04 August 2006
In these straitened times, it is no surprise that finance directors are looking to make savings on insurance. Many organisations are now planning to ditch traditional insurers for a pooled approach. Ronan Ball discusses the benefits and pitfalls
With treasurers under increasing pressure to make budgets go further and meet efficiency targets, many are investigating alternative ways to stretch resources. One area that has gained momentum recently is the practice of 'mutual insurance' or 'pooling', whereby a group of organisations with similar interests collectively bear the risks taken by each organisation. It has become the main alternative to traditional insurance being considered by the public sector.
Plans to pursue this option are under way with a number of groups, the most high profile being 28 London boroughs, led by Croydon. They were given the go-ahead in April following a study into the feasibility of the idea. Under the plan, the boroughs would no longer use a traditional insurance provider but would create a joint guaranteed insurance mutual to bear the risks and provide cover for them all. This could be up and running as early as next year, as several long-term insurance agreements across London boroughs will be coming to an end over 2007 and 2008.
Another body considering a mutual option is a group of 21 English and Welsh councils known as the Councils' Alternative Risk and Insurance Group.
It has been estimated that the London boroughs could make substantial savings on their insurance premiums, if the majority of eligible authorities participate. If no major claims are made and the members perform better than other local authorities, the pool could generate a surplus for members, as they would not be subsidising anyone else's claims. To a finance director, the figures clearly look tempting on paper.
Additionally, in recent years, insurance premiums have increased for certain types of risk. Higher excesses have been imposed and some cover is being restricted. In some cases, cover is not being provided at all for 'new' risks. Concerns have also been raised that losses are not being shared equitably and that there is a limited choice among traditional insurance providers.
Pooling can help to overcome some of these issues. With correct contribution levels, pooling helps to smooth the premium cycle and avoids pound swapping with an insurer. Cover is based on the pool's own terms and can cater for risks that a traditional insurer is unwilling or unable to write. Insurance can be more easily 'debundled', giving the pool the ability to insure individual classes.
A commercial insurance company has an obligation to its shareholders to make a profit. A mutual is not bound in the same way, and consequently any contributions made are solely for the purpose of paying claims and administering the pool. Any investment income from the pool goes straight back to the members of the mutual.
The benefits of mutuals are clear, but as with any new venture, caution should be taken and any associated risks need to be considered and accounted for.
One of the arguments in favour of mutual insurance is that members can avoid the fluctuating premiums of traditional insurers. However, it is generally felt in the industry that commercial insurance premiums have now reached sustainable levels. There have also been many valid reasons why insurance premiums have fluctuated – for example, the severity of serious injury claims, retrospective legislation encompassing liability for incidents for which premiums have not been collected, new types of claim, the cost of reinsurance and, more importantly, the security of reinsurers. All issues that insurers face would also be faced by mutuals, meaning that members will need to allow for flexibility in their contributions to the pool.
Mutuals are particularly vulnerable to uncertainty in contribution levels in the early years, especially in the event of a large loss, as this could result in a call on members for additional capital. This might not be an attractive proposition to organisations that depend on finite financial certainty, such as the public sector. Therefore, to minimise avoidable risks, there will have to be a mechanism to deal with the need to raise additional capital. Where necessary, there will also need to be systems to support underperforming members that are unable to manage risks effectively, and to reward members for improving claims experience.
The start-up and operational costs of a mutual could work out to be significantly higher – as the pool rather than the insurer must handle control over claims, cash flow and management. With this comes responsibility and the need for external resource and technical expertise to answer queries on anything from policy cover, advice on dealing with unusual claims and guidance on new legislation. Advice from an actuarial perspective will also be essential for establishing solvency margins and contribution levels.
Before a mutual insurance operation is entered into, members must be satisfied that they comply with legal guidelines on the procurement of contracts. As the public sector has a duty to spend public money wisely, contracts must be tendered regularly to ensure that the best value-for-money option is being chosen. If the market is offering better value, then customers should have the freedom to choose the most appropriate solution that meets the authorities' overall strategic financial strategy.
In addition, the Treasury expects tax neutrality for the public sector. Any organisation that is funded by the taxpayer is not expected to undertake any activity to reduce tax payments. Some NHS trusts were warned that their funding would be reduced if they tried to reduce their tax bills through complex structures. This might apply in other areas with government funding.
To add further to the list of considerations, in an era in which major catastrophes are increasingly frequent due to extreme weather and increased terrorist activity, cover for catastrophic events is increasingly essential. A mutual-based insurance will retain an element of the risk itself.
The retention level will be determined by the members and is based on the size of the pool, the types of risks covered and the members' appetite for risk retention. Protection for costs in excess of the retained level or for any catastrophe claims will need to be provided by a reinsurer.
Catastrophe claims are, by their nature, more volatile than attritional claims, making this an essential but costly element of establishing a mutual. As mutuals are smaller than commercial insurers, they are less able to absorb such losses. Catastrophe protection will therefore need to be arranged at a low level, which will incur additional costs. It is also worth considering that flood or storm damage would be a concern if the members of the mutual are in the same area or region. The geographical element is something that the London boroughs have no doubt taken into account.
As with any partnership arrangement, there is an element of risk as any changes in the way things are done can present possible disruptions to the smooth running of business. To get the best out of working together, it is important to take certain factors into account right from the start. With mutuals, the key factor here is risk management. From the beginning, all parties involved need to be fully aware of the individual risks that each member is bringing with it.
Alternative risk financing will work only if robust risk management processes are adhered to. In the early stages there is the potential for a reduced focus on risk management, which could result in increased losses, rather than a lack of insurance. If an organisation understands and proactively addresses risk management, it will have fewer claims and should feel confident about controlling its own destiny through increased self-insured levels. All members will need to be proactive with how they manage risks to avoid a situation where those with good records inadvertently fund some of the costs of more passive members.
Establishing a mutual is a long-term project, and should not be considered as a short-term solution to a short-term problem. The nature of exposures and claims means that full financial results will not be known for many years. Insurers, as well as many mutuals, have failed, due to the difficulty in predicting the future and paying for the past. It will continue to be a challenge for customers and insurers alike.
As for the future of insurance, mutuals might be another alternative available to the public sector. It is right that local authorities look at all the options available. It is important to focus on the financing of risk, whether through insurance or other mechanisms as part of authorities' overall financial strategies. As
long as insurers continue to set their prices on the basis of the risks that each customer faces and continue to offer the best deal for their individual circumstances, the mutual option will continue to be another alternative in a competitive market. It is true that in recent months the mutual option has resurfaced within the sector, but it won't be a viable option for everyone.
Ronan Ball is head of single-tier authorities at risk management and insurance provider Zurich Municipal. In September, Zurich Municipal is hosting an on-line debate on the topic of alternative risk financing. For further details about how you can participate, e-mail [email protected] or contact Gemma Crisp or Clare Waller on 020 7592 3100
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