Archive for April, 2008

Mind the Gap

April 29, 2008

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Last spring my wife and I travelled to London with our eldest son and his wife.  We absolutely loved the week that we spent exploring the city and did most of our explorations via the Tube.  The Underground is itself a destination I think.  Descending into the deep tunnels reminded me of all those old WWII movies with the population of London huddled safely underground while the city above exploded and burned from air raids.   I laughed the first time I heard the very British recorded message, “Mind the Gap” as we came into the station on our first Underground sortie.

Playing the recorded message began in 1969 when it became obvious that the driver’s warnings were ineffective in preventing accidents involving twisted ankles and broken bones.   The announcement is a cultural icon now and you can find souvenirs with the logo all over London.

There is gap that needs to be minded in captive insurance programs as well.

Any insurance company must maintain capital in order to conduct its insurance business.  The amount of capital in an insurance company limits the amount of premiums that can be written depending on the insurance company’s domicile, type of business written and business structure.  Generally traditional US insurers are required to maintain Premium to Surplus ratios of 1.5:1 to 2:1.  For these companies that provide general commercial and personal lines insurance, a ratio much beyond 2:1 is highly scrutinized by regulators and review agencies alike.

When an insurance company reinsures a portion of its risk it is allowed to take a credit for that portion of the premium it reinsures against its Premium to Surplus ratios provided the reinsurance company is authorized by the regulators.  In other words, the reinsured premium doesn’t “use up” any surplus and allows the insurance company to write more business and still maintain acceptable leverage ratios.  When that same company reinsures risk to a captive insurance company, an unauthorized reinsurer, it must get a guarantee from the captive in order to take the surplus ratio credit.  This guarantee is typically in the form of a Letter of Credit or a 114 Trust account roughly equal to the amount of the premium ceded to the captive.  As long as the collateral is in an allowable form the front company can take their credit, write additional business and preserve their leverage ratios.

The front company also assumes a credit risk from the captive reinsurer in that losses may exceed the amount of money available to pay those losses.  Since the front company is responsible for the payment of claims and is reimbursed by the reinsurer after the claim is paid, there is a potential that the front company might not get reimbursed.  In order to control this exposure, the front company may add a reinsurance feature to the program called Aggregate Stop Loss.  This coverage comes into effect when losses in a program reach a predetermined level and results in any additional losses being paid by the front company.  Typically the attachment point is a multiplier of the loss pick and ranges between 165% and 200%.   The difference between what is funded for losses in the premium and the maximum amount of losses that might be paid by the captive is called “the Gap”.  It is essentially the risk that the owner of the captive assumes, above and beyond the premium paid, for losses in the program.

In order to mitigate the “credit risk” that the gap presents to the front company it is not unusual for some portion of the gap to be collateralized.  Typically the front company evaluates the financial ability of the captive and makes a determination of how much collateral is required.  This might vary anywhere from just collateralizing the ceded loss funds all the way up to collateral equal to the aggregate stop loss attachment point.

You must “mind the gap” in the sense that to collateralize this exposure may take as much as another 50% of the original payin premium to secure.  It might be argued that this collateral quantifies the upside risk potential in a captive insurance initiative, but at the same time it represents a significant cash flow event in the face of already having to fund the creation and capitalization of a captive.

Pro Forma analysis in the initial stages of a captive’s formation should take the need for gap collateral into consideration and can help to mitigate its impact by proper planning.  Aggresive negotiations with the front company’s involved will also help to structure a collateral scheme that benefits all the parties involved.

Choosing your consulting and management partners carefully when considering a captive insurance program is critical.  If we can be of any assistance in helping you understand the benefits and challenges of a program for your company, let us know.  dennis.silvia@cedarconsulting.net

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Captive Insurance- Only for the Hard Market?

April 23, 2008

I have to offer my apologies if you are a regular visitor to my blog.  I haven’t been able to post in the last few weeks because frankly I have been so busy with my work with clients.  I don’t offer this as an excuse, and it certainly isn’t a complaint, but I think it is interesting to note that in spite of a soft market, captive insurance initiatives continue to be front and center in the minds of commercial insurance buyers.

I think there are two reasons why the soft market hasn’t put a damper on new captive insurance program development.  First, I think there are several very compelling reasons to use captive insurance mechanisms to manage risk financing that are not cost-related.   Second, I think the current generation of risk management professionals remembers what a hard market looked like and they know that insurance is cyclical.  Let’s investigate these two factors separately.

Too often captive insurance mechanisms are marketed on the basis of reducing premium or as a tax play.  OK, sometimes they can do either or both, but those two advantages are typically short-lived.  Cost related advantages are real, but they are not the only, or the best, reasons to use a captive insurance mechanism.  The market swings soft and all of a sudden traditional insurance prices beat captive insurance prices in the short run or the IRS catches up with a tax loop hole and closes it up tighter than spandex on an overweight body.  If an insurance client is purchasing their insurance on a year-to-year tactical basis then they will live and die by the pricing sword.  What most professional insurance buyers have come to realize is that over a ten year horizon they will end up paying for their own frequency layer losses, a share of the severity losses and the expenses associated with policy and claims administration.  The real question for them is how do they want to pay for it.  Alternative risk mechanisms typically offer much more stable pricing over the course of a typical insurance market cycle.  Relationships are personal with reinsurance support so a company is less likely to be subject to being the “baby tossed out with the bath water” if they are in a tough risk segment but are a better than average player.  You know what I mean, the industry knee jerks on trucking companies for instance and all of a sudden decides that they don’t want to write them, any of them, and the pricing jumps for those few insurance companies that continue to write the risk.  Sometimes specific coverage or specialized forms are available nowhere else but in a captive setting (think abuse and molestation for religious or social service organizations).

The cyclical nature of the insurance industry makes for a very compelling strategic reason to be involved in an alternative risk mechanism.  Rather than being subjected to roller coaster pricing, captive participants see a more stable pricing base.  Are the lows as low?  No, but niether are the highs as high.  This makes for a better financial planning environment.   

In my opinion many insurance companies run their businesses by looking in the rear view mirror.  Its not surprising.  They price their current business by watching their historic losses, they invest long into the future for maximum potential return.  The problem is that losses happen in the here and now and insurance companies often get caught holding the dirty end of the stick between historic loss performance and future investment performance being worse than projected.  Once they see themselves heading for the ditch they have to react quickly and this more than often ends up as knee jerk pricing and market service decisions.  At the end of the day the insurance buyer ends up paying the price. 

I think the experience of the risk management community coupled with the availability of captive insurance initiatives to the middle market insurance buyer is driving the current rush to control costs through alternative risk mechanisms.  Knowing that behind every soft market is a looming hard market, risk managers are positioning themselves to avoid the next hard cycle.  Considering that there is a development period of between 6 and 12 months for programs like this, now is the time to consider an alternative to the traditional marketplace, and that is exactly why I am so busy today.

It’s the Tail that Wags the Dog

April 4, 2008

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Some coverages fit a captive program better than others.  There are two revenue streams from a captive program.  Underwriting revenue is earned when the losses and expenses in a program are less than the premium paid.  Investment revenue is earned based on the investment of the loss funding until it is needed to pay losses.

If a captive insurance program attempts to minimize the premium paid by its parent for coverages then eventually any excess premium will be wrung out of the deal and there should only be enough premium to pay costs and losses, in other words underwriting income will become zero.   This makes the potential of investment income an important issue.

In insurance parlance the “liability tail” is the length of time it takes to bring a claim from reporting to paying a claimant.  Some coverages have a very short tail.  For instance, if you experience a kitchen fire in your home you are very interested in getting the repair work done quickly so that you can move back in.  The shorter the time to effect repairs the better.  Property coverages then have a very short tail.  Liability coverages like Workers’ Compensation, Auto, General and Professional all have relatively long tails.

If your captive passes tax muster as a “real” insurer then you are able to recognize reserves for losses as an expense.  Combine this with the fact that you still hold the cash for these expensed losses and that the cash is invested until it is needed to pay the claimant.  The longer you hold that cash the better the investment return, hence the reason why Its the Tail that Wags the Captive Dog!

Now, does this mean that you should never include property coverages in your captive?  No, not at all.  There may be other very good reasons for property to be included that have to do with an overall strategic risk management plan.    I’ll post on that sometime in the future.