Drowning A Hazard At Any 'Pool' Party

Insurance markets all across the United States are heating up,driving risk managers everywhere to seek relief in pools–insurancepools, that is. For some risks, pools are a refuge–a market of lastresort. To others, pools represent a quiet oasis–an escape from thepressures of the mainstream insurance marketplace.

Whether refuge or respite, theres no doubt pools are becomingincreasingly popular destinations. In fact, the practice andconcept of pooling in general appear to be undergoing arenaissance, of sorts.

Workers' compensation residual market share is growing for thefirst time in a decade, auto plans across the country areexperiencing explosive growth, and states are under pressure toback pools designed to prevent a complete meltdown of the marketfor medical malpractice insurance.

Theres more–commercial property owners are more interested injoining or forming self-insured groups than ever; so are schools,municipalities, apartments and condos. Airlines want to poolterrorism risk, theres talk of a national terrorism pool forworkers' comp, and insurers have proposed pooling property-casualtyterrorism risk across all lines.

Pooling of risk, of course, is the very essence of insurance.Its what makes insurance tick. Why, then, are pools making such asplash on the insurance scene today?

The hard market is driving some of it. Although higher pricesget all the headlines when insurance markets get hard, tighterunderwriting does at least as much of the heavy lifting when itcomes to restoring insurer profitability. When the industry as awhole becomes choosier about risk selection, fewer risks will makethe cut and more will land in residual market pools.

Indeed, todays hard market has already forced thousands ofemployers into workers' comp residual markets across the country,nearly doubling the size of the residual market last year (seegraph).

Difficulty spreading risk through traditional mechanisms such asreinsurance in the wake of the Sept. 11 terrorist attack is anothermajor reason. Pooling helps reduce risk through diversification,although it remains inferior to the transfer of riskachieved through reinsurance.

The inability to exclude terrorism risk in many cases (such asin workers' comp) exacerbates the problem. Without access toreinsurance markets or the ability to add exclusions, aggregationof risk quickly becomes a severe problem, one that forces insurersto search for alternative ways to segregate, compartmentalize anddiffuse this risk. Pooling is the simplest mechanism available toachieve these goals.

Much of the residual market growth in workers' comp is thedirect result of insurers desire to reduce exposure to catastrophicworkers' comp losses in the event of future terrorist attacks. TheSept. 11 terrorist attack resulted in 5,800 workers' compclaims–2,200 of them fatal–costing insurers an estimated $2billion. Insured losses across all lines of insurance (includinglife) are estimated at $35-to-$40 billion.

It is also little wonder that within three weeks of the Sept. 11terrorist attack, insurers proposed (unsuccessfully, as of thiswriting) that Congress back a national pool for insuring terrorismrisks, modeled after a pool operating in the United Kingdom since1993 (Pool Re).

Insurers also harbor concerns over potentially massive workers'comp losses from a large earthquake. The table with this columnshows the expected number of workers' comp injuries, deaths andlosses in the event of a 2002 repeat of the 1906 San Franciscoearthquake. A repeat of the magnitude 8.3 earthquake is likely tokill and injure far more people than the Sept. 11 attack, producingcataclysmic dollar losses for workers' comp insurers.

However, an important distinction must be drawn between risksthat are pushed into pools by insurers responding to economic andrisk management concerns, and those that view pools as adestination of choice. The ignominy that a poor risk suffers afterfalling into a pool is balanced by the security associated with thecomplete transfer of risk and the virtual assurance of rescue fromthe pool at some point in the future.

Businesses that seek to pool risk by forming or joining aself-insurance group, on the other hand, run the distinct risk ofgetting in over their heads and drowning in an ocean of redink.

What is unique about the widespread interest in pooling is thatmuch of it is driven by a shocking degree of na?vet? about thenature and magnitude of risks actually faced by businessestoday.

Many businesses openly dismiss the possibility that they willsuffer damage from a terrorist attack, deem themselves unlikely tobe named in a massive class action lawsuit, discount the likelihoodof suffering severe damage from a natural disaster, and fancythemselves as too smart to lose lots of money on investments or getburned in an accounting debacle.

The reality is that Corporate America is at risk from all ofthese perils and more, and that the need for complete andcomprehensive insurance protection is greater than ever.

Most businesses believe themselves to be above-average qualityrisks, and that the higher prices they are being asked to pay forinsurance today greatly exaggerate the costs they are likely toimpose on the system. Therefore, the reasoning goes, Im better offjoining a self-insured group or starting a new pool altogether.

This reasoning is flawed for many reasons. First, not everybusiness can be above average. But secondly, the world of commercetoday finds itself operating on a higher plateau of risk than itdid just a few years ago.

Consider the forces that came together to form the “perfectstorm” of 2001 and produced the worst year in the history of p-cinsurance: recession, underpricing, catastrophic losses, medicalcost inflation, financial accounting scandals, abuse of the legalsystem and, of course, terrorism. Which of these perils isvanquished or even diminished through participation in pools orself-insurance? None.

Another inescapable hazard of “do-it-yourself” insurance isrooted in the law of large numbers. Self-insurance groups aresubject to the law of “not-quite-so-large” numbers, meaning theirannual loss experience could be volatile because the SIG is muchsmaller and more homogenous than a large commercial lines insurer.Reinsurance can help, but the tight market and reinsurer reluctanceto accept certain types of risk (terrorism, for example) couldexposes a business to losses it would otherwise escape entirelywith traditional insurance.

SIGs are an important part of the insurance market, and joininga well-run SIG might well be the right choice for some businesses.But todays hard market means that jumping into the risk poolthrough an SIG (or captive) is no Club Med–even when domiciled insome lush tropical location.

Robert Hartwig, Ph.D., is senior vice president and chiefeconomist at the Insurance Information Institute in New York. Hecan be reached at [email protected].

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, May 6, 2002.Copyright 2002 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.