Introduction

Insurance is a way to protect the assets you own from potential financial losses. Usually, this takes the form of an insurance policy between you and an insurance company whereby you pay a premium in advance in exchange for the company’s promise to pay for a specified loss at a later date. The insurance policy is a contract and can provide for varying degrees of coverage and costs. Costs are subject to the worldwide insurance market and can vary depending on the risks, actual losses, investment environment, and competition between insurers. Many commercial operations are looking to maximize their coverage and minimize their costs. One possible way of doing this is by joining larger groups to gain buying power and share risks. This could take the form of a Reciprocal Insurance Exchange.

What is a Reciprocal

A Reciprocal Insurance Exchange (or Reciprocal) is a group of commercial entities with similar risks that exchange contracts of insurance through a legal agreement. It is a form of risk transfer as each “subscriber” assumes part of the risk of the group so that if there were to be a loss, the loss is covered collectively. There can be long-term benefits to these arrangements but they also have risks and responsibilities. Although unincorporated, Reciprocals are treated as insurance companies and they can operate within one province or many. Operating in more than one province adds complexity as each province has its own requirements.

The initial step in determining if a reciprocal is right for you is to determine if there is a group of potential subscribers with similar risks who would be interested in pooling their risks and insurance resources.

Formation of a Reciprocal in Alberta

In Alberta, the formation of a reciprocal is controlled by the Superintendent of Insurance and there are strict financial and operational requirements that must be met. Where Alberta is the primary regulator the Superintendent of Insurance (“Superintendent”) is responsible for administering the Insurance Act (“Act”) and Regulations with respect to the regulation of provincially incorporated insurance companies as well as insurers who carry on business in Alberta. As part of the regulatory process, the Superintendent assesses applications for incorporation and makes recommendations to the President of the Treasury Board and Minister of Finance (“the Minister”) who has the ultimate responsibility for approving the incorporation of a provincially regulated insurance company under the Act. The certificate of incorporation is formally issued by the Lieutenant Governor in Council. While this sounds daunting, there are ways to manage the time and effort required through external management choices and effective committee structure. The management structure is one of the most critical elements to consider if you are thinking of forming a reciprocal.

How would it work?

A reciprocal is a not-for-profit business structure where the subscribing members sign an agreement (Subscribers Agreement) that specifies that they will contribute funds to cover the losses of the other subscribers in the exchange. This pooling of resources spreads the risk over a larger group and often over a larger area thereby presenting a better risk profile for the group as a whole. Pooling resources (larger dollar values) also can provide financial benefits when negotiating insurance policies.

As an example, if the loss experience is less than anticipated for the year, there could be a refund in the form of dividends, or more often, the surplus can accumulate for future losses. This is where careful and professional management is required to take a long view of the situation. This is different from traditional insurance companies as they would be looking for additional premiums as profit. Reciprocals aim to provide the protection of insurance with any ‘profit’ controlled by the subscribers. Much more goes into it but these are the general parameters. One requirement of a reciprocal is that there must be an Attorney-In-Fact (AIF) retained to help manage the entity. The AIF, while expected to maintain all and any underwriting standards, performs the role of an unbiased mediator to simplify and expedite transactions and may be an individual, partnership, or corporation. This person is the day-to-day manager of the reciprocal including administration, fees collection, claims management, and underwriting. They would work with an advisory committee of elected policyholders (from the subscribers) to assist in making decisions and setting the direction of the reciprocal.

“Net income and return on members’ capital is the ultimate indication of how efficiently members’ capital is managed by the AIF because poor underwriting or investment performance will erode member capital over time. A high expense ratio may indicate the charging of excessive fees by the AIF or a failure in operating the exchange efficiently. Premium growth should never be at the expense of sensible underwriting because high growth combined with poor underwriting is unsustainable. If investment yield is low or negative, the AIF is likely taking excessive investment risk, or interest payments are placing a burden on investment returns.” (Andre Breedt, Insurance Thought Leadership – Nov 30, 2016)

Pros and Cons of Reciprocals

Starting with the Cons, reciprocals can be difficult to set up, particularly if there is not a large enough identified pool of potential subscribers to make the spreading of the risk viable. If the pool is too small, the risks may be larger than would make sense. Larger pools generally mean the whole group has a lower risk profile. The initial period of reciprocal formation needs a group that understands the goals and objectives and is committed to following through. This would include the wherewithal to cover the costs of formation and development.

Each reciprocal will have its own reason for formation – it may be they only need liability protection. Others may need liability, property, automobile, boiler and machinery, fidelity, etc. This would all be covered by the needs of the subscribers and the terms of the Subscribers Agreement.

Fortunately, there are more Pros than Cons. First and foremost is the control the subscribers have over the claims and operational costs. Also, subscribers can have an influence in framing the policy language to address the specific needs of the group. Care must be taken to work with the AIF to ensure that the policy language does not lead to excessive claims as this would impact the viability of the organization. Having input into the limits and coverage to be provided in the insurance contracts is a big benefit for reciprocals. It may even allow for insurance coverage not available in a standard insurance arrangement.

Another benefit is that it would be expected that the start-up costs of a reciprocal would require very little capital. With no profit expectation, the premiums can be set to cover the expected costs of the operation and they would therefore expect to be lower than those from a traditional insurance company. Additionally, by pooling the subscribers’ assets and risks, the resulting entity is more diversified and therefore more favorable to the insurance market. There are many ways that the subscribers and the AIF can structure their policies to gain financial benefit. If there is a high frequency of losses with a low dollar value, the limits, and deductibles can be set to maximize the coverage. Similarly, umbrella policies can often be purchased at lower per unit cost if there is low frequency but high dollar value losses. The AIF is there to provide professional advice with no profit motive.

 Conclusion

After reviewing the information provided above, if you think that a reciprocal may be something that could address some of the concerns you may have with your insurance situation, please do not hesitate to contact Risk Management 101.

Disclaimer: Although the above article references events that have occurred in the past or are new to you, there are current policies/practices that can be learned and applied in today’s market. Should you wish to explore any element of this article further, please contact Darius Delon, President of Risk Management 101 at 403-999-2724 for a free initial consultation.