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Hugh's Views
Issue 1: October 23, 2001

Hugh Rosenbaum comments on some of the crises facing captive owners, and suggests some usual and unusual solutions to them.

In trying to absorb and digest the effects of the recent attacks, I began to realize that many of the current complaints that seem to have gotten louder since September 11th have common causes. These complaints suggested to me some general directions for solutions, or what you can do about it (whichever of the complaints "it" represents). Both the complaints and the solutions recall two or three of the "basics of captives".

It doesn't seem to matter what your definition of "captive " is, either. The complaints are the same. They bear listing:

Complaints I haven't heard yet, but probably will soon:

Won't all these produce a surge in new captive formations? Maybe so, but I note that there have already been increases in registrations in most captive domiciles from the hard market that began last year. But that's not the subject of this editorial. I am talking about solutions to the complaints.

The general solution to all these complaints, as far as captive owners and users are concerned, has two characteristics:

1. Commit more capital
   
   
2. Take more risk

What kind of specific solutions does this general solution suggest?

1. Take higher retentions: First and foremost is the oldest solution in the book. Always start with the highest possible retention the shareholders of the captive can bear. Take no notice of how much the captive, in its present condition can bear. Start with the big number at the shareholders' level, and then make the captive retention fit that number.
   
   In my opinion, only a very few captives retain enough risk compared to their own resources, and a ridiculously low level of risk compared to the retention capability of the shareholders.
   
   Taking higher retentions may imply for some captive owners and their managers a sea-change in the modus operandi of the captive. If before it was designed to retain the lower levels of frequency risks as a deductible funding mechanism, now the time has come for the captive to take some real risk in the next layers, and even do without aggregate stoploss protection.
   
   
2. Put in (or up) more capital. Taking much higher retentions in the captive implies that the shareholders, facing higher risk of losses exceeding premiums to the captive will have to either
   
   
   • Put up more cash capital (preferred) or
   • Promise to, if called
   • Find external funding
   
   In the case of RRGs and group captives, this could also mean surcharging all new applicants, and even making a call on all existing shareholders to put up more.
   
   Those group captives and RRGs that were obliged to take in new members with little or no up-front capital during the soft market times ought to immediately put all of those free-loaders on notice that they will have to contribute their share of the substantial capital that is now needed.
   
   In my opinion few captive owners and managers know how to argue the case for higher capital in a captive insurance venture. Maybe that's why almost all of the ones I see that are more than 5 years old have too much capital for the business they are writing and the risk they are supposedly retaining.
   
   A quick way to gain some insight into how to make the argument is to study the contingent capital alternative (see below). Another way is to open negotiations for "backing for fronting" with a savvy fronting insurer. Backing-for-fronting offers the possibility of solving the fronting capacity complaint a lot better than higher fronting fees does.
   
   It also seems to me that regulators, especially those in Vermont, will have to tolerate higher uncovered risk gaps in captives, and accept other forms of guarantees in place of cash capital, and other forms of protection in place of aggregate stoploss reinsurance.
   
   With higher capital, and substitutes for capital (see below), individual captives may be in a better position to provide some of the solutions to the complaints, and even generate more fees for the service providers running and advising them. But that's not all there is to the "more capital" solution. There are several "do-it-yourself" solutions with longer-term implications.
   
   
3. Do-it-yourself: Captive service providers, captive owners, and their various organizations and clubs, have lost touch with the original drivers of the captive business, which were:
   
   
   • control over your own destiny is worth paying for and
   • doing it yourself is generally better than counting on insurers and service providers to do it for you.

Now, new capital in large quantities is needed to

1. Buy or start a special-purpose fronting company for exclusive use of captives. And I don't mean a start-up that runs for a few years and then goes public. I mean one that is dedicated to serving its insured/shareholders, not one that has market share or shareholder returns as its objectives. I notice the disastrous result that scenario had for the owners and clients of Meadowbrook's do-it-yourself fronting company, originally dedicated solely to the interests of their captive clients.
   
   
2. A contingent capital facility, provided for and owned by captive owners, to supply the capital needed to cover bad years in individual captives (capital that would have to be repaid, but over an indefinite time period). Described by some as a call option, contingent capital has the advantage over straight debt or lines of credit because it costs less until called, and does not weigh down the liability side of the balance sheet (it's part of the capital account).
   
   Up to now individual mutual insurers have used contingent capital arrangements to shore up problem portfolios, but one-off contingent capital deals have been rare for captive insurance companies. A group financing facility, created, run by, and dedicated to participating captives, would be as good an investment as any other in these uncertain times.
   
   
3. And finally, the do-it-yourself technique most favored by Vermont's Kate Westover - the pooling of captives, the sharing of risks, and even (this is the new part of the solution), providing post-loss guarantees for capital that would be better than the external contingent capital mentioned above.

The do-it-yourself pooling solution was the original impetus for ACE and XL, in which the original insureds together set up their own insurance vehicles as true group captives, at the outset, anyway. Those group captives that succeeded did so because of large marketing efforts by brokers and investment bankers, but actually began as a group of insureds in different businesses.

The big service providers are at it again, of course. Marsh has announced formation of a capacity company in Bermuda named Axis Specialty to be capitalized at $1 billion. AON and Willis, not to mention AIG, are readying theirs, too, at the time of this writing. I haven't seen any announcements about captive owners activating contingency plans for capacity creation.

Basics of Captives: What to all these aspects of complaints and solutions have in common? I have already alluded to the generalities of capital and risk as common characteristics. The following short list, drawn from many "basics of captives" presentations will serve as a reminder of what these solutions do and do not do. All I did was to replace the word "captive" with the words "new solutions."

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Hugh Rosenbaum, one of captive.com's friends and valued contributors, is a freelance consultant. Hugh can be reached by telephone at +4420 8883 6729 or by e-mail at hughro2@yahoo.com. Learn how you can spend a day with Hugh!

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