Charles Winter maintains that self-insurance is a viable option for law firms
Solicitors Regulation Authority rules give solicitors the flexibility to balance their risk financing approaches between purchasing insurance and retaining some elements of their risk profiles, subject to minimum levels of cover being purchased from qualifying insurers.
Self-insurance, or risk retention, in its simplest form is represented by insurance policy excesses or deductibles, although for larger practices it can mean risk retained in their own insurance company, referred to as a ’captive’.
Self-insurance for law firms and solicitors in their professional indemnity (PI) insurance programmes can have a number of tangible benefits that can be influenced heavily by the competitiveness or otherwise of the prevailing insurance market.
The decision of whether or not to self-insure, and if so to what extent, requires taking into account a number of qualitative and quantitative factors.
Retention for firms will vary significantly based on the sizes of their PI programmes, their risk appetites and their risk management profiles.
From a quantitative perspective, finding the optimum point of risk retention and risk transfer is key to obtaining the best financial outcome. However, it is important for a firm to understand not only its theoretical tolerance threshold, but also how far its actual appetite to retain incurred losses extends, and therefore set its self-insured retention within these parameters.
It is important to forecast the cost of losses in future periods for differing levels of risk retention. This can be done by using historical losses as a basis, with calculations often being carried out by actuaries. Actuaries will revalue historical claims to their present value by taking into account aspects such as industry loss development factors, inflation and change in size and nature of a firm’s operations. It must be remembered that these remain forecasts and actual losses may differ, particularly if the firm enters new areas of business activity. Understanding the potential for volatility around the central forecast is therefore important.
Finally, by adding insurance premium quotes to the forecast losses at each retention level examined, the optimum risk retention or risk transfer point can be identified. However, what will also become apparent is that, as the self-insured retention increases, so too does the volatility of losses incurred and their impact on earnings and cashflow. It is therefore important to decide whether certainty of outcome outweighs any possible financial gains through taking higher self-insured retentions.
The management of cashflow is also important and the simplest and most common way to fund losses falling within self-insurance levels is to pay for them out of cashflow. The longevity of PI claims is such that losses may take several years to finalise, which means it may be hard to predict cashflow outcomes and their impact on available funds, particularly if bank lines of credit are already under pressure.
The second way to fund losses is through the setting aside of funds in a separate bank account. Unfortunately, a common experience is that a more immediate need for funds arises and this claims pool provides an attractive solution. Once drawn down, invariably these funds are not replenished and a return is made to the pay-as-you-go approach.
For large firms with sizable PI programmes and significant premiums, a third option is to take a more formalised approach and incorporate a captive through which the self-insurance can be managed. This is an insurance company in all aspects other than it only offers insurance cover to affiliated parties. It underwrites risks, either in a layered structure or by way of co-insurance, collects premiums and pays losses.
However, this is a long-term approach that requires capital, will incur frictional costs and will be required to meet compliance regulations in its domicile of incorporation. It will therefore be most beneficial where there are sufficient savings from retaining higher self-insured retentions or through other qualitative benefits provided.
Perhaps the most important benefit to law firms from the use of captives is in having control over the handling of claims rather than deferring to outcomes dictated by insurers. A captive provides more flexibility in responding to fluctuations in price or capacity offered by insurers and becomes a strategic tool in renewal negotiations. When capacity is constrained it can also access a wider range of insurance markets that would otherwise be unavailable.
A captive also often acts as a focal point for management attention in dealing with risk management and claims activities. To assesses the viability and identify other benefits, a captive feasibility study needs to be undertaken, which will substantiate the formation and use of a captive, if appropriate.
Ultimately, if the insurance market is competitive and capacity is not constrained, increased levels of self-insurance may not be financially profitable, which together with the increased volatility associated with higher retentions could be a persuasive argument to transfer risk to conventional insurers and focus on improving risk management practices.
Charles Winter is head of risk finance at Aon UK