Archive for July, 2008

Archimedes had it Right!

July 1, 2008

Archimedes, a Greek mathematician c. 250 BC, was the first to explain the principle of the lever explaining how a large weight could be lifted by a relatively small weight by the use of a rigid lever and a properly positioned fulcrum.  The process was called leverage.  Archimedes, recognizing the power of leverage was quoted as saying, “Give me a place to stand and with a lever I will move the whole world.”

Well, the concept of leverage has made its way into our world in many ways, mechanical and conceptual.  Insurance companies use a form of financial leverage in order to conduct their day-to-day businesses.  In exchange for a relatively small premium someone with risk can insure against the loss involved with that risk by utilizing insurance.   In this example the insurance company is the lever, the fulcrum is the degree of risk, the premium is the smaller weight doing the work and the weight being lifted is the loss potential.  Depending on how risky the deal is determines where the fulcrum is placed which determines how much premium needs to be applied to “lift” the weight of the potential loss payment.

Leverage is used within the insurance company as well.  Insurance companies would be very inefficient risk takers if they had to maintain a dollar of surplus for every dollar of risk they assume.  Instead, insurance companies are allowed to leverage their surplus to allow for a multiple of premium to be written.  Just how much “leverage” can be applied is a matter of prudent financial planning and in most cases is limited by regulatory action in their chosen domicile and the review and comment of rating companies like AM Best.

Most traditional US companies are limited to a 2:1 Premium to Surplus ratio.  Much more than 2:1 leverage and the insurer’s financial wherewithal is questioned.  Granted, based on the types of coverage and the clientele of traditional insurers that is probably a good leverage ratio.  Regulators want to protect the unsophisticated insurance buying public.  But when you enter the realm of sophisticated risk-managed large deductible insurance buyers these protections are much less necessary, but still imposed.

Captive insurance arrangements typically allow for higher leverage ratios depending on the domicile for the risk.  Some domiciles apply risk-based analysis  in order to determine Premium to Surplus ratios and often are in the 3:1 or higher range.  Other domiciles have prescribed Premium:Surplus ratios up to 5:1.

If part of the cost of insurance involves a charge for the surplus tied up to write a coverage, which mechanism would provide the most efficient, less costly surplus charge?  Obviously the one that allowed for the most leverage, a captive insurance product.  If you combine this with the fact that a captive typically assumes the higher frequency layer of insurance costs which represent about 60% of the loss funding in an insurance program the magnitude of capital tied up to support risk can be dramatically reduced in a captive.

Archimedes had it right.  Give me a captive insurance company and a good domicile and I’ll cover the risk of the world!