Risk means different things to different people. The term is often used in different ways so that the meaning can sometimes be difficult to really understand. But what all definitions of risk have in common is that they attempt to quantify what happens if something goes wrong.
On the general insurance side there are many sophisticated techniques of risk management. Risk management may involve cutting the cost of the risks should they emerge and/or reducing the chances of those risks occurring. These risk management techniques may extend to the em-ployee benefits arena - either to the insurance needs of employers in respect of risk benefits or to captives that need protection against adverse experience.
One such technique is 'Monte Carlo' simulation. As the name implies this involves projecting the future rather as one would when gambling in a casino.
To understand how this technique works, and what it can do for the financing of employee benefits or for a captive insurer, we shall consider group life as an example.
For each person we project forward and roll an electronic dice to see if they survive or die over the period. If they die the benefit is assumed to be payable; if they survive it is not. We then repeat this process for the next employee and accumulate the total benefit pay-able so far. This process continues over the entire population so that we estimate the total benefit pay-able in this simulation. A sufficient number of simulations are then projected to enable us to assess the risk distribution of the benefit.
In plain English this means that we are able to assess not only the expected cost of the death benefit but also how uncertain that ex-pected cost is. We can ascertain whether the benefit is as likely to fall within a particular range as outside it or whether there is a 99% chance that the benefit will be less than a certain amount. In other words we can measure - and hence control - how risky the benefit cost is.
A benefit ofthis technique is that we can do what-if" projections. We can amend the benefits and see how the costs and the riskiness change. This modelling process is a valuable way to look into the future without actually experiencing it first hand.
For the technique to yield meaningful results we need to base our projections on past experience. It is important to segment the population into groups that are not too diverse in risk characteristics. Also important is to allow for changes expected to occur in future.
Similarly we can project a portfolio of different benefits to see how risky they are in aggregate. Then, by cutting off the top of the costs of these benefits and adding known reinsurance or insurance costs, we can see how effective the various different reinsurance programmes are at controlling risk.
This technique is not necessarily suitable for all companies. Here are some examples of where it does not work:
p Each individual risk is large and only a few such risk units covered.
p It is impossible to fit the risk units (the people, that is) into reasonably harmonious groupings.
p There have been fundamental changes to the underlying risk factors (for example, new production processes may effect the risk of employees having accidents at work in the future).
As with all actuarial techniques we must never forget that we have only built a model, not a representation of reality. Consequently it is very important to monitor outcomes to see how they compare with the predictions. It may be that the model will require incremental change or refinement - or even radical reaffirmation. Sometimes we have a tendency to try and fit reality into the model even when it doesn't fit properly. This tendency should be steadfastly resisted.
The value of this technique lies in the added dimension that it can bring to the risk management of employee benefits. Traditionally the options have been akin to an on/off switch - either you insure or you do not. This technique adds the further dimension that you can experiment with different types and levels of insurance and compare the end results.
Let us now turn to the position of a captive insurer. Many employers use multinational pooling to in-crease the efficiency of their financing of employee benefits around the globe. In many cases however, pooling does not go all the way.
There may be a number of reasons for this. For example, it may be impossible to consolidate all insurances with one network. Secondly, network retention may be considered too high by the em-ployer. Thirdly, the employer may have grown to the size of being less risk adverse than previously and may look to retain more of the risk itself.
But once the risk has gone into the captive the employer needs to assess whether the captive could endanger the solvency of the whole company. To ensure the protection of the company the captive must limit the exposure to adverse experience in some way.
This can be done either by limiting the risks taken into the captive, or by reinsuring appropriately. Where the risk limitation is achieved at the front or rear end, the technique described may be applied to quantify the financial efficiency of the risk reduction programme adopted.
In summary, techniques exist to help employers take control of the risks inherant in their employee benefit plans. The time has arrived for employers to decide how much risk to accept or by insuring appropriately - how to protect against a bad experience.
The employee benefit manager can put him or herself in the position to quantify how much to pay for the ability to sleep at night. That surely is what risk management is all about.
Simon Wasserman is head of Aon's international practice in London"
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