Public Sector Consulting Group

South East ALARM 2004

Keith Bolton

Client Director – Public SectorE-mail: keith.bolton@ars.aon.co.uk

Tel: 0117 948 5018Aon is a member of the GISC. A member of BIBA

INSURANCE ROUND UP

2

Agenda

• What is insurance ?• Recent & current insurance markets• What are the alternatives to traditional insurance ?

• The future ?• Conclusions

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What is insurance ?

• Evil necessity or necessary evil ?• Take it or leave it ?• Different for individuals, companies and public

sector• Great for insurers if premiums more than

claims• Great for insured if claims more than

premiums• Contributions of the many to pay for the losses

of the few

4

What is insurance ?

• A methodology for transferring the financial consequences of certain events, if they occur, to another party

• A Contract where the insurer, subject to the payment of a premium together with various terms and conditions, will pay the insured (or a third party) if a prescribed event happens

• The insurance can act as a budget protection or smoother because premiums are normally predictable whereas costs of incidents and accidents can vary considerably

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What is insurance ?

• Insurance policies tend to be segmented into similar risks but generally fall into two groups :

Short tail – property, personal accident, moneyLong tail – liability

• Not all risks are commercially insurable• The insured always retains ownership of

risks

6

Statistics

• Statistics can be compared to lamp-posts !

• They can throw light on a subject• They can be leaned on• You know what dogs do to lamp-posts !!

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Premium rates in 2001 were mostly at or below 1993 levels …

Lloyd's Premiums Ratings Index - All Classes

0%

20%

40%

60%

80%

100%

120%

140%

1993 1994 1995 1996 1997 1998 1999 2000 2001

Pre

miu

m In

de

x (

19

93

=1

00

%)

Property direct(US)

Property direct(non US)

D&O

EmployersLiability

General liability

Combined EL &GL (Average)

Personalaccident

Professionalindemnity

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… whilst catastrophe losses continued to increase …

Losses from major natural catastrophes

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UK Employers Liability Underwriting Ratio 1985 - 2003

90

100

110

120

130

140

150

160

170

180

190

Source: ABI

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Tort Costs as a % of GDP

0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0

U.S.

Italy

Germany

Belgium

Australia

Spain

Switzerland

Canada

Japan

France

U.K.

Denmark

Source: Tillinghast-Towers Perrin (April 2003)

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UK Commercial Market

-1200

-1000

-800

-600

-400

-200

0

200

400

600

800

1000

1200

-20-18-16-14-12-10-8-6-4-20246810121416

Underwriting Result Underwriting results as % of net premium

Under-writingResults

Source: ABI

Under-writingresult as % of net

premium

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UK Insurance Company Insolvencies

• 202 Insurance companies have ceased trading since 1974• 93 Lloyds Syndicates ceased trading between 1997 & 2001

0123456789

1011121314151617181920212223242526

No.

of

Com

pan

ies

Source: The London Market Run Off Yearbook 2003 & Lloyds of London

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Insurance pricing tends to go through cycles

Top of the cycle

Rate adequacy achieved

Strong industry returns tempt some companies to loosen U/W standards in a

quest to grow market share. Start

of soft market.

Some companies in some markets fail, others retire from certain lines or go out of business. More

industry restructurings and lay offs. Organic

growth is very difficult. More M&As.

Bottom of the cycle

Sensing the upswing, some insurers attempt to lock in cheap

reinsurance with multiyear agreements.

Retro market begins to harden, followed by reinsurance market.

Rate adequacy achieved

Top of the cycle

Competition for market share intensifies, rates are

cut, and U/W results weaken. More reliance on

investment income.

Marked depletion in policyholder

surplus for 3 or 4 consecutive years.

Often positive runoff slows down as well runs dry.

Insurers and reinsurers ROEs

bottom out. Pressure from shareholders intensifies.

Insurers strive to implement rate

increases.

Some reinsurers pull out of certain lines or retire from

business.

Often when the P&C

cycle is on the upswing, the overall economy is

on the downswing.

Growth in non-traditional markets as buyers of

insurance & reinsurance

seek alternatives.

Source: Swiss Reinsurance Company, Canada

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Causes of recent situation

• Insurers’ have made big underwriting losses for too many years

• Reinsurers losses have led to higher insurance costs and restrictions in cover

• Reduction in insurers balance sheet values limits their ability to write cover, so capacity has dropped

• Falling equity values and interest rates have made bottom line results worse as, in the past, investment gains usually mitigated underwriting losses

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Insurance cycle – Top of cycle

• Rate adequacy achieved - high profits lead to competition and more capacity

• There is temptation to drop underwriting standards to increase or maintain market share

• Tendency for investment income to be recognised

• Start of soft market

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Insurance cycle – Bottom of cycle

• Some insurers/reinsurers fail or retire from some classes

• Restructurings, mergers and acquisitions occur to try to save on expenses

• Returns on equities fall resulting in pressure from shareholders

• Start of hard market with pricing and capacity problems

• Growth of non traditional approaches

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Recent implications for UK Local Authorities

• Reduced competition for risks from insurers (although public sector not so badly affected as many commercial risks)

• Liability premium rates are continuing to harden (rise)

• Indemnity limits and scope of cover are being reduced

• Higher deductibles are being imposed• Far more underwriting information required

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Recent implications for UK Local Authorities (contd)

• Insurers more selective and heavily discriminate against perceived poor risks

• Mandatory risk improvements• Premium payment warranties are being

imposed• Insurers may decline cover for certain

classes or certain risks• Long term agreements unreliable

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Local Authority Renewals in 2002 & 2003

Local Authority Average Averagerate increases % increase % increase %

2002 2003

Casualty (25% - 292%) 78.75 68.0Property (25% - 150%) 43.66 32.0Motor (5% - 25%) 15.31 16.0

• Range and average taken from sample of Aon clients across all regions in the UK

• No authority was unable to insure but pricing (i.e. budget implications) for many was an issue

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In 2004 ………………..

• Liability rates are still rising and further increases expected, although the pace of growth is clearly slowing down.

• Cost of Liability Claims increasing, Why ?– Woolf + 2%– Ogden tables + 8%– Litigation Costs + 5%– NHS Recoveries (potential) + 7%– Conditional Fee Arrangements + 5%– Claims cost inflation circa + 15% per annum

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In 2004 ………………..

• Long tail exposures such as VWF, asbestosis, abuse, ex-pupils and stress with no ability to charge premium retrospectively

• Increasing Legislation leading to increasing risk exposures

• Property and motor prices are starting to fall

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What is Insurance and What is the Cost ?

• The contributions of the many to pay for the losses of the few

• Finance for events that MAY occur, to offer budget smoothing and protection

• Mixture of internal and external insurance arrangements

• Known premiums versus unknown costs – bet or gamble ?

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What is Insurance and What is the Cost ? (contd)• Elements of Insurance Premium

– Working claims costs – typical “burning cost” is 60/70% of premium

– Catastrophe loss contribution– Reinsurance premiums– Contributions to insurers’ reserves for previous

years losses– Claims handling costs – allow for £100/£400 per

claim (+ VAT)– Insurers administration– Insurers Profit (target is circa 15%)– Insurance premium tax (5% currently)

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What is Insurance and What is the Cost ? (contd)

• Traditional insurance may not be a financially efficient transaction for a large organisation.

• So only buy what you need !!

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How should Public Sector bodies respond ?

• Insurance is not a financially efficient organisation if £1 in premium always results in 70-80p in claims payments and costs

• Can you avoid insurer admin, profit, and Insurance Premium Tax (5%)?

• Your choice – Short term response or long term strategy.

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How should Public Sector bodies respond ? (contd)

• Reduce exposure to frictional costs and swings in insurance market pricing– Surf the underwriting cycles and act

individually– Take defensive reactions to cycle– Create new “market” or risk financing

vehicle (Alternative Risk Financing)– Only insure for fidelity guarantee ?

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What are the Alternative Risk Financing Options ?

A number of alternatives exist ….• Pooling• Mutual Insurer• Discretionary Mutual• Consortia Purchasing• Captives/Protected cell captives

N.B: Rule of thumb – Risk retention groups should comprise members with a similar risk profile, i.e. District Councils, Police/Fire or Authorities with a common denominator (e.g. a County Council and its Districts)

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Why look at ARF structures ?

• Access to new/more insurers/reinsurers for catastrophe level cover

• Financial savings – reduce frictional costs element of premiums. Some options will save you IPT – 5%

• Less exposure to volatility in capacity and price of premiums

• More flexibility and control - only buy what you want• More incentive for risk management• Opportunities for other savings via partnership

approach with other public sector organisations• Sharing of information and ideas to raise risk

management standards within public sector• Achieve Best Value

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Pooling

• Local Authorities “pool” resources (financial and/or expertise) to finance losses, manage claims, etc

• Individual members take retention within excess and/or stop

• Risk above excess levels is funded by pool up to individual loss limits and aggregate loss limits

• Pool re-insures exposure above loss limits and aggregate stops

• Members of pool contribute premiums according to assessment of loss history and exposure date – (professionally underwritten)

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Pooling (contd)

• Pool requires management committee formed from members• Will need to contract out claims management and actuarial

services, plus broking for re-insurance• Benefits & Pitfalls

– Saving of frictional costs, e.g. insurer’s profit & admin– More control over risk financing and protection from much of

volatility in market– Requires commitment from critical mass – maximum of 8-10– Requires substantial commitment and agreement between

members e.g. objectives, entry/exit criteria, structure/extent of cover and pool management

– Loss of independent decision-making by individual members

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Mutual Insurer

Local Authorities band together to form an insurance company licensed to write cover for public sector risks

• Mutual offers another source of cover to public sector – “Son of MMI?”

• Mutual writes a slice of cover above individual members risk retention and reinsures its exposure to members claims above individual and aggregate loss limits

• Capitalisation required in addition to licensing, legal and formation costs

• IPT payable• Members of mutual contribute premiums according to

assessment of loss history and exposure date – (professionally underwritten)

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Discretionary Mutual

Not insurance. Local Authorities band together to form a mutual company which pass losses to its members on a discretionary basis – not according to policy wording

• Discretionary Mutual provides a layer of funding above individual members risk retention and reinsures its exposure to members claims above individual and aggregate loss limits

• Claims for funding considered and decisions made on whether to pay by panel elected or appointed by members

• Some capitalisation required in addition to licensing, legal and formation costs, but less than mutual insurer – could be covered by letters of credit

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Discretionary Mutual (contd)

• Members of mutual contribute premiums according to assessment of loss history and exposure data – (professionally underwritten)

• Discretionary Mutual requires management committee formed from members representatives

• Will need to contract our claims management and actuarial services, plus broking for re-insurance

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Discretionary Mutual (contd)

• Benefits & Pitfalls– Saving of IPT – not insurance so exempt– Reduction of other insurer frictional costs, e.g.

profit & admin– More control over risk financing and protection

from much of volatility in market– Requires commitment and agreement from

critical mass of members – minimum of 10– Some loss of independent decision-making by

individual members– Requires leap of faith and trust between members

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Consortia Purchasing (Buying Group)

• Advantages– Negotiating Strength – cost, cover, services,

risk management– Partnership Approach – Development of

Best Practice and raising standards– Information Management – systems & data– Ability to share project work/ideas/solutions

– avoids re-inventing the wheel

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Consortia Purchasing (Buying Group)

• Disadvantages– Commitment and co-operation between all

members is required – sometimes hard to achieve!– Challenges past practices and arrangements– Works best if members align their insurance

requirements & adopt common standards/cover – some members may need to do more work than others!

– Works best with healthy level of competition in market (for insurance cover)

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Captives

• Insurance vehicle owned and controlled by Insured. Established to finance risk within individual loss and aggregate loss limits

• Captive reinsures exposure above single loss and aggregate loss limits

• Based offshore - not subject to UK regulation but regulated by country of domicile e.g. Channel Islands, Isle of Man etc

• Business Plan required to secure regulatory approval• Capitalisation needed to finance exposure – can be base

or letter of credit

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Captives (contd)

• Protected cell captives can be used to “insure” multiple organisations with funds ring fenced within a single captive insurer

• Offers access to new/more markets for catastrophe cover

• Offers flexibility. You define the cover you want – not constrained to what insurers will offer

• Set up costs and ongoing management fees payable to Captive Managers

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Evaluation of Options

• Need to compare traditional insurance with each ARF option

• How ? – Three phases :-Need critical mass of Local Authorities to commission

Feasibility Study – information gathering, data analysis, legal issues, structural options & recommendations

Detailed structure design, rating issues, entry/exit criteria, draft agreement/Memorandum of Association, membership, voting, decision-making, results in indicative quotes to compare to insurers terms

Set up – new vehicle established, capitalised if necessary, licensed & ready for business

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Evaluation of Options (contd)

• Suggestion – Should you consider moving from claims occurring to claims made basis for Employers’ Liability and Public Liability risks either as a move in isolation or as part of an ARF solution ???

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The Future

• The office of the future will only have two employees

• A man and a dog• The man is there to feed the dog• The dog is there to stop the man from touching the equipment

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Who will be the insurance winners in the future ?

Winners will be :• Creative and innovative• Get it right first time and every time• Efficient networking• Widespread ability to address and meet needs of

clients• Continual improvement in delivery of services• Listen hard and work hard• Investment in improvements

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Conclusions

• Even if soft market returns the hard market will follow again

• The public sector should always be able to insure• Thorough review of individual risk management

and risk financing and claims strategies are needed, whatever you decide

• Consortia Purchasing can work well for groups of committed organisations with sufficiently similar objectives even where a competitive and soft market exists

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Conclusions (contd)

• May need to consider purpose of consortium being wider than purchase of insurance – e.g. risk management development, risk assessment, actuarial services, claims management services

• To achieve long term benefits the public sector need to consider and compare ARF options with the conventional insurance market

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Questions/discussion ?