Loss Portfolio Transfers Can Bolster Buyers

Since financial liability for the losses are transferred to the reinsurer, the primary insurer does not have to show it as a liability against surplus.

If the treaty limit is equal to the amount of reserves being transferred, the reinsurer doesnt pick up underwriting risk. It only assumes the timing or investment risk associated with those reserves.

For example, an insurer has workers' comp reserves with a present value of $10 million on its books. If it enters a financial reinsurance treaty in which the limit is equal to or greater than $10 million, the reinsurer is assuming some of the timing and investment risk but none of the underwriting risk.

(For the uninitiated, timing risk is the risk that the losses will be paid at a faster clip than anticipated, leaving the reinsurer with less investment income on those reserves.)

Some treaties may have internal limits, which are set to control the timing risk. For example, a ceding company might be limited to collecting no more than 20- or 30 percent of the reinsurance proceeds in the first three years, 45 percent in the first four years, and so on.

When such internal limits are structured properly, the primary insurer retains the timing risk, but the investment risk is transferred to the reinsurer.

The same theories hold true with loss portfolio transfers, often referred to as finite risk contracts, between self-insured companies or captives and their reinsurers.

Through the loss portfolio contract, the companys known reserves are transferred to a reinsurer for a premium. The reinsurer assumes responsibility for paying the losses as they come due. Depending on the terms of the contract, the reinsurer also may assume the timing or investment risks on the deal for additional premium.

In pure loss portfolio transfers, real risk is not transferred to the reinsurer because the loss reserves are capped at the contract limit. So, for example, if reserves with a present value of $10 million are transferred, and the limit on the finite risk contract is $10 million, the reinsurer will only ever pay out $10 million.

If the losses deteriorate, the reinsurer can go back to the self-insurer to recoup the difference.

Since real risk isnt transferred, the premium on pure finite risk contracts is not tax deductible.

A lot of time and effort will be spent before such a transfer can be executed. One of the biggest stumbling blocks to a loss portfolio transfer is explaining when and under what circumstances the reinsurer may go back to the company for additional premiumor for funds to pay losses that deteriorated beyond expectations at the time the transfer was negotiated.

Other types of financial reinsurance also may be availabledepending upon market conditions and the experience of the company that wants to transfer the liabilities. Among these are retrospective aggregate treaties or contracts and prospective aggregate treaties or contracts.

Retrospective aggregate contracts transfer not only known loss reserves, as in loss portfolio transfers, but also incurred but not reported (known as IBNR) claims. The contract takes into account the possibility that some losses may have occurred but not yet been claimed.

Prospective aggregate contracts assume financial responsibility for losses that occur after the effective date of the contract. It is similar to traditional insurance, but spreads the risk of losses over the entire term of the contract.

When do businesses typically look at finite risk contracts? Some companies want to smooth out the peaks and valleys of claim payments in a self-insured program. The financial risk is spread out over scheduled premium payments, permitting the business to better budget these expenses.

Companies that are discontinuing a product or operation, going out of business, or merging with another may see such a transfer as a way to clear out liabilities that it no longer wants toor canmanage.

Businesses need to be aware, however, that such programs are not without financial riskprimarily that losses will deteriorate severely and additional funds called for retroactively.

In my July 19 column about joint and several liability in a group self-insurance programAIK Comp of KentuckyI offered similar cautions. This is because I believe that too many businesses think only of todays benefit and cost-savings without looking carefully at the potential downside associated with alternative programs.

One readerTimothy Hanna, chairman of the Michigan Council of Self-Insured Group Administratorsfelt my July column failed to present a balanced view of group funds.

Mr. Hanna may be correct, since the purpose was to call attention to what joint and several liability means when a group programs financial situation deteriorates. That is not to say that groups are not a validand often successfulmeans of handling risk.

In addition, risk retention and self-insured groups often provide loss control and claim services that are tailored to the needs of their members. These services often are superior to traditional insurer offerings, primarily because they are customized to the needs of the group.

But we still must read with alarm when the financial backbone of a program such as AIK Comp snapsjust as we do when a carrier (such as Kemper, Reliance or Home) plummets.

Often we really do get what we pay for and need to carefully consider not only the cost of managing risk today, but the likelihood that the vehicle we choose will be around for as long as we have claims that need to be paid.

Diana Reitz is editor of the National Underwriter Company publication "The Tools & Techniques of Risk Management & Insurance," as well as the "Risk Funding and Self-Insurance Bulletins," both available at www.nationalunderwriter.com/nucatalog.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, September 3, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.