.”