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Title: Allocating Risks Among Market Participants: Lessons from the Insurance Industry


1
Allocating Risks Among Market ParticipantsLesson
s from the Insurance Industry
  • Presentation to
  • Rethinking Credit and Collection for
  • Gas and Electric Deregulation Conference
  • Roger Colton
  • Fisher, Sheehan Colton
  • Belmont, MA
  • January 1998

2
The Insurance Industry Models
  • Three types of "public pools" exist
  • Customers failing to select competitive provider
  • Payment-troubled, disconnected
  • High cost / bad risk

3
Risk Allocation Pool Inappropriate
  • Reasons why customers failing to select a
    competitive provider should not be part of a risk
    allocation pool.
  • Different policy considerations exist
  • Not how to allocate high risk or high cost
  • How to "jump start" the competitive market
  • How to overcome market barriers to "choice"

4
Models of Public Pools
  • Three models to allocate risks in high risk/high
    cost public pools
  • Assigned risk plan
  • Joint underwriting association
  • Reinsurance facility

5
The Assigned Risk Plan Model
  • Develops a standard set of rates and policy terms
    for assigned risk business.
  • Companies are assigned unwanted policyholders on
    a random basis, generally in proportion to the
    amount of total insurance that the companies do
    in the state.
  • The company to whom a consumer is assigned takes
    full responsibility for either the profit or the
    loss resulting from its "assigned risks."
  • The company provides all of the services normally
    coincident with the insurance policy, including
    accepting premium payments, paying claims, and
    performing the other ordinary business functions
    of providing insurance.

6
Joint Underwriting Association Model
  • A limited number of companies --frequently known
    as "servicing carriers"-- agree to handle all of
    the involuntary business.
  • The servicing carriers perform all of the
    functions of the insurance carrier
  • The servicing carriers are compensated for
    providing these services.
  • Although policies are issued in the names of the
    servicing carriers, the risk is borne by the
    association.
  • The association's underwriting losses are made up
    from surcharges imposed upon public pool
    participants as well as by "residual market
    equalization charges" imposed on all insureds in
    either the voluntary or residual market.

7
Reinsurance Facilities ModelOverview
  • Through a reinsurance facility, the risks imposed
    by public market participants are "reinsured"
    through a public pool facility.
  • A reinsurance contract is precisely what it
    indicates a contract through which an insurer
    procures a third person to insure against loss or
    liability by reason of the original insurance.
  • The reinsurance facility involves a paper
    transaction between the facility and the
    insurance company that is often transparent to
    the consumer.
  • The insured will generally pay the same rate as
    found in the voluntary market.
  • The profits or losses from facility operation are
    shared proportionately among all facility
    participants.

8
Reinsurance Facilities ModelEligibility for
Coverage
  • Objective measure Carriers can cede
    "unacceptable risks" to the reinsurance facility.
    An "unacceptable risk" is one that statistics
    prove will be unprofitable.
  • Subjective measure Insurance carriers have an
    absolute right to cede a risk to the state
    reinsurance facility. The only criterion for
    eligibility is that the company does not wish to
    retain the risk without regard to any objective
    criteria.
  • Market driven Consumers who are otherwise
    unable to obtain coverage in the private market
    will be served by the pool.

9
Reinsurance Facilities ModelAllocation of Costs
  • Apportionment can be based on market penetration.
    In this scheme, losses/profits are apportioned
    irrespective of the number of risks ceded to the
    facility.
  • Apportionment can be based on facility
    utilization. In this scheme, losses/profits are
    apportioned based on the degree to which a
    company uses the facility relative to total
    facility use.
  • Apportionment can be based on a weighted average.
    Use of a weighted average might, for example, be
    based on 80 facility use and 20 market share.
  • In some instances, liability capped at 1 of net
    worth, to protect small companies.

10
Reinsurance Facilities ModelDistribution of
Gains
  • Any gain after loss payouts is distributed to
    persons served by the facility.
  • Only way for carrier to make a profit on the
    customer is to retain the customer in the private
    market.

11
Assessing the Relative Merits Defining Five
Criteria
  • Whether new entrants are encouraged
  • Whether suppliers and/or incumbents retain
    management flexibility
  • Whether supply and cost responsibility are shared
    by all market participants
  • Whether the structure and/or process addresses
    all three target groups
  • Whether the structure/process succeeds in
    promoting universal service.

12
Assessing the Relative Merits Applying the
Criteria (1 of 2)
  • Residual market mechanisms in the insurance
    industries are not designed to encourage new
    market participants. If incorrectly designed,
    however, these mechanisms may interfere with the
    entry of new companies.
  • Different residual market mechanisms grant
    different levels of management flexibility to
    industry participants. Reinsurance facilities
    grant maximum flexibility to industry
    participants. Assigned risk pools and joint
    underwriting associations provide for little, if
    any, flexibility.
  • All residual market mechanisms in the insurance
    industries provide for a sharing of costs between
    companies. Cost allocation can be based on
    unweighted facility use, unweighted market share,
    or a weighted combination of the two.

13
Assessing the Relative Merits Applying the
Criteria (2 of 2)
  • Neither the assigned risk pool nor the joint
    underwriting association directly address
    universal service for the poor. Consumers who
    have lost insurance service because of the
    failure to pay premiums are specifically excluded
    from participation in the residual markets. This
    operates against the interests of low-income
    consumers since these mechanisms often offer
    service at significantly higher prices.
  • Assigned risk plans and joint underwriting
    associations fail to promote universal service.
    They have been found to result in lesser service
    being provided at significantly increased rates.
    In addition, excessive cession of "clean risks"
    to these pools impedes universal service.

14
Advantages of Using Insurance Models
  • There is an established mechanism for sharing the
    costs of the residual market. A variety of
    cost-sharing methods have been explored,
    modified, and abandoned. Various cost-sharing
    methods have been found to be both effective and
    fair.
  • The cost sharing mechanisms are competitively
    neutral. Neither consumers nor market
    participants can choose to avoid the costs of
    serving the residual market through a selection
    of carriers or through a selection of services.
  • The reinsurance facility approach maximizes
    consumer choice. Residual market participants
    are not assigned to an unwilling carrier.
  • The reinsurance facility approach also maximizes
    management flexibility. Management is left to
    decide whether to serve the residual market, how
    to serve that market, and how to manage the risks
    of serving that market.

15
Disadvantages of Using Insurance Models(page 1
of 2)
  • Rather than allowing for management flexibility
    and innovation, the assigned risk pool seems to
    adopt the worst aspects of the electric utility
    industry's cost recovery philosophy. There is no
    incentive for, and no reward for, managing the
    risks in the residual market and lowering the
    cost of serving the residual market.
  • Unless provided through a reinsurance facility,
    under which residual market customers are
    provided the same service at the same rates as
    other customers, the residual insurance pools do
    not promote the affordability of insurance
    service. As a result, the "availability" of
    insurance may be illusory given its
    unaffordability.

16
Disadvantages of Using Insurance Models(page 2
of 2)
  • Unless cost allocations are based on facility use
    (including some type of weighted approach),
    limits are placed upon the cession of risks, or
    specific incentives are provided to consumers
    through the voluntary market, there is a strong
    tendency for residual insurance markets to become
    over-populated.
  • Without specific incentives created to move
    residual market participants into the voluntary
    market, consumers remain in the residual market.
  • Given a facility-based cost allocation method,
    and an assumption that new market entrants tend
    to under-price service thereby attracting a
    disproportionate share of residual risks, such a
    cost allocation serves to discourage new entrants.

17
For more information
  • roger_at_fsconline.com
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