Alternative Risk Financing
This article is intended to provide a brief summary of risk financing for local authorities to enable consideration to be given to the alternatives available. Any decisions made should be undertaken on individual merits following thorough financial review with a risk financing specialist.
How do you finance risk?
All Local Authorities purchase insurance, although the only class that is mandatory to purchase is Fidelity Guarantee – the protection of the public purse1.
Most large Local Authorities also finance risk in a sensible way by taking substantial levels of self-insurance to reduce the frictional costs of pound swapping with insurers. However there are many authorities who have largely the same insurance programme now as they did 10 or even 20 years ago - despite undergoing significant internal and external change.
Insurance Premium Tax (IPT) has increased from 6% to 9.5% and will rise again to 10% in November 2016, therefore the cost of purchasing insurance has increased.
Why would you choose to insure or self-insure?
The simplest reason for insuring is to remove the potential risk of uninsured losses. Your balance sheet would be exposed to substantial fluctuations from good to bad years.
The choice to insure should be based on a number of factors:
- How much risk are you willing to take on to your balance sheet?
- What protection (cover) is available?
- Will the protection pay in the event of a claim? (Cover / Insurers financial solvency / Claims Handling abilities)
- What is the cost to transfer the risk?
The latter point is particularly important in assessing what level of insurance is to be purchased. When insurance is cheap (soft market conditions) it may be much more cost effective to transfer as much risk as possible to an insurer for a fixed cost. However, when costs are expensive (hard market) consideration should be given to increasing your levels of self-insurance.
Undertaking an actuarially modelled Programme Design Exercise is the ideal method to assess the options available to you. This work enables you to see how many claims fall within different cost bandings and where the likely transfer to an insurer becomes cost effective.
Most large Local Authorities will undertake periodic reviews already to assess their levels of self-insurance and this is a sensible and prudent move.
What are the alternatives to insurance?
ART (Alternative Risk Transfer) solutions represent an alternative to conventional insurance including Captive, Risk Pooling, Discretionary Mutuals. There are certain “drivers” which make such options more attractive.
- Lack of Capacity or competition in the composite insurance market
- Instability of the cost of insurance in the short to medium term
- Local Authorities already retaining significant levels of risk
- Higher rates of Insurance Premium Tax
- Pressure to save money – i.e. external insurance costs
This may make alternatives to traditional insurance worth reviewing. Whatever alternative is used, the benefits would be the greater level of control afforded to the owner of the “ART” solution, the reduced tax burden and greater level of return of investment where underwriting profits are made.
However there are potential risks of each of these methods with a greater level of self-insurance likely to be taken; so a year with a poor claims experience directly impacts the organisation. There is also a greater need to retain significant sums on balance sheets to protect against risks where you need to maintain higher levels of self-insurance due to the increased exposure.
However on balance, we consider that the time is approaching where ART solutions need to be reviewed again by Local Authorities to compare these to what is being offered by the traditional insurance market.
The continuing push to work together whether via Combined Authorities, Shared Services or any other mechanism is creating more cross-border work and the potential for risks to fall between two or more authorities. The use of some form of ART solution across partner organisations could remove this risk and enable a wider consideration of risk to be applied instead.
Risk Pooling is a method used substantially in the United States to enable public entities to purchase cover efficiently. Such methods could be considered in the UK to share risks across organisations. However, to ensure one Authority is not simply subsidising another, Actuarial methods can be used in exactly the same way as undertaken by an insurance company, to allocate premiums across the members. This would use a pre-agreed calculation structure signed off by all members based upon the risks insured, loss experience and possibly including risk management work evidenced by each member. In essence, you are becoming the underwriter yourselves.
Within the Localism Act, there are powers for Local Authorities to form insurance mutuals2 and this followed case law confirming that the “Teckal” exemption applied to such mutuals. However, to ensure that the Authority is genuinely getting the best financial outcome we would recommend that an actuarial review is undertaken to provide an assessment comparing the cost of insurance coverage via that obtained via any other method of Alternative Risk Transfer.
It is worth acknowledging that MMI (Municipal Mutual Insurance) went in to run off some 20+ years ago and that Insurance Managers at some Local Authorities may be less comfortable with some forms of Alternative solutions due to costs that are still rising from this previous mutual.
We would recommend that any “ART” solution is actuarially modelled and reinsurance purchased on a bespoke basis including appropriate reinstatement clauses. This enables a greater level of protection from the commercial insurance market, but at a much higher level of attachment than is currently purchased and therefore at a lower premium.
Most Local Authority Insurers provide cover largely a single line basis. Therefore each class of insurance – Property, Liability, Motor, Fidelity Guarantee etc. – are considered individually. A loss on one class could be significant for that line in isolation but overall be well below the total premium paid.
The use of multi-line policies can be a way of transferring risk to insurers and looking across all classes of insurance together enabling you to be protected against premium fluctuations from single classes.
There is a potential downside to this approach when tendering in that you remove “specialist” providers who can offer cover only for single policies which could be beneficial, and this could also reduce the number of bids for your insurance tender.
Balance Sheet Risks – What are you not insuring?
The insurance purchased by Local Authorities is largely pretty similar, principally protecting physical assets and legal liabilities. The cover, whilst drafted within ITT documents, is fairly standard across most insurers.
However, the risks you have on your balance sheet could be considerable and completely uninsured – and they may be greater risks than some of the areas you are paying to insure.
Examples of this could include:
- Weather related costs – increased pothole claims, heating, gritting expense, reduced turnover at revenue generating events / locations
- Pension liabilities
- Uninsured environmental costs
- Bad debts
- Historic uninsured risks
- Almost anything on your balance sheet that has a potential to increase costs against you3
Are you holding contingent provisions for these types of balance sheet risks, provisions which would be removed if the risk was transferred?
Insurance could be used to protect you against these risks, particularly against “spikes” of costs. This insurance could also be combined with the traditional insurance risks to increase the total pool of sums being protected, thereby increasing your pool of
self-insurance, reducing your IPT costs and spreading risk across different ‘classes’ of insurance.
Most large Local Authorities retain liabilities for historic risks on their balance sheets. These could be in relation to areas such as uninsured MMI liabilities or self-insured funds held within provisions and reserves.
However, are you aware that these could be transferred to an insurer via a Loss Portfolio Transfer (LPT)? This method can remove substantial historic liabilities from your balance sheet, thereby reducing challenges to substantial ‘held’ funds and potentially transferring the risk for a competitive cost compared to the funded sums.
LPTs are relatively commonplace within the insurance sector for organisations with substantial levels of self-insurance. It is a method of ‘cutting off’ the long-tail liabilities thereby returning capital liquidity to the organisation rather than it being tied up for many years until the risks have all but evaporated.
The greater the level of self-insurance taken on liability risks the more worthwhile it is considering an LPT to transfer those historic risks once the ‘expected’ level of claims have been dealt with.
Which option(s) should you take?
This document is deliberately non-committal on the options available. Each organisation is different and has differing risk appetites and should be reviewed on their own merits.
In these times of major ongoing change and substantial reductions in funding, the time is right to review how you finance “risk”. We recommend that you engage with a risk financing specialist such as Arthur J. Gallagher to discuss your needs and to help you assess what options are available to you.
1 Third Party Motor insurance is also compulsory for Leased Vehicle Fleets
3 It should be noted that the more “likely” the cost is to occur, the less likely insurance would be available at a competitive price