What Attracts Corporations to the New Integrated Programs?

The traditional approach of a tower of monoline coverages, each with a separate policy limit, has not been meeting the needs and operations of many corporations. Companies have been looking to integrated programs that combine lines of coverages in one aggregate policy—generally for a multiyear term. These integrated programs also go by names such as concentric risk and basket aggregates. The features that are attracting corporations to these programs include the following:

• Less administration time and cost
• Less time and cost for negotiations with brokers and underwriters
• Elimination of the need to build a tower of coverages
• One loss triggers just one policy
• Elimination of gaps in coverage (seamless coverage)
• Elimination of the need to buy separate limits for each type of coverage

Judy Lindenmayer’sJudy Lindenmayer was one of the experts contributing to the creation of this video education segment. program for FMR (Fidelity Investments) was one of the earliest integrated programs. She referred to it as concentric risk. She explained how she lowered her cost through the use of an aggregate limit. Under traditional coverage, an insured may be purchasing limits that are $50 million per year, but it is unlikely that there would be a major loss every year; thus, the full limit would not be used. Therefore, there is a waste of large limits in many of the years while the insured continues to pay for them. The solution to the redundancy and the extra cost is “the integrated program, with one aggregate limit over the three-year period. You buy one $50 million limit.” Obviously, this is going to cost the insured less money. Judy Lindenmayer claimed that cost reductions could be as much as 30 or 40 percent.

Norwest, a bank with assets of $71.4 billion and 43,000 staff members in 3,000 locations (in 1997) across the United States, Canada, the Caribbean, Central and South America, and Asia was another company that could provide an example of what attracts corporations to the new concept. Until 1994, Norwest had traditional coverages. Each class of risk had an individual limit of self-insurance, a layer of commercial insurance, and an excess coverage. There were many risks that were not covered by insurance because of lack of availability.

K. C. Kidder, Norwest’s risk manager, established a new integrated risk-financing program for simplicity and efficiency. In addition, she opted for the multiyear integrated approach. Kidder’s other objectives for the major restructuring included the following:

• Provide aggregate retentions applicable to all risks
• Develop a long-term relationship with the insurer
• Stabilize price and coverage
• Provide catastrophe protection
• Reduce third-party costs significantly
• Use the company’s captive insurer
• Maximize cash flow and investment yields
• Include previously uninsured risks.

Coca-Cola was another major company that was motivated to use an integrated program.David G. May, “The Real Thing,” Financial Executive 13, no. 3 (1997): 42. Allison O’Sullivan, Coca-Cola’s director of risk management, was looking for a program that would do the following:

• Provide long-term stability
• Recognize the company’s financial ability to retain risk
• Create value through attaining the lowest sustainable cost
• Increase administrative efficiencies
• Provide relevant coverage enhancements
• Strengthen market relationships
• Enhance options for hard-to-insure business risks worldwide

Another attractive integrated product of limited use is the multitrigger contract. A multitrigger contractInsurance in which coverage is triggered by the occurrence of more than one event happening within the same time period. is insurance in which claims are triggered by the occurrence of more than one event happening within the same time period. The time period is defined in the contract and could be periods such as calendar year, fiscal year, season, or even a day. In a traditional single-trigger policy, a claim is based on the occurrence of any one covered loss, such as an earthquake or a fire. In the multitrigger contract, a claim can be made only if two or more covered incidents occur within that defined contract period. This coverage costs less than individual coverages because the probability of the two (or more) losses happening within the contract time period is lower than the probability of a single loss occurring. In the multitrigger policy, the insurer recognizes this lower probability in the pricing of the product. Thus, it would cost more to buy the earthquake insurance on a stand-alone basis than it would cost to buy earthquake insurance contingent on some other event taking place within that contract time period, such as a shift in foreign exchange or a shift in the cost of a key raw material to the client. Insureds who are concerned only with two very bad losses happening at the same time are those who would be interested in a multitrigger program.

What Is the Response of the Insurance Industry and the Brokerage Community?

Market conditions are contributing to insurers’ responsiveness to risk managers. The insurance industry and brokerage community have created a new concept of bundling risks into one basket, under one limit, for multiple years. David May of J&H Marsh and McLennan, Inc.,Today, the company name is simply Marsh. During the period of the case, many brokerage houses merged. The large mergers and the decrease in the number of brokerage houses prompted the consolidation of the brokers and agents organizations into the Council of Insurance Agents and Brokers. reported that “many insurance markets have lined up behind this new approach, offering close to $1 billion in capacity.”David G. May, “All-in-One Insurance,” Financial Executive 13, no. 3 (1997): 41. The industry provides large capacity for these types of programs. Two observations of their use include the following: (1) the corporations that use them are large with substantial financial strength and (2) the multiyear term of the programs promotes long-term relationships.

The U.S., European, and Bermuda markets all have been actively participating in various program combinations. XL and CIGNA were among the first players when they teamed up to combine property and casualty lines of coverage. The market demanded broader coverage, and the two insurers, in a very short time, have expanded their offerings. Another active player is Swiss Re with its BETA program. AIG, Chubb, and Liberty Mutual are active in the U.S. market.

Most of this capacity is not dependent on reinsurance. Some insurers offer one-stop shopping, while in other cases the structure uses a number of insurers. Coca-Cola’s program, for example, was provided ultimately by several carriers.

How Do You Determine What Coverages to Include in an Integrated Program? What Limits Are Appropriate?

Integrated programs may include different combinations of coverages and may be designed for different lengths of time and different limits. Insurers provide many choices in their offerings. Programs are put together based on each corporation’s own risk profile. These products are individualized and require intensive study to respond to the client’s needs.

The typical corporations looking into these types of programs are Fortune 200 corporations—companies needing $100 million to $200 million or more in coverage.John P. Mello, Jr., “Paradise, or Pipe Dream?” CFO: The Magazine for Chief Financial Officers 13, no. 2 (1997): 73. These are corporations that have much larger and complex risks and need to work with a few carriers.

Judy Lindenmayer of Fidelity Investments explained the process of determining which coverages to combine the following:

• Review loss history
• Consider predictability of losses
• Review annual cost of coverage and coverage amount by line
• Consider risk tolerance level
• Select an aggregate limit that exceeds expected annual losses for all coverages

FMR had two separate integrated programs, as shown in Figure 23.5 "Fidelity Investments Integrated Risk Program".Dave Lenckus, “Concentric Risk Programs Means Big Saving—Innovative Programs to Save FMR Time, Money,” Business Insurance, April 14, 1997, 98. FMR’s program for its mutual funds combines the government mandated fidelity bonds and E&O liability insurance. FMR took a very conservative approach, with a separate program to protect its mutual funds clients from employees’ dishonesty or mistakes. For the other part of the company, the corporate side, the coverage included consolidated financial institutions bond coverage, which protects the employee benefits plans and protects against employees’ dishonesty. The other coverages were Directors & Officers (D&O), stockbrokers Errors & Omissions (E&O), corporate E&O, E&O liability for charitable gifts, partnership liability, and electronic and computer crime. The corporate program was designed to respond to the risk management needs of the corporate side, which was “on the cutting edge on a lot of things” and therefore less conservative than the mutual funds’ concentric program.

Integrated programs include coverages such as D&O, fiduciary liability, crime, E&O, and employment practices liability. The following are examples of the coverages that may be included in an integrated program under one aggregate limit:

• Property
• Business interruption
• General, products, and automobile liabilities
• Workers’ compensation
• Marine liabilities and cargo
• Crime
• D&O liability
• E&O liability

For specific companies, it may also include the following:

• Product recalls
• Product tampering
• Political risks
• Environmental liabilities

Both Coca-Cola’s and Norwest’s programs combined a very broad array of coverages. Coca-Cola’s program combines over thirty different risks in one contract. Although Coca-Cola did not do so in 1997, Allison O’Sullivan, then-director of risk management for Coca-Cola, said that she was open to the idea of blending financial risks like interest rate and currency exchange fluctuations. Norwest’s program had a layer of true integrated insurance, with an aggregate of $100 million limit over a five-year period. It combined the following coverages in its program:

• Aircraft liability (nonowned)
• Automobile liability
• D&O (corporate reimbursement)
• Employers’ liability
• Fiduciary liability
• Foreign liability
• Foreign property
• General liability
• Mail and transit
• Mortgagee E&O
• Professional liability
• Property
• Repossessed property
• Safe deposit
• Workers’ compensation

Understanding the loss history of each line of coverage is very important to selecting the appropriate limits. The aggregate limit must be adequate to cover losses of all combined lines for the entire multiyear period.

How Do Deductibles Operate?

Programs may be structured with one aggregate deductible for the term of the policy or with separate, per occurrence deductibles. Norwest’s integrated program had a $25 million aggregate retention over a five-year term. They had another five-year aggregate retention that was covered by its Vermont-based captive, Superior Guaranty Insurance Company. Above their retention, they had a finite risk layer (explained in the next section of this case) of $50 million. Fifty percent of this layer was covered by the captive. The other 50 percent was covered by American International Group (AIG).

The FMR aggregate programs are also structured over retentions. As discussed previously, FMR had two separate programs. The mutual funds program had multiple deductibles and the captive was not used.Dave Lenckus, “Reinsurance Program Strives to Find the Right Blend of Risks,” Business Insurance, April 14, 1997, 100. For the corporate concentric program, FMR’s captive, Fidvest Ltd., wrote up to $10 million in aggregate limits, as shown in Figure 23.5 "Fidelity Investments Integrated Risk Program". Fidvest’s retention included most of the risks except for the trustees’ E&O. The captive retained only $5 million of this risk.

The decision about the appropriate retention levels forces the risk manager to look at risks and risk tolerance.

Why Do You Need a Reinstatement Provision?

As noted previously, selecting the limit that will cover all included losses over the entire multiyear period is an estimate based on a number of factors. But that estimate can prove to be wrong. The insured could use up his or her entire aggregate limit before the end of the term. For that reason, it is important to include one or more reinstatement provisions. Negotiating a reinstatement provision on the front end is critical to provide the following:

• Additional limits if the initial limits are exhausted
• A guarantee of coverage when needed
• Coverage at the right price

The FMR program contained reinstatement provisions in the event its aggregated limits were exhausted. Figure 23.5 "Fidelity Investments Integrated Risk Program" illustrates that FMR had one reinstatement on the corporate program and an option to purchase two additional reinstatements for the funds’ program.

What Are the Overall Advantages of the Integrated Risk Concept for Insureds?

The integrated risk programs are reported to produce in excess of 25 percent savings. This savings results from the following:

• Large premium decreases as a result of utilizing fewer carriers
• Flexibility of mixing the most appropriate risks (i.e., customized plans)
• Comprehensive coverage
• More efficient operation of the captives and retentions
• Reduced administrative costs and greater efficiency regarding renewals

The risk manager does not need to shop every year and prepare for renewals. The worry about the volatility of the traditional, cyclical insurance market is also reduced. These programs are expected to increase in prevalence. They have been combined with other new-generation products, such as finite risk, which is discussed next.

Differences between Finite Protection and Traditional Insurance

The key difference between the finite risk program and traditional insurance coverage is that the funds paid to the insurer

• earn interest, which is credited to the insured, and
• are refundable to the insured.

An Example of How the Finite Risk Program Can Be Structured

Figure 23.6 "Finite Risk Program of Fidelity Investments, $100 Million Coverage Limit" shows an example of how a finite risk program operates. In this example, the insured has implemented a three-year program with a $100 million aggregate coverage limit for the entire period, with annual premium payments of $20 million. Thus, the insured has promised to pay $60 million over the three-year period, as denoted by increasing increments for each year on the graph. Actual risk transfer—that is, the conventional insurance layer of the finit eprogram—exists between the $60 million that the insured pays in and the $100 million limit. Thus, there is $40 million in risk transfer. This risk transfer layer is shown in dark blue on the graph.

At the end of the three-year period, the deposits may be returned to the insured with interest, less any losses. As will be discussed later, a return of funds constitutes a taxable event and the insured may choose to roll the funds over to the next term.

What If Losses Exceed the Funds Paid to Date?

In the example in Figure 23.6 "Finite Risk Program of Fidelity Investments, $100 Million Coverage Limit", the insured has paid in $20 million in the first year. But what if losses exceed $20 million in the first year? This is the timing risk that the insurer takes—the risk that losses will exceed the insured’s deposit—in which case, the insurer has to pay for them prior to having received the funds from the insured. The graph shows the timing risk in white. It is the difference between the insured’s accumulated payments into the fund and the total amount the insured promises to pay into the fund over the entire time period (in this example, $60 million over a three-year period). The timing layer is similar to a line of credit for the insured. The insured must still pay the insurer for the losses that were paid out in advance, or “loaned” to the insured.

The FMR Corporation structured its finite program around its integrated risk program. Figure 23.7 "Structure of Fidelity Investments’ Finite Risk and Integrated Risk Programs" displays how FMR’s finite program fits around the two integrated programs described previously. The finite program is outlined with dotted lines. An important part of its program was the inclusion of risks that are traditionally uninsurable. If a loss occurs under the finite program that is also covered by its underlying integrated coverage, the finite program acts as a layer above the integrated limit. Thus, the finite risk protection is pierced when the integrated limit is exhausted—no deductible is incurred under the finite program. If a loss occurs under the finite program and it is not covered by the integrated program, a $100,000 aggregate deductible applies. Such losses are paid if and when aggregate losses under the finite program reach $100,000.

A finite program can fit into a corporation’s risk-financing structure in other ways as well. It can be used to fund primary losses. It can also be used in intermediate layers to stabilize infrequent but periodic losses.Gregory K. Myers, “Alternative Risk Financing in the Traditional Insurance Marketplace,” John Liner Review 10, no. 3 (1996): 13.

An Example of How the Experience Fund Operates

Now, let us show an example of how the experience fund works. Table 23.25 "Finite Risk Experience Fund" displays a chart of an experience fund with annual deposits of $20 million for a three-year term. Assume an annual interest rate of 6 percent is credited quarterly to the fund. Also assume that the interest accrues on a tax-free basis, as would be the case if the fund is placed with an offshore insurer where investment income is not subject to taxation. In this example, the insured incurs a $5 million loss in year two. At the end of the term, the insured’s balance is $62,120,260. The funds may be returned to the insured or rolled over to another contract term.

Pricing

Pricing of the product will vary. There can be an additional premium to pay for the risk transfer and timing risk elements. Alternatively, the insurer’s risk can be paid for by the spread between the interest it expects to earn on the funds and the interest credited to the insured.

Suitability of Finite Risk

Finite programs typically are used by large corporations with one or more of the following characteristics:

• High retention levels
• Unique or difficult to insure risks
• Risks where adequate limits are not available
• Ability to make large cash outlays

Advantages of a Finite Risk Program

Finite risk programs offer a number of benefits to corporations:

• Improves the balance sheet—by including risks for which noninsurance reserves had been established, it allows the company to remove these reserves from its balance sheet.
• Reduces volatility in earnings—instead of paying unpredictable losses out of current earnings, the insured is paying equal payments to the insurer to cover losses; if losses exceed the payments, the insurer pays them and the insured can work out an arrangement to pay them back up to the agreed-on amount that should be paid into the fund.
• Allows for profit sharing if the loss experience is favorable—the insured earns interest on the payments that it pays to the insurer. In addition, these payments can be structured as tax deductible, whereas reserves on the balance sheet are not deductible until losses are paid.
• Helps secure insurance for uninsurable risks—because the losses are paid by the insured, a program can be structured without limitations on what types of risk can be included.
• Accesses new capacity for catastrophic risks—finite programs can be structured so they are layered over a very large retention level, a captive, or other insurance program, such as integrated risk programs or conventional insurance.

Determining the Risks to Include in a Finite Program

Finite risk programs can be structured to include any type of risk, contingent on approval by the company’s auditors.Types of risks included in the program may be restricted by the corporation’s external auditors. They are touted as a means of financing traditionally uninsurable risks. Thus, a corporation looks at its own risk profile to determine the appropriate risks to include in the program. A corporation can do this in one or more of the following ways:

• Examine the balance sheet for reserves—reserves are established for risks on which there is no insurance coverage. The size of these reserves reflects the potential impact of the risk.
• Examine insurance policies for existing exclusions—this exercise reveals important risks that currently are uninsured.
• Ask senior managers what keeps them awake at night—in addition to potentially identifying previously unidentified risks, the process reveals the firm’s tolerance for risk by determining what is important to senior managers.

Potential Disadvantages of a Finite Risk Program

Finite risk programs are becoming increasingly popular. But they are not without disadvantages:

• Tax and accounting questions—accounting and tax rules say that there must be more than timing and interest rate risk for the insurer in order for the insured’s payments to be tax deductible. The tax code requires that the finite financing arrangement involve real underwriting risk transfer with a reasonable expectation of loss. Transactions that do not meet tax and accounting rules regarding risk transfer will be treated as deposits. The main requirement is that the insurer (or reinsurer) must stand to realize a significant loss from the transaction. Judy Lindenmayer mentions a general rule of thumb that has developed, whereby 10 to 15 percent of the estimated exposure should be transferred to the insurer, and the risk so transferred must have a 10 to 20 percent chance of loss. Actuaries, however, caution against specifying probability thresholds because they do not allow for the differences in frequency and severity of various exposures.“What is ‘Risk Transfer’ in Reinsurance? Comments on Financial Accounting Standard 113,” Contingencies, September/October 1997, 50–53. (Based on a report of the American Academy of Actuaries Committee on Property and Liability Issues.) Evaluation of the risk transfer element is a complex process that requires a complete understanding of the transaction, the details of which are beyond the scope of this course.
• The premiums should not be construed as a deposit for accounting purposes. The risk transfer element must be verified by outside auditors. It is permissible to base the tax and accounting for the finite program on two different foundations. However, doing so may draw the attention of income tax auditors.
• Any monies that are returned to the insured at the end of the period constitute taxable income. To avoid a taxable event, the insured can roll the funds over to the next term.
• Time-consuming and complex to develop—although finite programs can save considerable time once they are in place, they can take up to a year to develop.
• Frictional costs may be greater than perceived benefits—these costs are estimated to range from 5 to 10 percent. A fee is paid to the insurer, and a federal excise tax applies to premiums paid for programs that are domiciled offshore.
• Opportunity cost of committed funds—the programs entail large outlays of cash each year of the term. These large outlays, and the fact that they tie up the funds, can overshadow the net cost efficiencies that might have been obtained. Generally, these cash outlays require the involvement of the company’s CFO or other senior manager. Often, the cash outlays form the obstacle to obtaining senior management approval of the program.