Taking the luck out of pooling
The major employee benefits networks are reporting their busiest periods for new business for some time. The existing total market of around 2,200 pools is likely to expand by 8% this year and there is more in the pipeline.
This change in fortunes is not completely accidental. Behind the numbers are the problems at Enron and other US companies, the persistent forces of shareholder agitation who above all want clarity and the recognition of global accounting standards, forcing the evaluation of pension liabilities and benefit risks.
This thin thread of connections leads in part to the revitalisation of the pool as the choice of vehicle for both the management and cost control of employee benefit risks. The buyer must beware though.
Pool profit or loss?
As many as one third of all employee benefit pools suffer overall losses at some stage in their history, and occasionally, these losses will be unmanageable.
In response, the networks have evolved a number of different risk management tools to counter these risks, which vary in their effectiveness and their cost. Risk managers and HR managers who run pools face a difficult decision to balance the need for reducing exposure with the desire to maximise the cost benefits, without always having any firm idea of whether the tools they are presented with give fair value or adequate cover.
To give an example: a UK chemical company has 10,000 employees, 60% of whom have their employee benefit risks pooled under the most common form of pool, a loss carry forward basis. They have a concentration of 2,500 employees at two sites in the UK. The pool premium is £4.8m (E7.5m).
The exposures are as follows:
The UK accumulation exposure has also increased due to the higher than average individual sums assured.
In a loss carry forward pool in its purest form, this client is on risk for these sums assured, without limit. So if, in a typical year, the client obtains 10% of the pool premium as a dividend after claims expenses are met, then the margin between profitability and loss in this example is just £480,000 or three average claims.
The networks have evolved a number of products to counter this volatility:
1. Limited Loss Carry Forward – Here any overall pool loss in one year, is carried forward to set against profits in the subsequent years. If there is still a negative balance from this original loss after often three or five years, they are eventually paid off by the network reinsurer.
2. Stop loss – Here any overall loss accumulated in the pool is covered by the reinsurer at the end of each pooling year.
3. Excess loss – individual losses are capped at a maximum agreed with the network.
4. Catastrophe cover – usually three or more claims from a single event are treated as one single death with the balance covered by the reinsurer.
As usual the devil is in the detail. As the chart* below shows, the availability of risk management tools varies substantially between the networks. However, following some basic rules should reduce the risk of losses in the pool:
1. As a general rule of thumb, the larger the pool the less volatility. Therefore it makes sense to start out with Stop Loss or Limited Loss while the pool is developing
2. Every network offers some form of Excess Loss cover to cap higher claims. The less Stop Loss cover the pool has, the greater is the need to identify and cap large individual exposures, such as highly paid employees in the UK.
3. Clients with concentrations of employees need to evaluate the exposure and risk from the pool. Stop Loss or a Catastrophe cover may the most effective solution, depending on the network and the cost. Risk models are available to quantify this risk more accurately
4. Lastly, analyse the local risk that is to be pooled. The old adage, rubbish in – rubbish out comes to mind. Many losses can be avoided, simply by checking that the local contract has been properly underwritten and that the terms are reasonable.
Getting the best out of your pools needn’t be a matter of luck. Lets face it, people call it luck when you’ve just been more sensible than they have!
Extract from Watson Wyatt 2002 Networks audit
Peter Eyre is a partner at international consultants Watson Wyatt in Reigate