Multi-year aggregate insurance policies as a risk retention and risk finance solution explained

There are various ways to structure risk retention and risk finance solutions for the commercial and corporate market. Alfons van der Vyver, Executive Head of Risk Finance Solutions at Centriq Insurance, elaborates on these …

Also called finite risk insurance or spread loss policies, these structures provide the insured with a solution which offers various benefits in the event of adverse loss experience. These include cash flow relief, income statement protection, and conventional risk transfer.

“Many businesses who analyse their claims experience might find that they have an appetite to retain their exposure to a defined pattern of losses over periods longer than one year. Large losses may be completely absent, or occur infrequently. Whilst the business might not be able to absorb the full loss, or a significant deductible on such a loss, in any one year, it could absorb such an exposure over a longer term. And this is where the spread loss policy comes in,” notes Alfons.

Features of this type of structure

Alfons explains that the spread loss policy provides cover over a fixed term longer than one year, with deductibles, annual limits, term limits and minimum premiums set at inception. Premiums are adjustable within certain parameters according to the loss experience.

In order to determine the adjustment premiums, or the performance bonus payable at expiry, the insurer maintains an experience account. The insurer invests the premiums it receives and credits the experience account with a performance bonus determined with reference to a specified benchmark, which may take on the form of a segregated portfolio (depending on the size of the contract).

He adds that the insurer’s (or the brokerage’s) margin, and losses, are deducted from the experience account balance. If the experience account goes into negative, the contract may require the insured to pay an assessment premium.

Commenting on just how the annual and term limits of indemnity are set, Alfons says that the insured’s ability to fund the structure to a level where the sum of premiums and investment return, less the risk margin, are taken into account.

In a structure which contains significant risk transfer, the insurer may be exposed to some or all of the following risks:

• Credit risk, which arises if the experience account balance goes into negative, and the insured doesn’t pay the annual or assessment premiums as they fall due.
• Underwriting risk (also called tail risk), which arises in certain scenarios, e.g. where attritional losses erode the experience account to levels where the remainder of the term limit is substantially greater than the projected experience account balance.
• Investment risk (market risk), which arises where the insurer’s investment portfolio performs below expectation, resulting in the tail risk gap being greater than expected.

In order to do accurate pricing on a spread loss policy, the insurer requires adequate loss history. “A period which is at least equal to the term of the proposed structure is usually useful,” he says. Considering the historical loss distribution, and factoring in the required margins, the insurer determines the probability of it breaching its risk appetite.

Alfons notes that the spread loss policy is best suited to a loss distribution where either zero losses are expected, or large losses only occur once every three to five years (high severity, low frequency loss distributions). “The policy could be structured over a longer term, but usually the business would review the structuring of their overall insurance programme within such a timeframe,” he explains.

Benefits of a spread loss policy

The benefits of this type of structure include:

• cash flow from an effective line of credit to fund unexpected losses within a risk retention programme;
• protection against significant income statement volatility where the insured has appetite to retain the risk over longer term;
• conventional risk transfer to protect against high adversity, low probability loss scenarios; and
• tax efficiency, if structured correctly.

“Spread loss policies could be used to finance and cover any number of risk types, including property (fire/material damage and business interruption), various types of guarantee lines, or as a reinsurance solution for a conventional insurer looking to protect its net account,” Alfons concludes.