Most people relate Alternative Risk Financing to Captive Insurance Companies. In full disclosure, it is a fancy term insurance brokers use to describe anything from a deductible to a self insured retention ("SIR"), to a Trust, to a Captive Insurance Company, to a Risk Retention Group. While it is well beyond the scope of this site to go into all the details of all forms of Alternative Risk Financing, I did want to give a brief description of them as it is a common question.
Deductible - A Deductible is the amount of a claim that you are responsible to pay. These can be "Indemnity Only" deductibles or "Indemnity and Expense" deductibles. The difference between the two is that for an Indemnity only deductible, you only spend money if and when the plaintiff receives a settlement or award. Whereas, with an indemnity and expense deductible (what some call a "first dollar" deductible), you are responsible for payment for legal fees/expenses as soon as they start accruing.
Self Insured Retention - a Self Insured Retention ("SIR") works very similarly to a deductible. The main difference is that with a SIR, the limit of liability you purchase sits on top of the SIR whereas with a deductible the limit does not. For example, if you purchase a $1,000,000 limit of insurance and have a SIR of $250,000, you will be responsible for the first $250,000 spent on the policy and then you have a $1,000,000 limit above the $250,000. On the contrary, if you purchase a $1,000,000 limit with a $250,000 deductible, the $250,000 is within the $1,000,000 so you effectively only purchased a $750,000 policy.
Retrospective Rating Plans- In a sense, any auditable policy could be considered a retrospective rating plan. However, for this purpose, I am referring to the situation where the carrier charges a rate and if your loss experience is worse than a negotiated metric, you may owe more premium. But, if you experience is less than a negotiated metric, you may get a refund of premium. You can also obtain these programs where there is only an opportunity for the carrier to owe you money back and not an opportunity for you to have to pay more. There are many variations of this policy structure. But, for example purposes, lets say the carrier believes you are going to have $700,000 in claims. Accordingly, they charge a premium of $1,000,000. You believe you will only have $200,000 in claims. So, you may be able to negotiate a program where the deposit premium is $500,000 and if you perform as you expected, you will get money back. But, if you perform as the carrier expected, you will owe more money. In this "soft market", these policies are becoming much less common.
Trust - A trust is a vehicle where you fund the Trust and the monies in the Trust are responsible for any claims, deductible or SIR. The disadvantage of a Trust is that you do no get to write off premium or losses until they are actually incurred.
Captive Insurance Company - One of the most common forms of "self insurance" is a Captive Insurance Company. These can either be on shore or offshore. You fund the Captive with the initial Surplus, then pay premiums to a Captive Insurance Company that will issue you a policy. These can be very costly to establish, can be time consuming, and usually do not make economical sense until your frictional costs of operating the captive are less than the operating expenses of an insurance carrier. The main benefits of a Captive are that it puts you in control of your insurance and gives you direct access to reinsurance. Due to your Client's insurance requirements, you will most likely need a "fronting" carrier that is rated by AM Best which will add to the costs.
Risk Retention Group - A Risk Retention Group is similar to a captive except they are always onshore as it is a Federal Law that allows them to be in existence. The laymen's definition is that a Risk Retention Group is allowed to write a single line of insurance so long as all the insureds of the Risk Retention Group are owners and all the owners of the Risk Retention Group are insureds. Once established, a Risk Retention Group can offer policies in any state so long as minor formalities are followed. You can either form your own Risk Retention Group or join an existing Risk Retention Group. These are generally more costly to establish and maintain than a Captive Insurance Company.
What is Alternative Risk Financing?