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Q: What level of funding do you recommend for a self-insurance program?
Funding levels for self-insurance programs range from minimalist to expected to conservative to highly conservative. We may think of these in terms of the probability that the amount of funding will be sufficient to cover future claim payments, which is referred to as the confidence level.
If the odds are less than 50% of there being a claim, we would classify the funding as "minimalist;" if the odds are between 50% and 75%, "expected;" if between 75% and 95%, "conservative;" and if over 95%, "highly conservative." These assessments also are affected by the self-insured retention level; the higher the SIR level in relation to the overall size of the program, the less likely we would characterize a certain funding level as conservative.
I typically recommend a conservative to highly conservative approach to my clients. The reason becomes apparent if we consider the risks posed by funding at a 50% confidence level. At that level on average, every-other-year losses will exceed funding and, not infrequently, losses may exceed funding by a large amount. More often than not, when losses for older claim years develop adversely, losses for the most recent claim years also turn out to be higher than anticipated. Adoption of a 50% confidence level philosophy greatly increases the strain that such a double hit places on a fiscal year budget, and the need to dip into outside funds to keep the program solvent.
Let's take a look at a simple example.
Your self-insured workers compensation program has a fund balance of $5 million, equal to your best estimate of what the loss reserves should be. Your annual funding is $2 million and your self-insured retention is $1 million. Your practice is to fund at the 50% confidence level. It so happens that 2007 turns out to be a bad year. Your loss reserves balloon to $7 million for earlier years and current-year losses are $3 million. By year-end 2007, your program is $3 million short of needed funds. Further, the increased losses mean that the outlook for next year's losses will be $1 million higher than previously thought. The 50% confidence level leaves your organization without a cushion to weather such inevitable adverse years, and leaves you in search of additional funds (or a new job).
Contrast that with a conservative funding philosophy, which can also be viewed as a method of smoothing year-to-year results. If you fund at the 80% confidence level, four out of five years things should turn out better than you have banked on. Each of those years you will be putting away surplus in anticipation of an upcoming adverse year. And, if your most recent year turns out poorly, you will most likely have favorable development on reserves for prior years to offset the bad news.
Another benefit of conservative funding is that, after a few years, a surplus should be built up such that the annual funding level can be reduced--if the experience is not unusually adverse. For instance, once the fund is built up to a confidence level of 95%, our annual funding recommendation may be only at the 75% or 85% confidence level. The buildup of excess funds can be used either to offset current losses or prudently raise your retention. These excess funds can also insulate you from the worst parts of the underwriting cycle. When premiums for excess insurance are unusually high, you can be in a position to accept a much higher retention and thereby significantly reduce the premium you pay.
Another key benchmark is to always have sufficient unassigned funds to cover at least one full loss within your retention, above and beyond the level of losses you would normally anticipate.
As I noted earlier, the self-insured retention is a significant consideration in recommendation of funding levels. An adverse year for a company with a $2 million retention is likely to be much worse than a bad year for a similar entity with a $500,000 retention. For such clients, we typically recommend a highly conservative funding policy, and usually advise evaluating the excess premium cost to reduce the retention.
A disadvantage of carrying a conservative fund balance can be the risk that some other part of your organization may raid your program's "extra" dollars. Though this represents a significant concern during years in which funds are in short supply throughout the organization, it should not be a justification for carrying a marginal fund balance.
Education of management regarding the long-term financial benefits of a conservative funding strategy is key both in protecting this asset and in maintaining the fiscal health of the self-insurance program.
This month's column on actuarial issues in the casualty field is written by Richard E. Sherman, president of Richard E. Sherman & Associates Inc.
Ask A Risk Manager, Ask A Benefit Actuary and Ask A Casualty Actuary answer written questions from readers on risk and benefits management issues and actuarial problems.
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