Mind the Gap

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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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