Theres more–commercial property owners are more interested in joining or forming self-insured groups than ever; so are schools, municipalities, apartments and condos. Airlines want to pool terrorism risk, theres talk of a national terrorism pool for workers' comp, and insurers have proposed pooling property-casualty terrorism risk across all lines.

Pooling of risk, of course, is the very essence of insurance. Its what makes insurance tick. Why, then, are pools making such a splash on the insurance scene today?

The hard market is driving some of it. Although higher prices get all the headlines when insurance markets get hard, tighter underwriting does at least as much of the heavy lifting when it comes to restoring insurer profitability. When the industry as a whole becomes choosier about risk selection, fewer risks will make the cut and more will land in residual market pools.

Indeed, todays hard market has already forced thousands of employers into workers' comp residual markets across the country, nearly doubling the size of the residual market last year (see graph).

Difficulty spreading risk through traditional mechanisms such as reinsurance in the wake of the Sept. 11 terrorist attack is another major reason. Pooling helps reduce risk through diversification, although it remains inferior to the transfer of risk achieved through reinsurance.

The inability to exclude terrorism risk in many cases (such as in workers' comp) exacerbates the problem. Without access to reinsurance markets or the ability to add exclusions, aggregation of risk quickly becomes a severe problem, one that forces insurers to search for alternative ways to segregate, compartmentalize and diffuse this risk. Pooling is the simplest mechanism available to achieve these goals.

Much of the residual market growth in workers' comp is the direct result of insurers desire to reduce exposure to catastrophic workers' comp losses in the event of future terrorist attacks. The Sept. 11 terrorist attack resulted in 5,800 workers' comp claims–2,200 of them fatal–costing insurers an estimated $2 billion. Insured losses across all lines of insurance (including life) are estimated at $35-to-$40 billion.

It is also little wonder that within three weeks of the Sept. 11 terrorist attack, insurers proposed (unsuccessfully, as of this writing) that Congress back a national pool for insuring terrorism risks, modeled after a pool operating in the United Kingdom since 1993 (Pool Re).

Insurers also harbor concerns over potentially massive workers' comp losses from a large earthquake. The table with this column shows the expected number of workers' comp injuries, deaths and losses in the event of a 2002 repeat of the 1906 San Francisco earthquake. A repeat of the magnitude 8.3 earthquake is likely to kill and injure far more people than the Sept. 11 attack, producing cataclysmic dollar losses for workers' comp insurers.

However, an important distinction must be drawn between risks that are pushed into pools by insurers responding to economic and risk management concerns, and those that view pools as a destination of choice. The ignominy that a poor risk suffers after falling into a pool is balanced by the security associated with the complete transfer of risk and the virtual assurance of rescue from the pool at some point in the future.

Businesses that seek to pool risk by forming or joining a self-insurance group, on the other hand, run the distinct risk of getting in over their heads and drowning in an ocean of red ink.

What is unique about the widespread interest in pooling is that much of it is driven by a shocking degree of na?vet? about the nature and magnitude of risks actually faced by businesses today.

Many businesses openly dismiss the possibility that they will suffer damage from a terrorist attack, deem themselves unlikely to be named in a massive class action lawsuit, discount the likelihood of suffering severe damage from a natural disaster, and fancy themselves as too smart to lose lots of money on investments or get burned in an accounting debacle.

The reality is that Corporate America is at risk from all of these perils and more, and that the need for complete and comprehensive insurance protection is greater than ever.

Most businesses believe themselves to be above-average quality risks, and that the higher prices they are being asked to pay for insurance today greatly exaggerate the costs they are likely to impose on the system. Therefore, the reasoning goes, Im better off joining a self-insured group or starting a new pool altogether.

This reasoning is flawed for many reasons. First, not every business can be above average. But secondly, the world of commerce today finds itself operating on a higher plateau of risk than it did just a few years ago.

Consider the forces that came together to form the “perfect storm” of 2001 and produced the worst year in the history of p-c insurance: recession, underpricing, catastrophic losses, medical cost inflation, financial accounting scandals, abuse of the legal system and, of course, terrorism. Which of these perils is vanquished or even diminished through participation in pools or self-insurance? None.

Another inescapable hazard of “do-it-yourself” insurance is rooted in the law of large numbers. Self-insurance groups are subject to the law of “not-quite-so-large” numbers, meaning their annual loss experience could be volatile because the SIG is much smaller and more homogenous than a large commercial lines insurer. Reinsurance can help, but the tight market and reinsurer reluctance to accept certain types of risk (terrorism, for example) could exposes a business to losses it would otherwise escape entirely with traditional insurance.

SIGs are an important part of the insurance market, and joining a well-run SIG might well be the right choice for some businesses. But todays hard market means that jumping into the risk pool through an SIG (or captive) is no Club Med–even when domiciled in some lush tropical location.

Robert Hartwig, Ph.D., is senior vice president and chief economist at the Insurance Information Institute in New York. He can be reached at [email protected].

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, May 6, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.