STRIMA September 18, 2002 Branson, Missouri Alternative Risk Financing Steven P. Kahn, CPCU, ARM Managing Director ARM Tech, an Aon Company Presented by: Jenny P. Emery Senior Vice President Towers Perrin Reinsurance

A Definition Alternative risk financing refers to loss funding mechanisms other than commercial insurance. Exhibit 1

Key Point Closely evaluate: Real risk financing needs “Hazard” risks and other risks All costs of the mechanism Financial, political and legal support you will need Exhibit 2

Loss Portfolio Transfer In return for a premium payment, an insurance company assumes responsibility for incurred but unpaid claims. Exhibit 3

Advantages of LPT 1.Establishes a defined level of certainty for future loss payments (up to the policy limits). 2.Insurer is responsible for: Loss development IBNR 3.Removes what is often an unfunded liability. 4.May place claims administration responsibility with another organization. Exhibit 4

Key LPT Issues 1.Limits: Size of each claim insurer will pay Aggregate amount insurer will pay 2.Scope of coverage within which claims fall. 3.Allocated loss adjustment expenses: Insurer pays all ALAE Insurer pays pro rata share of ALAE Insurer pays no ALAE 4.Data needs: Actuarial study: —Loss projection —Payout pattern Claims audit Discount factor you want to use 5.Data credibility. Exhibit 5

Finite Risk Insurance A program in which the insured pays a premium to the insurer based on the losses the insured can expect to pay. The insurer will pay losses within set limits and credits interest earnings to the insured. Exhibit 6

Typical Features of Finite Risk Insurance Multi-year policy Insurer has interest rate risk but seeks to limit this Insurer has timing risk Insurer profit is based on fees and use of funds Insured has a credit risk Insured may receive a premium return if losses are less than expected Can apply to uninsurable risk Exhibit 7

Catastrophe Bonds 1.State issues bonds 2.If the specified type of loss occurs: a.Interest is forgiven b.Interest and principal are forgiven 3.Specified losses: a.Earthquake b.Wind c.Flood All exceeding certain size and damage 4.A few specifics: a.Principal put in trust b.Period interest payments c.Principal repaid at maturity Exhibit 8

What is a “Pool” A group of entities that: –Jointly retain losses to a selected level –Arranges services needed to support the program Exhibit 9

Alternative Forms 1.Trust 2.Risk retention group 3.Group/association captive 4.Joint powers authority 5.Licensed insurer Exhibit 10

Typical Pool Structure Exhibit 11 Individual Members Excess Insurance Pool Retention (Loss Fund) Loss Payments Premiums Services: Legal defense Claims administration Other

Advantages of Pools 1.Reduce cost 2.Stabilize cost 3.Customized rating plan 4.Directed loss control 5.High-quality claims service 6.High-quality administration 7.Broad coverage 8.Build long-term equity Exhibit 12

Potential Disadvantages of Pools 1.Less flexibility 2.Management time 3.Underfunding 4.Industry-specific loss problems Exhibit 13

Key Issues 1.Rating plan that: Provides savings to all Does not result in adverse selection 2.Use of agents 3.Building surplus vs. keeping rates low 4.Sufficient administrative support: Staffing Other expenditures 5.“Political” issues Exhibit 14

Challenges You Have Tackled Managing and reducing risk created by state operations Optimizing use of commercial insurance Measuring and managing risk financing costs for budgetary stability Deriving real value from service providers Exhibit 15

Ideas for Challenges You Should Tackle Next 1.The risk you pay for….indirectly 2.The unreasonable penalties the excess market wants you to pay 3.The de-stabilizing risks that the insurance industry isn’t very good at Exhibit 16

Sources of Indirect Risk “Cost Plus” contracts: –One-time (e.g., construction) –On-going (e.g., outsourced services) State-funded services that require minimum insurance: –Social service agencies Exhibit 17

Example Success Story: Public Sector Transportation Before Six contracted bus companies spending $15 million/year on auto liability Poor services; no incentive to manage risk Cost passed-through to DOT After DOT-sponsored insurance program: –Large SIR’s –High limits –Quality coverage and service –Incentives to improve risk management All-in program cost: $11.5 million/year Annual Savings: 23% Exhibit 18

Unreasonable Penalties in the Excess Market Sources of trouble: –Years of underpricing –Emerging exposures (asbestos, mold) –9/11 –Investment losses Impact on buyer of excess: –Expanded definition of “working layer excess” –“Exorbitant” cost for truly remote protection Exhibit 19 “If the risk is really so remote that I shouldn’t charge much for it, then it’s not worth writing it. I have to charge with the expectation that a loss will occur.” — U.S. Reinsurance Executive

Example Success Story: NLC Mutual Reinsurance Before Numerous state- municipal league- sponsored pools buying excess Typical costs 10% to 25% of premium dollar Little negotiating power After NLC Mutual negotiating Reinsurance Treaty on behalf of many pools More capacity; better pricing Dividends returned to member Result: 18.86% of Premium Returned to Members over past 8 years Exhibit 20

The De-stabilizing Risks Terrorism Newly emerging (e.g., mold) Industry-specific risks Exhibit 21

Example Success Story: A Work in Progress - Terrorism Pool 250 million xs 50-million 40-million xs 10-million Companies set their own retentions and buy insurance The first pool layer is “pre- funded” The second pool layer is “post- funded” Offshore Industry Captive The premiums from the first layer are ceded by the pool to a captive owned by the members     Exhibit 22

A Word About Alternative Risk Vehicles The Public Sector Bias They are gimmicks to avoid taxes –And not relevant to the public sector They create lots of “frictional cost” They require lots of new structure, which may not be politically palatable The Truth They are structured facilities that can enhance long-term success of self-insurance or risk-retention programs The “value” of the added costs can be easily offset by: –Better terms/costs for reinsurance –Allowing for participation by multiple entities New tools (e.g., segregated cell captives) have greatly simplified formation and management Exhibit 23

STRIMA Alternative Risk Financing Steven P. Kahn, CPCU, ARM Managing Director ARM Tech, an Aon Company Jenny P. Emery Senior Vice President Towers Perrin Reinsurance