Title: Allocating Risks Among Market Participants: Lessons from the Insurance Industry
1Allocating 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
2The Insurance Industry Models
- Three types of "public pools" exist
- Customers failing to select competitive provider
- Payment-troubled, disconnected
- High cost / bad risk
3Risk 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"
4Models of Public Pools
- Three models to allocate risks in high risk/high
cost public pools - Assigned risk plan
- Joint underwriting association
- Reinsurance facility
5The 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.
6Joint 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.
7Reinsurance 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.
8Reinsurance 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.
9Reinsurance 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.
10Reinsurance 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.
11Assessing 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.
12Assessing 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.
13Assessing 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.
14Advantages 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.
15Disadvantages 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.
16Disadvantages 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.
17For more information