Magazine article Risk Management

Re-Evaluating Risk Financing Assumptions

Magazine article Risk Management

Re-Evaluating Risk Financing Assumptions

Article excerpt

Rapid changes in the property/casualty insurance and reinsurance markets-as well as the new concept of what constitutes a large loss-- are forcing insurers to re-evaluate the lines of business they write, their retentions and their pricing structures. Many insureds are reconsidering how and where capital should be allocated because of the new conditions caused by dramatic price increases, reduced capacity (or no capacity for terrorism, for example) and tighter underwriting. Almost all are using risk-based capital (RBC) allocation analysis at a level of intensity not seen since the financial markets crisis ten years ago.

Conducting RBC Allocation Analysis

Federal support of the industry may alleviate the terrorism exclusion problem, but price increases and reduced capacity will remain. In response, insureds, particularly large companies, will need to rethink their risk financing strategies and make adjustments in their allocation of risk retention and risk transfer dollars. It is inevitable that these changes will lead companies to consider assuming higher retentions and self-assuming additional lines of coverage. Moving in this direction is a timetested reaction to market contractions, but it may not be the right response in many cases. Insureds, self-insureds and companies contemplating self-insurance can-and probably should-use the same RBC analysis process used by most commercial insurers. They need to address two basic questions:

* Has the company allocated an appropriate amount of capital to support each of the risks that it has assumed?

* Does the return on equity (ROE) on that capital (as measured by the ratio of expected annual premium savings to the allocated capital) meet or exceed the company's internal hurdle rate?

To answer both questions, the company needs to adopt a way of determining the amount of capital needed to support the self-assumed risks regardless of whether these risks are not insured, are self-insured through a formal mechanism or are insured in a captive company. Companies may adopt the National Association of Insurance Commissioners' (NAIC) riskadjustment guidelines, but because each company's risk profile may differ from the assumptions built into NAIC standards, each company needs to make its own adjustments. For example, a company may have a highly volatile product liability exposure, but a very stable workers' compensation exposure. …

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