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The Rise of Alternative Risk Financing Solutions
26 June 2024
Growth in alternative risk transfer as traditional insurance markets harden
We live in a volatile world where geopolitical risks, economic inflation, natural disasters and an increasingly complex regulatory environment are applying pressures on all fronts, including the insurance sector. Underwriting requirements are becoming stringent, and prospective clients are having to provide far more granular information about their portfolio of risks as well as risk mitigation measures, while reduced capacity and insurer appetite for certain classes of risks remains a real concern.
According to Julie Smith, corporate strategic account manager at Aon South Africa, businesses may be surprised to find that renewals are much tougher than before, with risks that were previously covered now either being uninsurable or attracting onerous terms, conditions and hefty deductibles.
“Securing sufficient insurance capacity from local and global insurers continues to be challenging. Hardening insurance market conditions are the cause of reduced reinsurance capacity and appetite, which means that traditional insurance solutions are becoming unaffordable, or in some cases, the risk has become uninsurable,” says Julie.
The insurance market is, however, more amenable to businesses that take greater ownership of its risk mitigation by deploying proactive risk strategies and risk sharing through increased deductibles that can in turn be funded through alternative risk financing solutions. This is achieved by either incorporating a captive insurance solution or implementing an aggregate fund, or a combination of the two,” Julie explains.
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Captive insurance defined:
Captive insurance solutions are valuable tools to navigate volatile market conditions in terms of risk financing and filling the widening gaps in coverage, especially in challenging risk markets such as cyber, property, terrorism, sabotage and weather catastrophes.
“A captive is effectively an insurance company that is set up by the business primarily to self-insure against its own specific risks, which allows the business to take financial control of its insurance allocations. If the business is running mature risk management programs, hand in hand with risk consulting solutions, it may be able to rather consolidate its premiums instead of simply paying them away on traditional insurance, leveraging it to build scale within a captive,” Julie explains.
Adding captives to an organisation’s risk financing toolkits starts by assessing the total cost of risk and the optimal program design to strike a balance between risk retention and risk transfer. It allows the business to take on a sizable increase in its risk retention level because the business has ultimately reinsured its own risk. The business is then able to partner with a risk financing partner to lock down an insurance policy with more favourable terms and deductibles.
“Having a captive arrangement in place is an attractive drawcard that the business brings to the table in terms of risk retention levels for actuaries to factor into the equation alongside the organisation’s past claims history. It makes most sense when the actuarially calculated expected losses are significantly lower than the premiums and deductibles set by a traditional insurer,” Julie explains.
Aggregate Funds
An alternative to a captive solution is an aggregate fund, where the business approaches the insurance sector to set up a contingency fund for things that are not necessarily insurable. In this scenario, the business essentially invests in an aggregate excess that puts money into a risk-financing house. An example would be a big fleet company that has an aggregate excess plan with a stop loss attached to it.
- An aggregate excess is the overall retention fund for the client. In this example, the fleet operator has put a R10m aggregate excess on a fleet of 1000 trucks. Considering the business’ claims history, they would be able to secure a better insurance premium by taking more of the risk on themselves.
- Within the aggregate excess there could be protection for the client by way of a stop loss where the insurers will agree to pay for any one loss over a specified limit. For example, within your R10m aggregate excess, you may have an R500k stop loss agreement, which means the business will only ever pay for a single insured loss up to an R500k limit – anything above that would be carried by the insurer.
“The aggregate fund still forms part of the contract with the insurer and claims to the fund are treated like any other, duly assessed and documented by the insurer. The key benefit of an aggregate fund for the business is its ability to manage its claims better and money left in the aggregate fund, can be transferred to the following year,” Julie explains.
Insurers tend to be more amenable to businesses that proactively finance, retain and manage more risks themselves. As a result, businesses require increasingly sophisticated risk modelling solutions to support informed decision-making on risk financing alternatives such as captives and aggregate funds, to optimise the total cost of risk. Striking the balance between financial analysis and risk engineering is a high-stakes and complex task, best undertaken with the guidance of professional risk consultants who have the capacity and expertise to enable better decisions around alternative risk financing solutions.