WORKERS COMPENSATION FUND conversion has become a hot industry topic, as many self-insured funds are finding their competitiveness relative to the standard market rapidly decreasing.

As fund administrators recognize that their funds are becoming less competitive with the standard market, they need to explore conversion alternatives. Conversion may ensure the very survival of these programs in the current soft market. As a fund becomes less competitive with the standard market, many of that fund's "better" members -- as defined by loss history, experience modifier and the like -- depart in favor of the standard market. This leaves the fund with a higher percentage of less-desirable members.

This adverse selection trend ultimately dilutes the fund's spread of risk and triggers the "death spiral" of the fund. The death spiral analogy may seem a little extreme; however, this was, in fact, the pattern of demise for the standard market during the pre-reform times of high residual market loads late in the 1980s and in the early 1990s.

Cost, the initial factor spurring the popularity of self-insured funds, is now the same factor leading to their demise. Self-insured funds have the additional problems of being unrated by A.M. Best Co., the inability to cover members' multistate exposure and, most importantly, joint and several liability. These problems were previously seen as tolerable by fund members, given the cost of being in the hard standard market at the time. Now that the standard market is competitive and does not have the added pressures mentioned above, the midsize employer, which is always margin conscious, will favor the standard market.

There are two basic conversion options currently available after the dissolution of the self-insured fund -- either its reformation as a comparable fully insured safety group or its conversion to a fronted captive.

The conversion approach selected should be decided based on the self-insured fund's philosophy, its size, and its appetite for risk assumption/risk reward return. This discussion will focus primarily on the fronted captive, because the fronted captive, like self-insurance, maintains the element of alternatively funded risk sharing.

The safety group approach basically converts the self-insured fund into a fully insured association program. As a fully insured program, multistate capacity and the elimination of ongoing joint and several liability are automatically achieved. Retroactive joint and several liability can be eliminated by executing a loss portfolio transfer, which is addressed below.

Additional competitiveness relative to the standard market through the safety group is possible through aggressive loss control and claims management and the return of profit-derived dividends to program participants. The safety group approach allows a sponsoring association that lacks the initial capital or resources to convert to a captive arrangement the ability to continue offering a competitive insurance program to its members.

Fronted captives provide the same risk retention merits as self-insurance, along with the "disguised" advantages of a fully insured program. Basically, a self-insured retention is replaced by a comparable quota share layer that is assumed by the fund -- now referred to as a captive. An insurer issues "first dollar" policies in front of the captive's retained risk layer. Due to capitalization and management cost requirements, the formation of a single-parent captive is usually not a feasible option for a self-insured fund.

Association captives with multiple owners that can share start-up and operational costs are becoming more common. Rent-a-captives are the most viable route in most cases. The most common rent-a-captives are owned and managed by insurers that, for a captive management fee, allow entities such as self-insured groups to join. Rent-a-captives are already capitalized and operational, and they provide turn-key management functions for accounting, banking, asset management, and so on.

Some level of collateralization relative to the amount of retained risk will be required for participation in a fronted rent-a-captive. This is due to the inherent exposure assumed by the insurer for providing first-dollar policies while collecting only a relatively small portion of the risk premium.

Assumption of a quota-share layer allows program participants to share in the underwriting profitability and investment return achieved by the rent-a captive. The quota-share participation can be structured in a variety of ways, depending on whether the program's appetite for risk assumption is higher, lower, or the same as that of the self-insured fund.

The amount of potential risk reward is ultimately much greater than self-insurance through the captive arrangement, largely due to the ability to realize greater return on investment income of asset funds. State jurisdiction, with regard to self-insurance, normally restricts the way in which fund assets can be invested. Investments are usually limited to very conservative investments, such as treasury bills, government bonds, money markets, and the like, which in turn, limit return.

Since fronted captives "disguise" a quota-share risk retention program as fully insured coverage, state self-insurance regulations pertaining to asset investments are not applicable. This allows asset managers to use more aggressive investment vehicles, while still exercising prudence. Higher investment return equates with better dividend return to the participants of the captive.

There are also several tax advantages that can be obtained by using an offshore domiciled captive. Derived investment income held outside the United States is not taxable until it returns to this country in the form of shareholder dividends. This allows for greater accumulation and accrual of investment income.

The loss portfolio transfer allows the self-insured fund's existing losses, including those that have been incurred but not reported, to be "bought out" by and transferred to an insurer or reinsurer. The losses are thus totally removed as a liability of the self-insurance fund. Typically, if an insurer determines that a self-insured fund's expected losses have been appropriately reserved, the self-insured fund can negotiate a transfer of the loss portfolio to an insurer based on a "premium" amount, which is relative to the amount of the initial loss portfolio. Consideration is given toward the net present value of the initial loss portfolio in order to discount the cost of the resulting "transfer premium."

Insurers typically assume a loss portfolio for a set dollar amount. They then try to "manage" and "close out" all claims for an amount less than the transfer premium paid plus accrued investment income.

Once the loss portfolio has been transferred, all retrospective joint and several liability is eliminated. For a safety group conversion, ongoing joint and several liability is non-existent, since the group is now fully insured. A fronted captive continues to have ongoing joint and several liability due to its quota-share layer. This liability, however, can be eliminated by negotiating a prospective or "rolling" loss portfolio transfer. Once a loss portfolio transfer has been executed, it is common for state jurisdictions to release any collateralized funds posted by the self-insured fund, as all retrospective and prospective claim liabilities have been eliminated.

When considering what funds may be candidates for conversion, the philosophy surrounding the initial formation of the group should be considered, as well as its desire to remain operational.

If the fund's creation was solely for the purpose of escaping the hard standard market, the fund may be comfortable disbanding when its primary reason for existence has been mitigated. Conversely, if the fund was created to provide the additional "member benefit" of an association, the group will probably wish to continue offering a competitive workers compensation program to its membership. These funds, as part of a larger parent association, will most likely be the best conversion candidates. Stability of membership and an ongoing commitment from the parent association to market and promote the program to its members are necessary to maintain the growth and success of the program.

It is apparent in many cases that conversion of a self-insurance fund to either a fully insured safety group or a fronted captive can be quite advantageous. The lack of a rating as an insurer, the inability to provide multistate coverage, and joint and several liability are typically cited as the most problematic issues confronting self-insured groups in today's soft market. By taking advantage of the ability to combine the best aspects of fully insured plans with those of self-insurance, these issues can be mitigated, if not totally eliminated.

The use of a capable program manager and third-party administrator will also contribute toward heightened effectiveness. The converted program will realize a higher, more personal level of service than is typical of the normal standard market insurer. The added potential to achieve higher returns based on participation in and investment through a captive can result in a workers compensation program that should perform better, have a lower ultimate cost, and significantly outperform the standard market

Phillip C. Giles is assistant vp and national sales manager for LDG Underwriters in Wakefield, Mass.