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Issue 11 -- February 24, 2005
The title of this article could have been "Reinsurance - who needs it?" That title would have been inspired from one that appeared in the January 2005 issue of the Journal of the Institute of Risk Management (a UK commercial publication) by Paul Hopkin, Director of Risk Management for the Rank Group, entitled “Captive Insurance Companies - who needs them?” His basic idea was a good one, to challenge accepted wisdom about captives, but his approach was full of unsubstantiated generalizations and flawed by his narrow-minded point of view, sometimes over the top. He could have equally well asked “Insurance, who needs it?” Or, for this article, “Reinsurance who needs it?” This article is about reinsurance of or for captives, not about fronted reinsurance to captives. Readers are warned that it is intended to take a fresh look at accepted wisdom, not to answer the question, or to dismiss reinsurance for captives, as Hopkin unsuccessfully tried to do for the whole subject of captives. Sometimes, by asking questions in what appears to be an outrageous manner, one can begin to draw out the real answers. Capacity for captives One of the reasons for captives I often hear mis-stated is that they create capacity. They don’t, of course. What might create the capacity referred to is the access to reinsurance that captives provide. So reinsurance is supposed to provide capacity. Capacity means the higher limits of coverage, up where the severity is enormous and the probability is small, and broad conditions of “all risks”. Captive owners have been often preached to that these catastrophe levels are not for them they are better left to the reinsurance markets the professionals. But hang on -- reinsurance capacity isn’t there any more for “all risks”. Exposures such as pharmaceutical product liability or large target risk buildings find much less reinsurance capacity than they would like. And there are general categories of businesses for whom reinsurers go and “laser out” types of claims or causes of claims just when they are emerging. It is also well-known in captive circles (notice the unsubstantiated generalization) that some captive owners would like to buy $5 billion (or more!) of capacity for their long-term project development risks or their professional and product liability risks, but there isn’t enough reinsurance capacity to meet the demand. Enlightened captive owners are now learning how to do without reinsurance capacity. One recent example comes from the P&I clubs, who have started up a financing facility in Bermuda that will replace some reinsurance capacity when they want it to. Substitute for Capital The constant refrain I hear from reinsurance promoters, especially reinsurance brokers, is that reinsurers have more capital and know better how to deploy it than owners of captives. Instead of retaining $100 million in the captive and holding on to $100 million (or more!) just in case, transfer the risk to the reinsurance market for $1 million annual cost, sometimes more, sometimes less. The reinsurers, the argument continues, have a 20-year time frame for their capital and a large spread of risks as well. So by “borrowing” their capital short term, and taking part in their wonderfully efficient pooling, you (the captive owners) are getting a better deal. If you buy it, then you don't need all that capital in the captive, and can stick to retaining low-level risks with more predictable outcomes. But there’s another side to that capital issue. The substitute capital argument is indeed seductive for startup captives, but it seems to me to be the best way to suppress captive activity. It is designed to convince captive owners that they shouldn’t take risks, that they should stick to the small stuff, and have a time frame of 1 year. Oh yes, and they should invest whatever assets they have in conservative fixed-income securities, preferably sovereign guaranteed investments yielding not much more than 5% these days. And I keep hearing from reinsurance startups in Bermuda that the return on investment for them is a minimum of 15%. In other words the reinsurers are not making their capital available for cheap. And some captive owners also can take 20-year positions; just as many of them have their own internal spread of risks around the world as well. By convincing captive owners not to commit capital to their captives and stay small, reinsurers are just arguing in favour of their own business model. Enlightened captive owners whose financial resources are big enough don’t have to buy that argument. [Emphasis added] Providers of sophisticated ART techniques When I get through the blizzard of terms and techniques offered to owners of captives, the two ART (with emphasis on the “T” which means “transfer”, don’t forget) techniques captive owners most want are annual aggregate protection for single lines of business and stoploss protection for multiple lines (note the narrow-minded point of view refereed to in the first paragraph). They would prefer these to be for one year protection deals, but would be happy with 3-year protection deals, if the reinsurers would offer them. In former times, reinsurers did a lot of this kind of business, with and among Lloyds syndicates, for primary companies, even for captives. But when the market turned hard, reinsurers stopped offering either stoploss or long-term deals to captive owners. As a result, enlightened owners of captives came to the conclusion that they would “make rather than buy” multi-year stoploss protection. They are doing this by offering that protection to their client companies or members, and taking the risk at group level. If the volatility risk is reduced at the operating unit level by the captive offering budgetary protection, it hasn’t been reduced one bit at the group level. But the point is that captive owners are supposed to be willing to take risks. That’s what they do in their commercial undertakings. Some of these internalized systems are very sophisticated, and take the place of the missing reinsurance for the captive. Providers of name, fame, and underwriting We all hear frequent mentions of the “soft” reason for reinsurance, which is that reinsurers provide name recognition for captive owners seeking to gain acceptance from domicile regulators and fronting companies. There is also mention of their underwriting knowledge and information that is somehow “available” to captive owners and their brokers. I have had to discard this information argument after a number of futile attempts to make “available” reinsurance data apply to a particular captive insurance programme. But I recognize the vice-like grip the regulators and fronting companies have on captive owners, by insisting that no captive programme is valid without recognized “name” reinsurers protecting the captive. There is a dark side to this, of course. Somewhat reluctantly, I am obliged to recall that reinsurers, even “name” reinsurers, also suffer reversals of fortune and rating downgrades. Reinsurers have been known to refuse to recognize difficult claims from captive ceding companies as well. That name, fame and underwriting prowess comes with its uncertainties and price, as well. Hugh’s Views: So, if reinsurance isn’t going to provide the capacity captive owners want, or continues to exclude key risks; if it doesn’t offer long term contracts and aggregate stoploss, “who needs it”? A lot of captives -- but not all -- is the answer. Can't get enough of Hugh's oft-irreverent views? You're in luck! Follow this link to all of Hugh's pearls of wisdom:
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! Visit Hugh's Captive Consulting and Music Websites
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