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Issue 07 / October 2015

How a risk-based premium allocation methodology improves risk financing

At a glance
  • Internal transfer pricing, divestiture of businesses and exposure to specific risk are key considerations
  • Data quality is a significant consideration when making assessments, especially for severity exposures
  • Effective premium allocation allows for appropriate premium for the risk borne by a captive insurer
A detailed understanding of risk in every region you operate in is essential to ensure that premium allocations are efficient and commensurate with your spread of risks, says Marc Paasch

As companies try to manage their international risks more strategically through the use of multinational programmes, accurate allocation of premiums has become increasingly important. 

Using claims that precisely calculate the exposure at group and entity level enables the premium to be divided equitably.

Large, multinational companies with a total-cost-of-risk approach understand that it is not necessary to allocate premiums to locations where no risks are located.

Take, for example, a pharmaceutical company with its permanent establishment in the UK, but which exports across Europe.

While the company may purchase product liability insurance to cover action taken in any of the countries into which it exports, the cost of this cover would not have to be apportioned between every jurisdiction into which it exports. 

This is because, while the company might face legal action outside the UK, the insurance protects the legal liability of the company with its permanent establishment in the UK and therefore the risk is located in that country alone. 

Key considerations

With a more stringent approach by country authorities, the introduction of Solvency II and increased compliance, multinationals with group insurance programmes need to apply risk-based premium allocation methodologies to all their various entities, taking account of several key issues:

1. Internal transfer pricing

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It is the group buying and then allocating the price paid to subsidiaries so, because of the accounting and tax implications, internal and external auditors need to validate this transfer pricing. The methodology’s stability is therefore vital.

It is very difficult to allocate premium based on specific criteria in one year and then change this criteria the following year, as auditors and regulators will look at the process to ensure it is conducted fairly.

2. Whether the company is divesting businesses

When a group is in acquisition mode, it is a straightforward process to allocate the premium since the more growth is recorded, the greater the stability of the premium.

If a group purchases a new company or division, the premium paid for the main programme usually increases only slightly and splitting the premium with the new entity reduces the cost to the group.

But when a group starts to make divestitures, the premium typically does not fall so the amount paid by the remaining subsidiaries will increase. Having a clear and stable risk management framework is very useful in this situation, as it provides clarity on how premium is calculated and subsidiaries can see why they need to pay more for the same coverage.

3. Exposure to specific risk (the key criterion)

The level of exposure to liability has to be established, which is achieved by calculating the exposure curve for every subsidiary or jurisdiction.

This is done by reference to the claims history of the entity, the claims history of the wider industry in which it operates and also severity or ‘what if’ scenarios. Using claims that very precisely calculate the exposure not only at group level but also at entity level enables the premium to be divided on an equitable basis. This is the key benefit of more advanced risk management practices.

Improved risk management of subsidiaries is also important, particularly in relation to increased investment in prevention, because this will enable entities that currently have high exposure to reduce their exposure. 

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The obvious key drivers for risk mitigation are product liability, sound design, manufacturing and labelling. However, risk can also be created through poor contracts and absence of sound insurance to back up contractual provisions.

Therefore, global companies need to also pay particular attention to contractual provisions, such as indemnifications, and hold harmless provisions and insurance requirements with their suppliers who can be located all over the world.

Severity scenarios

Data quality is a significant consideration when making these assessments. Claims history is usually readily available, but it can be more difficult to acquire information on claims history across the industry sector within that country.

Data for the severity exposure calculation is the most difficult to acquire. In relation to property it is possible to establish asset values and probable maximum losses because there are tangible values, but for liability or business interruption exposure it is necessary to build exposure scenarios on a case-by-case basis. 

Many large companies engage in this type of work because they are already doing it at group level and it is a natural extension to do the same at subsidiary level. Brokers compile data by industry, country and even type of peril so they are able to help companies assess their exposure risk.

However, severity scenarios tend to be company-specific so it is up to the company to conduct this exercise by leveraging the experience and knowledge of their risk management department and related resource. 

Captive implications

Effective premium allocation is not just about group programmes where insurance is purchased centrally – it also has implications for captive programmes, so allocating the appropriate premium for the risk borne by a captive is equally important.

In Europe, Solvency II means it is more important than ever that companies are able to demonstrate that premiums are commensurate with the risks being covered.

Under Solvency II, captive premiums are assessed in a very specific manner and internal and external auditors are heavily involved in looking at transfer pricing issues and ultimately premium allocation.

Every time a risk is transferred from one entity to another, there needs to be data to support the price for that transfer. Using the three key data points (company claims history, industry claims history and severity scenarios) creates a transparent process for quantifying the amount of premium that needs to be allocated to a country.

The only subjectivity in the process comes in the assessment of the severity scenarios, but if this is done to the best knowledge of the executives of the companies that are assessing the risk and the company can prove it was complying with best practice, this will be acceptable. 

Find out more

Photo of Marc  Paasch
Marc Paasch

Marc.Paasch@willis.com

Marc is working to develop Willis’s global alternative risk transfer (ART) practice. He is be responsible for steering implementation of a range of ART solutions, including: weather solutions, captive fronting and multi-line or multi-year stop-losses, structured insurance solutions, adverse development covers, residual value insurance, insurance linked securitisation for corporates and contingent capital solutions.

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Photo of Marc  Paasch
Marc Paasch

Marc.Paasch@willis.com

Marc is working to develop Willis’s global alternative risk transfer (ART) practice. He is be responsible for steering implementation of a range of ART solutions, including: weather solutions, captive fronting and multi-line or multi-year stop-losses, structured insurance solutions, adverse development covers, residual value insurance, insurance linked securitisation for corporates and contingent capital solutions.

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