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Risk Management and Captives

by Conor Jennings [Bio]
Caledonian Insurance Services Limited
January 2007

Conor Jennings of Caledonian Insurance Services enlists the help of an imaginary risk manager aptly named Ivor Cunningplan and his CEO boss, Neil B. Formy, to show the connection between good risk management and captive insurance.

***

A number of years ago, Ivor Cunningplan, then an enthusiastic but naïve risk manager, began to get a little bit frustrated with his work, and even with some of his colleagues. He had been appointed group risk manager by the directors of the company two years earlier amid a fanfare of excitement and publicity. Ivor's mission was to review and overhaul all risk management procedures and processes within the company. He was promised the full support of senior management. "The Company is really serious about this," he was told by the CEO, Neil B. Formy.

Frustration
Two years later with the review completed he began experiencing difficulty trying to convince some of his colleagues of the benefits of his new plans. The trouble was that none of Ivor's recommendations generated revenue for the company, and consequently none of the divisional managers wanted to cut into their precious budget for something that wouldn't generate money. Nobody was interested. "Oh I haven't budgeted for it. We're really busy at the moment and any interruption to our business will mean that we will miss our targets. Our clients will be furious".

The same directors that were so keen to have Ivor on board two years ago now avoided him in the corridor in case he asked them for their help. Ivor started to feel that he was the only one in the Company really interested in improving risk. He was not amused.

One thing that was certainly very close to the divisional managers' hearts was their annual insurance premium. At least, despite the lack of active support in the company, the insurance claims experience had improved over the past two years. Much of this was achieved by simply introducing early reporting procedures for all incidents, and tightening up a number of the many legal contracts in place at the time with service providers and with clients. Ivor thought that if he could reduce the annual premiums paid by the divisions, he might get more respect from his colleagues.

The more Ivor thought about this, the more excited he became. He'd done all the claims analyses and projections and knew what rates the underwriters should charge. There should be some good savings, as the company was already paying more than it should have been. He explained his plan to the then company insurance broker who said that it was wonderful stuff and he was sure that the underwriters would reduce the rates at the forthcoming renewal.

Many weeks later, Ivor phoned the same broker to find out what happened. His smooth talking broker told him that he was just about to call him - what a coincidence. While he had been playing golf with the senior underwriter only last week he had fought Ivor's corner tooth and nail for rate reductions. Unfortunately, the underwriter just wouldn't budge. His company suffered from the recent hurricane/war/pollution leakage/bankruptcy/political scandal. However, he really did appreciate all the good work that Ivor had done, and was confident that at the next renewal, once the market softened, the underwriter would reward Ivor and the company with a significant rate reduction. "Let's get together sometime with the underwriter and play some golf," concluded the broker. Ivor was now even less amused.

Ivor started doing some research. He discovered an interesting statistic which stated that over 50% of the US commercial insurance market had moved from the traditional insurance market to the ‘alternative market’. He knew that a fundamental requirement of successful self retention was good loss experience. Therefore, the business that moved was ‘good’ and the business that remained in the traditional insurance market was ‘bad’. But hang on, what about companies like his own which had an excellent claims experience?

It suddenly dawned on him that the ‘good’ business ended up subsidising the rest. The premiums of the few were paying for the claims of the many! How could he have missed something so obvious? Why hadn't his broker suggested anything? Ivor was obviously familiar with captives and risk retention groups, but had always thought that they were only for really large companies.

Ivor felt betrayed by his insurance broker and insurance company.

Ivor's first port of call was a consultant he had met at a recent insurance conference. The consultant agreed to work closely with Ivor to produce a full feasibility study to explore the best course of action for his self-retention plans. The consultant explained to Ivor that there were a number of critical stages to a full feasibility study.

Steps to success
The first stage was obviously to conduct a review of the existing insurance programme and to carry out a full claims analysis, the raw data for which Ivor had plenty. The initial results of the analysis very quickly confirmed Ivor's belief that the company should retain more of its predictable losses rather than dollar-swapping with an insurer which simply adds to the actual losses, its own high expenses, conservative claims reserves and profit margins. This was closely followed by the second stage which was a review of all the identified risk within the company, both insured and uninsured, to see which ones could be retained. This was easy for Ivor, as it fell in perfectly with the risk review he had carried out two years earlier.

The third stage was probably one of the hardest; this was to try to assess the company's appetite for risk - to determine how much the company was willing to lose. The consultant suggested that 1% of the company's total annual earnings might be a good place to start. "That represents a pretty big deductible," thought Ivor.

The fourth stage involved Ivor and the consultant exploring different scenarios such as avoiding certain risks altogether, increasing insurance deductibles, changing underwriters, having a segregated portfolio cell, or setting up their own captive insurance company. Based on these findings and having investigated all the various tax consequences, they determined that the company should have its own captive. They then developed this idea by obtaining insurance and reinsurance quotes and feeding this premium information into their ever-growing captive financial projections.

Things were becoming more interesting now as Ivor realised that there was a whole new world out there that he had been completely unaware of before. The fifth stage was a review of possible domiciles for the new company - onshore v offshore. He smiled to himself thinking of having board meetings in exotic places like the British Virgin Islands and the Cayman Islands. Who would the senior management appoint as the captive directors? Other considerations such as selection of the insurance manager, auditor, legal counsel, third party administrator, actuary and banker, all quickly fell into place.

Before he knew it, Ivor had an impressive report produced by an independent consultant which guided the directors through all the advantages of having a captive. Ivor had also asked the consultant to stress the importance of risk management, and to emphasise the important fact that the captive could afford to fund all new risk management initiatives within the parent company. The bottom line was that with a little bit of work up-front the company could easily afford to have its own captive insurance company. Within a short time this company would help reduce the parent company's total cost of risk considerably, thus adding to its overall profitability and so keeping its shareholders happy.


Success
The directors were at first sceptical about all of this, but once they studied the financial projections, they gave Ivor the all clear to set up the captive. With the help of the newly appointed insurance manager in the chosen domicile, the new business application was submitted and approved by the local insurance regulator, and the company was incorporated and up and running within months.

Ivor is still with the same company and, as promised, has reduced the total cost of risk by implementing all those risk management and contingency plans he had recommended so long ago. The best part of this is that the funding of all his risk management projects comes directly from the captive. In other words, the parent company doesn't have to pay a thing.

How many Ivors do you know?

P.S Ivor Cunningplan changed the company broker and insurance company prior to the establishment of the captive.

Conor Jennings
Managing Director
Caledonian Insurance Services Limited
Caledonian House
69 Dr. Roy’s Drive, P.O. Box 1043
Grand Cayman KY1-1102, Cayman Islands

Tel: 345 949 0050
(Dir 345 914 4875)
Fax: 345 814 4875
E-mail Conor Jennings