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Hugh's Views Issue 15 -- October 30, 2007
In my long experience with captive insurance companies I have come to see how their solutions to basic insurance problems can be of interest to all of you in the insurance business. One of the most difficult problems for captive insurance companies is the problem of premium allocation to the different participating companies, divisions, or (in the case of a group-owned captive) different members. How much premium? A captive often starts out with a different premise from a commercial insurance company for determining how much premium to collect. That premise for captive owners is: how much premium do we have to collect for the risk we are retaining? A practical variant is “how much premium do we have to collect to pay the reinsurers of the captive, plus the fronting companies, managers and other service providers, plus pay for the losses we are retaining”? Notice the difference: this does not start out with what is the local competition and how will we meet that competitor’s rate? The commercial insurance premise is that the rate has to be at or near market rates. Commercial insurers only figure out how much they have collected after the fact. Captive insurers have much better idea how much they are going to collect from the outset. Elements of importance: Captive managers then work up ways of allocating to the participating entities the total estimated premium needed as a function of these elements, in this order of importance:
It is worth noting how different this order of priority is for captive insurance programs than for commercial insurance. It is also unsurprising that captive insurance programs must keep an eye out for transfer pricing questions from intrusive tax authorities. The one common element between the allocation process for captives and the negotiating process for commercial insurers is their having to deal with overbearing influences. Captives have to deal with their own members (often the large ones) who wield influence. Insurers have to deal with overbearing brokers (often the large ones, too!). Entitlement to profits: The other side of captive insurance premium allocation is the way the profits from the captive are equitably distributed so that those businesses that put the least strain on the captive are able to participate in its positive results. This can take the opposite form, too, where losses for the year must be distributed among all the insureds. But it is more common to find captives making an underwriting and investment income profit for the year. What is less common for most captives, but found among an enlightened few, is the prospective allocation of some of those profits to the insureds that had the best results, using pre-determined formulae, and usually spread out over 3-5 years. Some commercial insurers used to offer such participation in the profits of an individual program too, but it is no longer practiced as much as it was. Speed of adjustment: The main difference in allocation systems of captives and those of commercial insurers, of course, is the flexibility and speed with which the allocation system results in modified premiums (or profitsharing). With a small number of “customers” and a high degree of central decision-making, the owners and managers of captive insurance companies can take allocation decisions earlier, and often with more accuracy, than can their commercial counterparts. This is because the information about losses, exposures, and changes in business risks are more quickly transmitted to the insurance company (the captive), and the resulting changes in allocation can be made quicker. A captive example: One example of flexible allocation was recently encountered in a captive insurance system used by a multinational with a captive domiciled in Guernsey. It was based on a formula using 80% for losses and 20% for exposure. That is, once the initial total amount that had to be collected was estimated, then 80% of this was divided among the businesses according to their 3-year loss history, and 20% was divided among them using an exposure base, in this case total turnover. This kind of formula was also used, in somewhat modified form for the allocation of underwriting results, too. One of the divisions argued that their claims were always overstated, over-reserved, and settled out for less, which resulted in the formula penalizing them in earlier years. The manager was able to demonstrate that while this might be true, the correction for settled claims in succeeding years would result in a reduction in the heavier allocations in the future. “It was all a matter of timing”, they told me. Hugh's view of allocation systems:
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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! Visit Hugh's Captive Consulting and Music Websites
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