There is continuing debate about what constitutes the optimal financing method for global benefits risk. In a simplistic form the question at issue is whether greater financing economy can be achieved by self-insuring benefits in a captive, or experience-rating insured benefits in a multinational pool. In fact, the optimal benefit financing arrangement for any multinational company will depend on its benefits ‘exposed to risk’ and may lie somewhere between these polarised alternatives in the form of a financing construct composed of elements of each.
The benefits ‘exposed to risk’ generally comprise benefits payable on death in service, during short term sickness or long term disability or on accidental death or injury, and reimbursement of medical and hospital expenses. The exposures may also include the longevity risk in respect of retirement pensions and some investment risks as well.
The first objective of benefit risk financing is to minimise the cost of benefits. This is consistent with the strategic aim of a business to obtain the lowest cost of risk in relation to any exposure. It requires all risk management expenditures, (including insurance premiums and moneys set aside for risk reserves) to be analysed on the same basis as any other trade off that commits present resources against the expectation of future returns. This necessitates a procedure for the regular monitoring of losses and risk management expenditures in respect of all the multinational company’s health and risk benefit plans in each location in the form of an audit covering the following critical factors of ‘risk benefits cost’:
q uninsured benefit losses;
q administration costs (including fees for the services of consultants and other external providers);
q pre-loss risk reduction and post-loss risk control expenditures, (eg corporate health risk management programmes);
q unreturned insurance premiums (including stop loss and catastrophe excess of loss reinsurance premiums) transferred outside the multinational group;
q unrecovered investment returns on cash flow that is on insurance premiums, reserves and dividends unpaid.
This is followed by the process of risk assessment entailing use of analytical tools such as risk identification that is the recognition of the nature of the exposures (for example mortality, morbidity and longevity) and risk evaluation that is measurement of the risks in terms of their frequency and severity and therefore their predictability.
These tools largely determine how the exposures are to be treated, whether by loss reduction/control and/or financing that is retention of the benefit risk or its transfer (usually by insurance). An insurer charges more than the cost of claims and expenses to allow a profit margin and except in situations where protection is required against the volatility of claims, it is generally uneconomic to buy insurance.
Efficient global benefit financing requires a central chronological loss-spreading mechanism for the ‘working layer’ of the risk (that is the part representing predictable losses). This financing mechanism can be modified as and when required by the addition of stop loss, or excess of loss, insurance protection against extreme claims, whether arising from natural causes or catastrophic events. A multinational pool offers an opportunity for self-insurance through its loss treatment systems, and either on its own, or in conjunction with reinsurance to a captive insurer, can usefully serve as a matrix for a central funding mechanism for global benefit risk exposures. What matters in the case of any risk funding vehicle, multinational pool or captive, is that the insurance protection purchased is relevant and that realistic investment returns can be realised on premium float and risk reserves.
The critical factors of ‘risk benefits cost’ summarised above generate a number of criteria for evaluating multinational pooling arrangements. In addition to the requirement for relevant insurance protection and realistic investment returns on premiums and reserves, the principal criteria are the range of accounting systems available, the quality and detail of financial reporting, underwriting conditions, administration and risk charges, and the option of economical reserving practices.
Multinational pooling does not automatically eliminate unnecessary insurance costs. Adaptation of the premium to the real cost of claims tends to be limited by the insurance network’s retention to cover expenses and profits. Further savings to cash flow, however, may be possible through reinsurance of all or part of a pool to a multinational company’s captive insurer.
Benefit financing in a captive confers a number of economies such as lower risk premiums, as captives operate with lower expense and profit margins than commercial insurers; enhanced cash flow, since premiums and reserves stay with the corporate group until paid out as claims; and tax-efficient investment of reserves. It is also beneficial to the captive by diversifying its risk portfolio and increasing capitalisation.
The arrangements established to enable captives to participate in benefit risk financing take the form of either reinsurance to a captive of part of the risks of a multinational pool, or reinsurance to a captive (either directly or through a local fronting insurer) of risks under a local company benefit plan.
The use of multinational pooling as a central funding mechanism, requires the availability of what is known as a ‘loss free’ accounting system. Unlike a conventional multinational pool the ‘loss free’ pooling contract is entirely without any built-in insurance protection whether it be (a) in the explicit form of compulsory ‘excess of loss’ reinsurance for peak individual sums at risk or ‘stop loss’ cover for aggregate claims exceeding a stipulated threshold or (b) in the implicit form of ‘unmanageable deficit’ relief operated at the discretion of the pooling network.
Compulsory forms of insurance protection are an obstacle to the realisation of an optimal pool because they are not tailored to the risk financing requirements in respect of the pool’s exposure to loss. Moreover, they expose the pool to further potential losses in terms of unnecessary risk management expenditures, whether in the form of reinsurance premiums or deficiency reserves held by the network to amortise unmanageable deficits.
Insurance protection has to be matched as precisely as possible to the pool’s exposure to loss, and should be purchased independently by the pooling client through the pooling network, or, where a company captive is acting as the primary reinsurer, outside the network from reinsurers of the pooling client’s choice. If the multinational company’s captive insurer underwrites third-party business, it may have strong well-established relationships in the reinsurance market which would facilitate the purchase of appropriately designed and economical reinsurance covers.
In principle, a captive insurer should always be a more economically efficient risk funding vehicle than a multinational pool because premiums (other than reinsurance premiums) and risk reserves stay within the multinational group until paid out as claims. In establishing a captive financing arrangement for global benefits risk, however, a number of practical difficulties may be encountered.
First, direct reinsurance to a captive of risks under a company benefit plan can only be achieved in countries with a relatively free insurance market (the UK, for example). In countries with restricted insurance markets captive reinsurance can generally only be achieved through a multinational pool. Second, financing global benefits risk through a captive requires an enabling network of local (fronting) insurers and this is most conveniently achieved through the medium of a multinational pool. Third, a captive insurer, acting on its own, may, unless it writes a significant amount of third party business, find it difficult to obtain stop loss, or excess of loss, cover proportional to its risk exposure. It should be able to purchase this protection much more readily, and on more economical terms, through a multinational pool because the international insurance network will usually have leverage with reinsurers as a major buyer in the reinsurance market.
It is generally an indispensable condition for the efficient financing of global benefits risk to establish a multinational pool that satisfies the evaluation criteria discussed above. If most of these criteria can be satisfactorily met, it will be necessary to judge whether the pool represents the optimal financing vehicle for the benefits at risk, or whether reinsurance of the pool, in whole or in part, to the multinational group’s captive insurer realistically offers opportunity for further reduction in the cost of the risk.
There are three broad criteria for judging whether a stand-alone multinational pool can be as economically efficient as a risk funding vehicle as a captive insurer. These are:
(i) Opportunity to purchase insurance protection proportional to the nature of the risk exposure at the same economic cost.
(ii) Commensurability of net investment return on all premiums and reserves (that is, reasonable parity of cashflow and financial returns).
(iii) Comparability of management expenses, including any reinsurance commissions.
There may be circumstances where it is simply impracticable to use a single multinational pool as a central risk funding mechanism. If an international network has insufficient geographical spread, it will be unable to provide the multinational company with pooled insurance coverages in all the countries where it operates. In such cases the only practical option may be for the multinational company to use two or more networks for pooling purposes. It could then treat one of its captive insurers as the central risk funding vehicle and establish, on the most favourable terms it can negotiate, quota share reinsurance treaties between the pooling networks and the captive and any required retrocessions of the risk against extreme claims. This would be the only way to integrate global benefit risk financing in a central funding vehicle and would probably represent the optimal use of multinational pooling in the circumstances.
Tony Salter is a senior manager in the healthcare and risk benefits practice at PricewaterhouseCoopers in London